Municipal Market Update:
Where Did the Yields Go?
October 7, 2009
By Gary Gildersleeve
Partner & Fixed Income Portfolio Manager
With rates at 40-year lows, we are very cautious and continue to emphasize defensive, high- coupon securities priced to shorter calls and research-driven, short-duration securities.
Tax exempt bond yields have continued the descent they began in June (see Muni AAA yields), with rates reaching 40-year lows across the maturity spectrum. This decline has occurred despite only slight declines in US Treasury yields, which have been somewhat range bound. Much of the value available among municipal bonds earlier this year has disappeared and municipal yields- as a percentage of similar maturity US Treasury yields-are at, or near, new lows for maturities from two to seven years.
Supply and demand imbalances
The culprits for this phenomenon remain the same: insatiable demand from individual investors (especially in the form of investments into municipal bond funds) and reduced supply of tax exempt municipals due to the continuing success of the Build America Bond (BAB) program. This summer's demand was fueled by significant reinvestment demand-from maturities, bond calls, and interest payments-which exceeded new issue supply. More recently, demand has been driven by an ongoing movement of assets from tax exempt money market funds-which on average yield less than 0.10%-into higher yielding bond funds.
Yield spread compression
Yield spreads between credit ratings have compressed dramatically this quarter as investors have sought yield amid diminishing rates. This has occurred despite persistent fiscal problems for most states and many municipalities. These problems are expected to worsen once federal stimulus funds-provided to the states through the American Recovery and Reinvestment Act- are exhausted. In both fiscal 2009 and 2010, the federal stimulus funds prevented state spending from falling even further than it would have without the funds.
Continuing state fiscal problems
The fiscal challenges facing states in fiscal 2011 and 2012 stem primarily from concerns over state revenue receipts, which have plunged 17% over the past year amid the national recession. California's dilemma is temporarily off the front pages but states in all parts of the country will continue to make headlines as they grapple with these issues. There will continue to be select opportunities in bonds issued by states with resilient economies and administrative skills. However, we will continue to emphasize mid- to upper-investment grade revenue bonds with stable and predictable revenue streams.
Looking ahead
Where to from here? Inflation does not appear to be a near term concern and Federal Reserve Chairman Ben Bernanke has gone on record that rates will remain low for an extended period of time. Money market yields, as a result, will continue to be anemic and spur individuals to carry on their search for higher yields. Simultaneously, new tax exempt municipal issuance will be constrained unless the refinancing of higher yielding issues picks up (creating more PreRefunded and Escrowed-to-Maturity bonds) and offsets the impact of BABs. This supply/demand imbalance in the tax exempt market appears poised to continue through year-end.
Nevertheless, tax exempt yields are hovering near all time lows. Should US Treasury market yields rise (as they did in March and June), municipal yields can be expected to follow. Why might US Treasury yields climb? The primary reasons include dollar concerns, ongoing US Treasury supply, federal deficit/budget concerns, unexpected strength in the economy, or comments from the Fed about raising rates.
Our portfolio positioning
Thus, we are very cautious on the tax exempt market and remain extremely selective in our purchases. We are focused on investments in defensive, high-coupon securities priced to shorter calls and research-driven, short-duration securities to pick up yield. Additionally, we recommend geographic diversification, even for investors residing in high income tax states. This is because the fiscal problems of certain states have unfairly tainted all of their issuers, providing higher yields and opportunity for credits whose finances are independent of their respective state's problems. The higher yields provided by various out-of-state issues in this low rate environment more than offset the additional state income taxes accrued, while further diversifying portfolio risk from the continuing headwinds facing municipal finances.
Gary Gildersleeve joined Evercore Wealth Management as a founding partner in 2008 with over 33 years of experience in managing fixed income investment strategies for high-net-worth individuals.
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