OCEAN CITY — News headlines relating to the municipal market — particularly in connection to Puerto Rico’s tumult and the Illinois state budget — continue to be overwhelmingly negative. Puerto Rico faces the prospect of defaulting on its $72 billion debt.
Prices for its general obligation bonds, as well as for the bonds of a number of the island’s agencies, such as the power authority, have declined sharply, dragging down the returns of the municipal high yield sector. These select issuers are likely to remain in the news over the near term, as uncertainty continues. However, spillover to the broader market should remain minimal, and we view weakness as an opportunity for muni rebalancing.
Our favorable view of municipal bonds is rooted in three factors.
First, municipal bonds continue to provide a tax benefit and, in a world where taxes are likely to move higher than lower, tax-efficient investments become more valuable.
Second, most municipalities have taken steps to reform ailing pension systems and close pension gaps. Furthermore, most municipalities continue to strengthen fiscal positions: For the first time in 28 years, total state net tax-supported debt fell by 1.2% year-over-year.
Third, on the revenue side, according to the U.S. Census Bureau, state and local tax receipts for the first quarter have increased on a year-on-year basis for the fifth consecutive year. In our view, these factors trump the headline risks of specific issuers.
Supply and demand for municipal bonds have helped drive their performance. Demand has been strong but year-to-date supply has risen from 2014. However, the issuance has been dominated by refunding activity. As a result, municipal debt outstanding is actually shrinking.
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. We continue to believe that, relative to other government fixed income securities, municipals offer attractive valuations. 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 versus 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
BofAML Global Fixed Income Strategy.
Recent spread widening in high yield municipals, which include Puerto Rican bonds, have dragged down the returns of the municipal high yield sector. While most Investors have focused on the high yield municipal sector for yield, the recent volatility in the sector has raised concerns over the concentration of Puerto Rico’s debt. Although 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 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 actively managed strategies with credit research expertise.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)