Municipal bonds, a favored fixed income asset class among high net worth investors, are experiencing strong demand this year despite the debt troubles of Puerto Rico, New Jersey and Illinois and gains that, unlike last year’s, are lagging those of Treasuries and investment grade and high yield corporate bonds.
Flows into muni bond funds topped $22 billion for the first five months of the year, and muni fund assets reached a record high of $632 billion as of June 1, according to Lipper. Demand from foreign borrowers seeking higher yields is adding to demand. Year-to-date investment grade munis have returned just over 3%, capturing most of the gains that BlackRock’s Municipal Bonds Group had been expecting for the full year.
Peter Hayes, a managing director and head of the group, said Wednesday the firm is now reassessing its outlook but expects another 1.5% return for the remainder of the year.
Despite the relatively strong performance of municipal bonds overall, however, he expects the problems of issuers like New Jersey and Illinois, which have large fixed costs for pensions but not enough revenues to pay them, will likely get worse, and general obligation bonds will suffer the most.
The GO category of muni bonds, backed by the full faith and credit of the issuer, have traditionally been considered the gold standard and safest type of issue among muni credits, but that view has been upended by the problems dating back at least to Detroit, said Hayes.
“The muni bond market is now questioning the willingness and ability to pay of some entities to pay,” said Hayes. He doesn’t expect that sentiment will abate anytime soon.
“Two things have to happen first,” said Hayes. “You have to have significant pension reform and cut benefits or you’ve got to pay for it. Many of the entities have the ability to pay for it to some degree but politically they don’t want to.”
Those politics could potentially change in some states if elections result in one party rule of the governor’s office and legislature, but in the meantime the muni market “will continue to question the GO structure,” said Hayes. And spreads in such states, which also include Pennsylvania and Connecticut, could widen further.
About Illinois which recently announced plans to borrow $550 million for capital projects, Hayes said the state should be penalized by muni market participants “in some way, by almost not giving them any access to the market….Think about it — they’re a state without a budget, they refuse to pass a budget, they have the lowest funded ratio on their pension of any state, and yet they’re going to come to market and borrow money.”
This week the focus of the muni market is again on Puerto Rico, which has already missed a few interest payments on its bonds and faces its largest one on July 1 — a $2 billion payment, 40% of which is on GO bonds.
Hayes said another missed payment by Puerto Rico may not have an immediate dramatic impact on the market because many buyers have already unloaded their Puerto Rican bonds and much of the news is already discounted in the market. Still, he said a missed payment of such proportions could reduce overall demand for munis.
Hayes supports the bill in Congress that would create an oversight board for the territory and forestall litigation by bondholders. A vote is expected to this week.
Asked about what types of munis make the most sense for individual investors now, Hayes said “the best value” continues to be on the revenue side. He favors A-rated revenue bonds used to finance transportation, health care, airports and well-established toll roads.
On the GO side of the market, he likes top credits like Georgia but noted that there’s not many such offerings.
Advisors who want some basic information about the muni market can now access a new database from SIFMA focused on the annual activity of capital markets in individual states. It includes the dollar amount of municipal, corporate bond and equity issuance; the number of financial advisors, BDs and investment advisory firms; and the top muni issuers and top public companies.
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