Municipal Bond Market Remains A Worthwhile Risk

OCEAN CITY — The decline in U.S. Treasury yields this year has made it more difficult to find value in U.S. government bonds. The search for value and yield has become more challenging and driven investors into alternate fixed income asset classes.

Yet, the municipal bond market is one area within fixed income where we feel investors are still sufficiently compensated for the risks they are being asked to take, especially after adjustment for taxes. Furthermore, like U.S. Treasuries, municipals can provide diversification for equity heavy portfolios.

One of the strongest factors supporting our view is the general strength of fiscal revenues and the attractive relative valuation of municipals, despite the widely publicized challenges facing jurisdictions like Puerto Rico and Detroit. While they highlight that the risks of investing in municipal securities are not to be ignored, the problems relating to those securities developed over time and were well-documented.

Through May, municipals are one of the strongest-performing asset classes within fixed income, returning almost 6.6%. Longer duration municipals have outperformed their shorter counterparts.

Relative to other fixed income securities, we continue to believe that municipals offer an attractive relative valuation. With all the fear in the municipal market, municipal-to-Treasury yield ratios, which are commonly used to value municipals, remain above their long-term average. While the ratios have recently declined, pockets of value exist, particularly for investors with the time horizon and risk tolerance for longer maturities.

Our positive view on municipals is anchored by three additional factors. First, municipals continue to provide a tax benefit and, in a world where taxes are likely to go up, tax efficient investments become more valuable. In our view, the current levels of tax-equivalent yield offered by many municipals are attractively priced. Second, the underfunding of pensions

by many municipal bond issuers remains well-known and states and municipalities have started addressing this issue. The progress beyond the headlines is simply not being fully considered by the market.

Third, state tax revenues continue to grow and help improve fiscal balances. In our view, these factors trump the headline risk.

Supply and demand for municipal bonds have helped drive their performance; demand has been strong while supply is down about 25% compared to the same period last year. The heavy selling of municipal bonds in response to headlines since last year highlights the importance of managing liquidity risk in an investor’s portfolio. Large surges in supply could lead to prices overshooting on the downside as credit spreads widen. Recently, the high-yield segment of the municipal market has gotten a lot of attention in the press as an opportunity for income. The differences between the high-yield municipal and high-yield corporate markets are significant. Based on the BofA Merrill Lynch bond indexes, the high-yield municipal market is much smaller than the high-yield corporate market and has a lower average credit rating.

As noted by our BofA Merrill Lynch (BofAML) Global Research Fixed Income Strategist, Martin Mauro, two of the more significant risks found in the high-yield municipals are greater sensitivity to changes in interest rates and a concentration of credit risk.

While there may be select opportunities within the high-yield municipal market, the risks are greater as well, and investors should consider whether the increased volatility is in line with their risk tolerance before investing.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)