The municipal bond market hasn’t had it easy this summer. A spate of adverse developments has led to growing worries about the potential risks of munis in recent weeks, including:
- Rising yields for U.S. Treasuries, which is a headwind to the rate-sensitive muni market
- The decision by three California cities to file for bankruptcy in the past two months
- Warren Buffett’s decision to sell his entire $8.25 billion position in municipals (acquired through credit default swaps) five years ahead of schedule, a possible indication that one of the world’s most legendary investors may no longer see a favorable balance of risk and reward in the sector
- A report from Fitch Ratings that rating downgrades are likely to outpace upgrades amid rising fiscal stress for state and local governments
- A report by the New York Federal Reserve Bank that municipal defaults are much higher than reported. The New York Fed tallied defaults among unrated bonds, which are counted separately from those rated by the major credit agencies. The report was widely derided as being a statement of the obvious, but it served to create still another source of negative headlines for municipals
In addition, there have been ongoing rumblings of concern that the rules will change regarding municipal bonds’ tax exemption following the election. This speculation hasn’t been limited to the realm of a victory by Barack Obama, as the perilous state of government finances has also led to discussion of whether the exemption would be watered down under a Romney administration.
While an attack on the $3.7 trillion municipal bond market is an unlikely development no matter who occupies the Oval Office, it could become more of an issue in the remaining months between now and the election.
With all of this bad news, municipal bonds probably have plunged in price, right? Not exactly. Since July 1, the largest muni ETF, iShares S&P National Municipal Bond Index Fund (NYSEARCA:MUB), has gained 1.8%. In the same period, the Market Vectors High Yield Municipal Index ETF (NYSEARCA:HYD) — which invests in lower-rated, higher-risk securities and should, in theory, be derailed by credit concerns — has returned 2.1%, outperforming the higher-quality MUB portfolio.
This tells you all you need to know: In the low-rate environment created by the Fed’s financial repression, investors continue to search for yield regardless of the risks. This “damn the torpedoes” mentality is reflected in the heavy demand for munis: according to Barron’s , municipal bond funds and ETFs have seen inflows of investor cash for 18 straight weeks, and 35 of the past 36. At the same time, the supply of new municipal securities (as opposed to refinancing-related issuance) coming to the market has been relatively light.
There are also important fundamental factors supporting municipals. Most notably, the tax-equivalent yields on municipal bonds (relative to Treasuries) have fallen, but they are well above historical averages. In addition, the historical default rate for rated municipal bonds is minuscule — a fact that’s unlikely to change despite the rising concerns about the muni market.
Still, a measure of caution is in order given that the rally in munis is now into its 18th month. Municipal bonds have absorbed the hits for now, but a market that’s so heavily supported by investment flows is extremely vulnerable to a shift in sentiment.
So when will it be time to worry? A look at the charts may provide a clue.
MUB, trading at $111.05 at the time of this writing, has established lower trendlines and a 200-day moving average that are all sitting in the $110 range. A sustained break below one or both of these levels would be a strong indication that inflows are waning. Similarly, HYD — at $32.67 — is also close to its lower support line at $32.50.
Technical analysis and municipal bonds don’t often appear in the same breath, but given the importance of supply-and-demand factors, this is a case where chart-watching could be an important indicator of market health.
The bottom line: Muni investors can continue to enjoy the ride for now, but this is no time for complacency. Keep an eye on the headlines, and watch the charts closely for indications that a shift in sentiment is underway.
