State and municipal budgets are running historic deficits, and from the steady diet of less than appetizing economic news, are unlikely to rebound anytime soon. What does it mean for yield in the municipal bond market, a sector that’s seen dramatic change in the past few years? We asked Robert Bigelow, vice president and director of tax-exempt fixed income strategies of HighMark Capital Management Inc.
There have been dramatic changes to the municipal market over the last several years. What new challenges are municipal investors facing?
The most significant has been the demise of the bond insurers. The penetration of the bond insurance market had been growing since the 1980s, peeking at about 50% of annual issuance, before falling to its current level of well below 10%. This Maginot Line had created a false sense of security for bond holders, while commoditizing the market. A prime example of this is to look at the spread between the 10-yr. AAA G.O. vs. the 10-yr. Insured Certificate of Participation (COP). In February 2008 that spread was 9 basis points, and as of the end of August 2010 this spread had increased to 148 basis points. Investors are now looking through to the underlying issuers’ credit.
What structural changes do you see in the municipal market?
The biggest is the advent of the “Build America Bonds.” The American Recovery and Reinvestment Act means municipalities can issue debit in either tax-exempt form, or taxable with 35% of their interest expense rebated from the U.S. government. Since the taxable market is so much larger, this allows municipalities to access a much larger pool of investors that would not benefit from a tax-exempt bond. This increase in aggregate demand has shifted about 30% of issuance in 2010 from tax-exempt to taxable, lowering net interest costs for municipal borrowers.
The ability to issue BABs under the Act is set to sunset December 31, but it has been so successful it is likely to be extended, albeit at a lower federal subsidy rate.
Where should an investor be positioned on the yield curve?
That depends on your interest rate outlook. We run a “managed ladder,” whereby we have a core laddered maturity structure, while augmenting it on the margin depending on our interest rate outlook.
The yield curve, although recently flattened some, is still exceptionally steep. So the cost of being in cash is extremely expensive, but the alternative of being long duration at these current low rates with the specter of the Fed raising interest rates in the future could be equally painful.
In the period of 1993-1994 the Fed lowered the Fed Funds rate to 3%, and as the Fed unwound this, there was a parallel shift up in the yield curve, causing long dated maturities to suffer the most. In comparison, the period of 2003-2005 had the Fed lower the Fed Funds rate to 1% before unwinding it leading to a flattening of the yield curve, with short rates rising dramatically, while long rates actually declined slightly.
This time, when the Fed increases interest rates both short and long rates will rise, with short rates rising a greater amount in basis points, leading to a flattening of the yield curve. Due to this we have been augmenting our tax exempt funds on the margin in a barbell to complement the core ladder. We like premium structured bonds on the long end to provide protection against a rate rising environment, and callable “cushion” structured bonds for the same reason, and they provide the ability to increase yield.