Municipal Bond Commentary
The Squeeze on Muni Supply Continues
Build America Bonds continue to be the primary driver of municipal bond returns. As you know, municipali-ties are able to issue tax-free bonds at a lower yield due to their tax exemption. The Build American Bonds program now allows municipalities the additional opportunity to issue taxable securities, with a portion of the interest expense (35%) subsidized by the federal government. Municipalities’ new preference to issue taxable bonds has created a shortage of tax-free bonds, which is positively impacting the value of existing tax free securities. As a result, Oakwood municipal bond clients enjoyed solid positive returns in 2009.
While the potential extension or expansion of the Build America Bonds program remains an open question for now, it has bolstered tax-free prices, which is helping to offset a recent decline in Treasury prices. As a result, the benchmark yield ratio of the highest quality tax-free bonds to their taxable Treasury counterparts has declined, to a more normalized 86% in the 10-year maturities. We expect this trend to continue, due to both the constrained supply of tax-exempt bonds, and the higher tax bracket investor’s demand for secure tax-free income. This is especially true as the Bush-era tax cuts are scheduled to end in 2010, raising the top federal income tax rate back to 39.6%.
As noted in the taxable bond commentary, the US economy appears to be on the mend. This does not however mean that quality levels throughout all municipal bond sectors will improve. Many states, including California and Nevada, are plagued with the worst housing slump since the Great Depression. Arizona, one of the states hardest hit by home mortgage foreclosures, recently suffered a Moody’s ratings downgrade, to A1, from Aa3. Others states’ revenues that climbed by double digits in 2006, have plunged at a record pace. During this difficult period, our approach has been to avoid all purchases rated single A or below and to shun all state-level California debt.
As the economy continues to rebound, most state and local coffers will slowly improve and this will trigger our reinvestment into single-A-rated bonds. Because of our current higher portfolio quality, this change in strategy will result in a substantial yield pickup. Before we implement the shift, we need to see further proof of sustained economic growth. However, regardless of the recovery’s timing, because debt growth at state level in California is chronic and inadequately constrained, we will continue to avoid all state-level California debt.
We recently began a strategy of using callable bonds in the intermediate-maturity area. In the past, we restricted callable investments to longer maturities, where ten years of call protection is the norm. By using callable bonds with a more narrow 1-2 years of call to maturity separation, we can add generous yield while still limiting risk to principal. When this strategy is combined with longer term investments, clients capture generous yield and added cash flow from coupon payments. The chart shows the benefit of extending maturities. We note that the yield curve has not been this steep since 1995.
Tax-exempt investors continue to reap the benefits that municipal bonds have to offer. Demand should remain strong in 2010 as the prospects of rising taxes and constrained supply continue to dominate market conditions.
