Investors Questioning Relative Value In Bond Market

OCEAN CITY — The decline of the yield on the 10-year Treasury bond to as low as 2.1% from 3.0% at the beginning of the year has left fixed income investors wondering whether there is any value remaining in bond land. The search for value and yield has become more challenging and driven investors into alternate kinds of fixed income investments.

The municipal bond market is one part of the fixed income world 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 portfolios that are heavy on equities.

We believe it is unwise to view the distressed situations in Detroit and Puerto Rico as representative of the entire municipal bond market. While they show 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.

Our view of municipal bonds is rooted in three 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. Municipal bond coupon payments are exempt from federal taxes. Second, while fiscal issues in some municipalities remain problematic, most have taken steps to reform ailing pension systems and close pension gaps. Third, on the revenue side, sales tax receipts continue to grow at a healthy clip, though personal income tax receipts remain stagnant.

Supply and demand for municipal bonds have helped drive their performance. Demand has been strong while supply is down about 5% compared to the same period last year. The heavy selling of municipal bonds in 2013 in response to situations like those in Detroit and Puerto Rico highlights a significant risk — large surges in supply could lead to prices overshooting on the downside. We believe an active manager with a seasoned research team is best positioned to manage and potentially take advantage of these supply and demand mismatches, whether the cause is negative news stories, interest rate concerns or a credit event.

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, indicating attractive relative value as compared to Treasuries. Municipals can also provide a more attractive yield than some corporate bonds of similar credit quality, providing an after-tax advantage for investors in the 28% federal income-tax bracket or higher, according to our colleagues at BofA Merrill Lynch  Global Fixed Income Strategy.

Recently the high-yield municipal sector has attracted a lot of attention from investors seeking income. While there are some opportunities in the high-yield municipal market, the risks are greater as volatility is historically higher and liquidity lower. There are differences between high-yield municipals and high-yield corporate bonds with respect to duration, interest rate sensitivity and concentration. Investors should take into account whether the increased volatility and lower liquidity are in line with their risk tolerance. Those looking to invest in high yield municipals should consider using an active manager with credit research expertise.

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