Municipal bonds 2014: Loving the unloved

Transcription

1 2014 Municipal bonds 2014: Loving the unloved James Dearborn, Head of Municipal Bonds What can we learn from 2013 that might give us some perspective on what to expect in 2014? If we wind the clock back a year and review our 2013 outlook, we will see that many of our predictions played out. Yet, our most important prediction expected returns for the year was off the mark. Our commentary correctly included cautionary comments about Puerto Rico, and anticipated a marked improvement in California s credit fortunes. We also worried about tax reform, but thought it unlikely. Finally, we were appropriately confident that supply would remain low. Unfortunately, an overly optimistic expectation that demand would be robust, given the higher top federal tax rates, was far off the mark. We expected low single-digit positive returns for the year basically a clip-the-coupon type of year. While we got the single-digits part right, we, regrettably, were wrong on the direction. Where did we err in 2013 and where do we go from here? 2013 will likely be remembered as the year of the redemption. By mid-november, municipal bond mutual fund redemptions had eclipsed $51 billion, with the string of consecutive weeks of outflows stretching back more than six months. These outflows were the worst in decades and contributed to the market s negative return (Exhibit 1). Exhibit 1: More money flowed out of municipal bond funds in 2013 than in previous years Cumulative municipal mutual fund inflows $ billion Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Source: ICI, November 2013 What caused the redemptions? The simple answer is retail investors fears: fear of rising rates, fear of contagion from the Detroit bankruptcy, fear of pension funding levels swamping municipal budgets and, fi nally, fear of distressed Puerto Rico holdings in their mutual funds. In a year in which nearly all fi xed-income classes experienced redemptions, municipal bond fund outflows were the largest. This persistent selling pushed municipal yields (considered on a taxable-equivalent basis) to nearhistorically cheap levels vs. other fixed-income products particularly investment-grade corporate bonds, Treasury securities and even, to some degree, high yield (Exhibit 2). Dec

2 Exhibit 2: Taxable-equivalent municipal yields fell to near-historically cheap levels in 2013 Attractive after-tax adjustment Municipal high yield* High yield (corp) Municipal* Corporate investment-grade U.S. Treasury Nominal yield (%) Tax-adjusted (%) Sources: Morgan Stanley Research, Bloomberg, Yield Book, Columbia Management Investment Advisers, LLC, November 2013 * Assumes 43.4% federal tax rate With 2013 redemptions as prologue for 2014, we believe that the relative cheapness of tax-exempt bonds positions them to outperform other fixed-income securities. In addition, we see an opportunity for municipal bonds to post positive, albeit modest, returns in 2014, due to: > The steepness of the municipal yield curve > Another year of anticipated low supply > A higher starting point in relative yields > An increased appetite for tax-exempt income This prediction acknowledges that the Federal Reserve (Fed) will likely end its quantitative easing (QE) and that Treasury rates should move modestly higher over the year. Admittedly, we cited some of these factors last year and incorrectly anticipated a modestly positive Why should 2014 be different? Importantly, we are starting the year at a much higher and more palatable level of interest rates than was the case at the end of In addition, we believe the fear factor will recede and that a closer focus on value, overall credit stability and the benefits of tax-exempt income will reignite investor interest. Below is a list of factors, positive and negative, that may play a role in the municipal market s performance in Rising rates We believe that Treasury rates will rise modestly in 2014 and may continue to trend upward in the years to follow as the economy grows and the Fed winds down QE. In the realm of fixed income, many investors are accustomed to thinking that if yields are expected to rise, they should abandon bonds. While rising rates are clearly detrimental to bond prices, if you are a long-term investor one who measures time in quarters and years rather than in weeks or months a period of increasing yields does not necessarily spell doom for your fixed-income investments. As an illustration, if yields increase 50 basis points per year for fi ve years (for a total increase of 250 basis points), the price of a 10-year non-callable single-a municipal bond would be expected to decline in each of those five years. However, price change is only part of the investment s total return. Each year, the bond continues to generate coupon income that will offset some, or all, of the price decline.

3 In this example, the total return in the fi rst year would be modestly positive as the coupon income exceeds the loss in value of the bond. Over the subsequent four years, the bond would be expected to decline less in value each year and the total returns (price change plus coupon) would be expected to be positive. If an investor held firm, despite having endured consecutive years of rising rates, the cumulative total return on this hypothetical bond would be in excess of +15% over the fi ve-year period. Most important for municipal bond investors is the tax-exempt nature of this coupon income, which magnifies the return potential, especially for high-tax-bracket investors. Limited supply We correctly anticipated that municipal bond supply in 2013 would decline from 2012, based on a belief that continuing fiscal austerity by state and local governments would spill over into their capital budgets. At year-end 2013, supply in the municipal market looked to finish the year at roughly $325 billion, or 14% below 2012 levels. Higher rates in the second half of the year largely brought an end to refinancing activity and were a large contributor to this diminished supply. While there is a legitimate sense that state and local governments may expand borrowing in 2014 to address unmet capital needs and deteriorating infrastructure, we believe that supply will grow only modestly in 2014, for a few reasons: > Water and sewer and local school construction are likely to drive issuance, but continuing austerity will mute overall expansion of the tax-exempt market. > Refi nancing is likely to be even lower, as higher rates will make these transactions uneconomical. > Even with the prospect of a modest increase in supply in 2014, technical conditions should be supportive as the market comes off two consecutive years of negative net supply redemptions and maturities exceeded issuance (Exhibit 3). Exhibit 3: Municipal bond supply may increase slightly in 2014 Tax-exempt bond issuance, redemption and net supply ( YTD) Billion Jan 12 Mar 12 May 12 Jul 12 Issuance Sep 12 Nov 12 Jan 13 Redemption Source: Goldman Sachs, November 2013 Tax policy changes Mar 13 May 13 Jul 13 Net supply A year ago, facing the imminent fiscal cliff, we worried that a grand bargain around tax reform and entitlement changes might put the municipal interest exemption at risk. Given the paralysis and intransigence of partisan politics, our anxiety was misplaced. Now, with conditions in Washington no better at the dawn of an election year, we believe that the prospect of broad tax changes that might affect the treatment of municipal interest income, while still possible, is remote. Moreover, we are heartened to see a more coordinated effort by numerous state and local groups to tout the benefits of municipal bonds as a key to addressing this country s aging and ailing infrastructure. Puerto Rico Puerto Rico s multi-year fiscal decline has been welldocumented and the island s bonds now trade at levels consistent with speculative grade securities. For many investors, the precipitous decline in the value of the island s bonds either in individual accounts or mutual funds caused much distress. Although recent steps by the island s administration have moderately improved its fi nancial operations, our internal rating on Puerto Rico s general obligation bonds remains below investment grade. Sep 13 Nov 13

4 The rating agencies still have an investment-grade rating on the island s debt. However, they may be forced, either by market conditions or further deterioration in the island s fi scal health, to lower the ratings. A downgrade below investment grade could jeopardize market access, thus preventing the government from financing its annual operating deficit. This potential crisis, combined with the large amounts of Puerto Rico debt held by retail and mutual fund investors, could lead to a larger systemic concern that could put downward pressure on municipal bond prices across the board. While not a foregone conclusion, especially with modest improvements in the island s fi scal health, Puerto Rico represents one of our largest areas of concern for Underfunded pensions, Illinois and Chicago We lump Illinois and Chicago in with the ongoing concerns about the unfunded status of many state and local government pension systems because they are the poster children for this problem. While many state and local governments across the country have begun to address the unfunded status of their pension systems through reforms to benefi ts, contributions and actuarial assumptions, there remains a not insignificant number who are allowing the problem to fester and worsen. While we are heartened that Illinois recently passed substantive pension reform, the state is not out of the woods yet, as state employee unions and retirees have vowed to challenge the legislation in court. Ultimately, we believe that fiscal reality and political pressure will result in reforms that will stabilize public pension systems and relieve immediate fiscal pressure on operating budgets. However, for many state and local governments, these changes may come too late to forestall further rating downgrades and higher borrowing costs. As in the past several years, it will be important for municipal credit analysts to not only evaluate the funding status of pension systems, but to also be confident that elected offi cials will have the political will to implement oftencontentious decisions that result in long-term fi scal solvency of their pension plans. Detroit bankruptcy rulings Detroit s bankruptcy filing last summer made national news and caused many retail investors to believe that Detroit was a harbinger of doom for other large post-industrialized U.S. cities. This has not turned out to be the case. Bankruptcy is a long, expensive and tortuous process where local control is vastly diminished, an outcome most wish to avoid. Our belief is that most financially struggling cities will do everything in their power to avoid bankruptcy, and many are using Detroit as a cudgel to push city councils, labor unions and other stakeholders to the bargaining table to avoid a similar fate. In the case of Detroit, we will watch closely to see how the court addresses the rights of holders of unlimited general obligation (GO) bonds. These bonds were issued after Detroit voters authorized the levy of an unlimited property tax pledge to make all principal and interest payments. Should the court invalidate the voters pledge of property tax security for these bonds, we would see that as a very negative outcome. Unlimited GO bonds have always been the gold standard in the municipal market. An adverse ruling, while legally precedent-setting only in Michigan, would create uncertainty and anxiety among municipal investors. Regardless of the outcome, we believe that thorough credit research is the key to avoiding the next Detroit and limiting the downside associated with any rulings that may be forthcoming. Fears about municipal credit overwrought Revenues and reserves trending positive Concerns about the solvency of state and local governments especially in a post-crisis era are widespread, headline-grabbing and, largely, without merit. The underlying credit picture within the municipal sector has stabilized and, in many cases, is improving. We expect this trend to continue into 2014, for a number of reasons:

5 > Aggregate state tax collections have improved for 14 consecutive quarters, signifying a slow but steadily expanding economy as well as an improving employment picture. > We anticipate that reserve balances will continue to improve in 2014 as state revenues, which recently exceeded pre-recession highs, gradually improve and spending remains in check. > At the local level, an improving residential real-estate market has resulted in higher tax receipts for four consecutive quarters. > We remain reasonably confident that governments will continue to demonstrate the willingness and ability to enact the measures necessary to preserve their financial footing and maintain adequate reserve levels. Most importantly, we anticipate that municipal bankruptcy fi lings will remain exceedingly rare and instances of municipal default will remain very low. That said, there will be outliers and we continue to caution investors to rely on experienced municipal credit analysts for help selecting bonds that offer the most attractive investment opportunities. Income from tax-exempt municipal bonds or municipal bond funds may be subject to state and local taxes, and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal income tax rules will apply to any capital gains. There are risks associated with an investment in bonds, including the effect of interest rates, credit and inflation. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities.

6 Important disclosures The views expressed are as of January 1, 2014, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor s specific fi nancial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate. Columbia Management Thought Leadership Columbia Management provides insight on markets, global and economic issues, and investor needs and trends. Our investment team examines the issues from multiple perspectives and we re not afraid to take a strong stand or point out opportunities, even when there is no clear consensus. By turning knowledge into insight, Columbia Management thought leadership can provide: > A deeper understanding of investment themes, trends and opportunities > A framework for more informed financial decision-making Access the insight, intellectual strength and practical wisdom of our experienced team. Find more white papers and commentaries in the market insights section of our website columbiamanagement.com/market-insights For more information from the authors in this book, please visit our blog blog.columbiamanagement.com Columbia Management Investment Distributors, Inc. 225 Franklin Street Boston, MA columbiamanagement.com blog.columbiamanagement.com Columbia Management Investment Advisers, LLC is a U.S. Securities and Exchange Commission registered investment adviser that offers investment products and services under the names Columbia Management Investments, Columbia Management Capital Advisers and Seligman Investments. Advisory services provided by Columbia Management Investment Advisers, LLC Columbia Management Investment Advisers, LLC. All rights reserved R1_789774