Strategy Insights. Municipal Bond Market Update. Second Quarter 2013

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1 Strategy Insights Municipal Bond Market Update Second Quarter 2013 William Black Co-Head of High-Yield Municipals Mark Paris Co-Head of High-Yield Municipals Robert Wimmel Head of Investment Grade Municipals Stephanie Larosiliere Client Portfolio Manager Highlights Concerns over rising interest rates triggered a late June market correction, significant bond sell-off and record-setting redemptions from municipal mutual funds. States continued to recover as the overall revenue picture strengthened amid tax collection season and improving house prices. Credit fundamentals are strong, however the high-profile Detroit bankruptcy filing in July poses headline risk as it continues to draw negative attention to the municipal market. Municipal bond fund redemptions compounded the effects of the summer selloff. Municipal bonds retreat after technical pressure ends an impressive streak of positive performance After nine consecutive quarters of positive performance, the municipal market experienced a soft second quarter in line with the broad fixed income market. The second quarter began with a fairly stable April, but as we moved into May that stability began to teeter when the market reacted to positive US economic data releases and comments made by Federal Reserve Chairman Ben Bernanke, indicating that the tapering of quantitative easing could begin sooner rather than later. The Barclays Municipal Bond Index posted its first negative quarterly return since Dec. 31, The Barclays Municipal Bond Index posted a total return of -2.97% in the second quarter of 2013 and -2.83% for the month of June, making it the municipal bond market s weakest month since September 2008, when the index returned -4.69%. Despite the negative quarter, on a tax-adjusted basis 1, the one-year, three-year and five-year total returns were 2.9%, 7.3% and 8.3%, respectively. 2 General obligation (GO) bonds outperformed revenue bonds during the second quarter. GOs returned -2.88%, relative to -3.19% for revenue bonds. Within the investment-grade municipal part of the market, housing and tobacco were the top performers, while industrial development revenue/ pollution control revenue (IDR/PCR), and water and sewer were the largest underperformers. The Barclays High Yield Municipal Bond Index posted a -4.08% return during the quarter. The tobacco and IDR/PCR sectors were the greatest detractors from performance, while the resource recovery, transportation and electric sectors were positive contributors to performance. On a tax-adjusted basis, 1 the one-year, three-year and five-year total returns were 9%, 10.7% and 10.9%, respectively. 2 All data as of June 30, 2013 unless otherwise noted. 1 Taxable equivalent returns: Based on an equally weighted national average federal and state (top bracket) income tax rate; local taxes have not been considered. 2 Sources: Bloomberg, Barclays Research. Based on an equally weighted national average federal and state (top bracket) income tax rate; local taxes have not been considered.

2 Issuance shows marginal growth Total municipal issuance for the second quarter was $92.4 billion, 1 an increase of 11.6% from first quarter 2013 issuance, but down nearly 20% from second quarter 2012 issuance. The bulk of the year-over-year drop in issuance occurred in June when issuers decided to postpone a variety of deals due to market volatility and higher rates. Historically, June has been the heaviest issuance month in the municipal bond market. This June, total issuance came in at $25 billion. 1 This figure is much lower than the average June issuance over the last five-year and 10-year periods, which were $41 billion and $43 billion, respectively. 1 Figure 1 Municipal Bond Issuance is Expected To Fall Below 2012 Levels US Municipal Bond Issuance Total Municipal Issuance ($ in billions) Refundings as a % of Total Issuance $ % 500 YTD Sources: SIFMA, Bond Buyer. As of June 30, 2013 Within the total issuance amount, new money issuance declined by nearly 8% to $39.7 billion 1 in the second quarter from $43 billion in the second quarter of This was below both expectations and the historical average. Year-to-date, new money issuance is essentially flat year-over-year, $70.6 billion versus $69.5 billion in The bulk of the drop in total issuance can be attributed to the slowdown in refundings. Year-overyear refunding-related supply declined 27% to $53.5 billion from $72 billion in We concur with industry reports that suggest the market will continue to see large drops in the volume of refunding-related supply as yield levels have risen. 1 Industry reports are now forecasting that total gross new issuance for 2013 will range from $330 to $350 billion, below the level seen in 2012, but still above 2011, when issuance fell to a new 10-year low. 2 Federal Reserve comments trigger a negative reaction in the municipal market What began as a moderate market correction of historically low interest rates in May ramped up in June to a mass sell-off due to the Federal Reserve s comments that appeared to indicate that the tapering of Treasury and mortgage-backed bond purchases would begin sooner rather than later. The result was a steep drop in Treasury bond prices and a sharp rise in yields, causing yields to reach levels not seen since These factors also sent municipal fund net asset values (NAVs) tumbling and shareholders reacted by redeeming at a record-setting pace. In the municipal market selling begets selling, and when fund managers sold out of bond positions at deep discounts to meet redemptions, they drove prices down, which in turn led to drops in NAVs, which led to even more redemptions. This was particularly evident in June when investors redeemed nearly $16.4 billion from municipal funds. Past performance is no guarantee of future results. 1 Source: SIFMA, Bondbuyer as of June 30, Sources: BofA Merrill Lynch, Citigroup, Barclays 2

3 Figure 2 Rise in Interest Rates Triggers Record Outflows From Municipal Funds $ in billions 1/11 2/11 3/11 4/11 5/11 6/11 7/11 8/11 9/11 10/11 11/11 12/11 1/12 2/12 3/12 4/12 5/12 6/12 7/12 8/12 9/12 10/12 11/12 12/12 1/13 2/13 3/13 4/13 5/13 6/13 10,000 5, ,000-10,000-4,369-2,576-3, ,734 2,024 3,053 4,830 6,574 6,467 3,776 2,435 5,024 3,812 5,511 5,606 4,015 4,881 5,151-3,113 7,123 2, , ,000-20,000-12,530 Source: Morningstar, as of June 30, ,367 As we saw in 2010, during the municipal bond selloff triggered by unsubstantiated comments in the media regarding fundamentals in the municipal market, once flows go sharply negative, they tend to pull the entire market down. The result is a negative feedback loop that magnifies the downturn and causes the market to oversell, typically lagging the rebound in Treasuries. This is precisely what happened in the second quarter shareholders redeemed $18.9 billion from municipal bond funds, wiping out all of the first quarter s positive net inflow and bringing the year-todate net flow to -$9.8 billion. 1 High yield municipal funds were hit the hardest during the quarter. Investors pulled $4.8 billion out of the $66 billion high yield municipal fund market. Intermediate-term and long-term municipal bond funds experienced similar outflows, with investors redeeming $3.8 billion and $3.5 billion, respectively. 1 From a fundamental perspective, municipal credits may be in the best shape they have ever been and as a result of the sell-off, absolute valuations have improved and the municipal-to-treasury yield ratio 2 appears to be increasingly more attractive. We believe that the correction has restored value to the market, which should attract crossover buyers. In our view, the current environment represents an opportunity to begin rebuilding the income-generating and total return capacity of municipal portfolios. Municipal defaults are not on the rise despite headline-grabbing bankruptcies Municipal defaults continue to be a rare occurrence. Municipal bonds in monetary default represented 1.27% of the total year-to-date municipal bond issuance and 0.059% of total outstanding municipal securities as of June 26, The number of Chapter 9 bankruptcy protection filings is on pace to be less than Through July 18 of this year there have been four Chapter 9 bankruptcy protection filings (Figure 3): the Sanitary and Improvement District No. 494 of Douglas County, Neb., which declared on May 24; Hardeman County Hospital District, which filed a Chapter 9 bankruptcy petition on March 21; Pauls Valley Hospital Authority, which declared on March 1; and the city of Detroit, which filed for Chapter 9 protection July Past performance is no guarantee of future results. 1 Source: Morningstar 2 A ratio used to assess the relative cheapness or richness based on yield of a AAA-rated municipal bonds relative to the yield on a US Treasury bond of similar maturity. 3 PACER; BofA Merrill Lynch Global Research. As of July 18, 2013 Strategy Insights: Municipal Bond Market Update 3

4 Figure Chapter 9 Filings on Pace to be the Lowest in Three Years Chapter 9 Filings by Year YTD Sources: PACER; BofA Merrill Lynch Global Research. As of July 18, 2013 More on Detroit Detroit filed for bankruptcy on July 18, making it the largest municipality to ever file for bankruptcy, and the first time that a state s largest city has ever filed. While this is a historic event, it definitely was not unexpected; in fact Detroit s finances have been on a declining trend for more than 50 years. In mid-june, Kevyn Orr, Detroit s emergency manager, said that he would try to negotiate with creditors for about a month before making the decision to file for bankruptcy. His debt-restructuring plan included an unpalatable offer amounting to less than 10 cents on the dollar on some of the city s unfinanced debt obligations, such as unsecured bonds and a portion of unfunded pension liabilities, which together total more than $11 billion. It was no surprise that the offer was less than cordially received by creditors. In fact, many market participants opined that a bankruptcy battle, which could possibly result in a more equitable solution from an impartial bankruptcy judge, would be preferable to accepting the city s pre-bankruptcy restructuring plan. We view this filing as an outlier from broader municipal credit trends. While we do not expect any near-term systemic market impact beyond Detroit, this event does reinforce our preference for remaining underweight general obligation debt and focusing on investing in essential service and project revenue credits. The reality is municipal bankruptcies are few and far between Municipal bankruptcies are rare. For example, of the 55,000 municipal governments in the United States that sell bonds, 276 have filed for bankruptcy protection since 1980 and only 58 have filed since Most of those filings were by special districts, not cities. Nebraska leads all states in municipal bankruptcy cases, with 55 since 1980, but those were special tax districts, not local governments. In 2013, Detroit filed the largest municipal bankruptcy in US history. In 2011, Jefferson County, AL, filed the largest county bankruptcy in US history at $4.2 billion. In 2012, Stockton, CA, became the largest city to file for Chapter 9 until Detroit. Before Jefferson County, the record for the largest Chapter 9 filing by population had been held for 17 years by Orange County, CA. 1 State revenue recovery continues, led by substantial tax increases in California States continued to increase their overall tax collection amounts in the first quarter of 2013, posting a 9.3% increase year-over-year. 2 The growth was driven by a number of factors, including taxpayer actions to accelerate income into calendar year 2012 to avoid higher federal income tax rates, the slow but continuing improvement in the US economy, and the impact of large tax increases in California. The first quarter results are the most recent statistics available on state tax collections. The first-quarter performance marked the 13th consecutive quarter that state tax revenues have increased. It also marked the strongest quarterly growth in personal income tax collections since the start of the Great Recession. Before the current streak, states saw five straight quarters of a decline in collections immediately following the recession. 1 Source: The PEW Charitable Trusts, The State Role in Local Government Financial Distress, July Source: The Nelson A. Rockefeller Institute of Government, as of June 5,

5 The first-quarter growth in overall tax collections was primarily driven by an increase in personal income tax collections. Personal income tax collections increased by 17.6% during the first quarter, primarily driven by tax increases in California that produced an additional $6.2 billion in income tax collections. The intensified pace at which the housing market has been recovering in recent months has been supportive of the continued economic recovery at the state and local levels. Historically, property tax collections have accounted for over 65% of local tax collections, and as home prices improve, local governments reap the benefit. According to S&P/Case-Shiller, average home prices increased by 11.6% on its 10-city composite and 12.1% for the 20-city composite in the 12 months ending April For four consecutive months, positive year-over-year growth has been observed in all 20 cities included in both composites. This data is evidence that the recovery in the housing market is broad-based. California is seeing impressive home price increases, with gains ranging from 3.4% to 4.9%. Los Angeles, San Diego and San Francisco posted their highest gains since 2004, 1988 and 1987, respectively. While the fiscal recovery at the state level appears to be headed in the right direction, the improvement has been much slower and more prolonged than in previous downturns. In conclusion We believe that despite hitting a rough patch this June, from a fundamental perspective, municipal credits may be in the best shape they have ever been. While the sell-off was difficult to endure, it did result in the improvement of absolute valuations and an increasingly more attractive municipalto-treasury yield ratio. 1 We believe that the correction has restored value to the market, which should attract crossover buyers for the remainder of the year. We also believe that as a result of the substantial 2013 income tax increases, on an after-tax basis, the income earned this year from a municipal bond will be more valuable than it was last year. It is our view that the current environment represents an opportunity to begin rebuilding the income-generating and total return capacity of municipal portfolios. Where are the opportunities in a rising rate environment? When rates rise, lower-quality bonds have tended to fare better than their high-quality counterparts. Unlike higher-quality bonds, lower-quality bonds tend to be more sensitive to credit risk and less sensitive to interest rate risk. These bonds tend to benefit from an improving economy. As a result, an environment of growth and stable interest rate rises may lead to the outperformance of noninvestment-grade credits relative to Treasuries and other high quality sectors of the market. For investors who prefer high-quality investments, they can seek to reduce their exposure to interest rate risk and price volatility by concentrating on short- and intermediate-term municipal bonds. Bonds in these parts of the municipal yield curve have lower average maturities and durations and have tended to have lower price volatility than long-term bonds. The case for intermediate-term bonds Shorter maturities may make intermediate-term municipal bonds less sensitive to movements in interest rates than long-term bonds. Given the current steepness of the municipal yield curve, they are well-positioned for price appreciation. Their positioning may provide attractive risk-reward trade off as well as price appreciation potential through the effects of roll down. 2 With the Fed stating its intent to keep rates low until 2015, the roll-down effect may be a benefit to the performance of municipal bonds in the intermediate part of the curve over this period. Intermediate bonds have typically yielded less than longer bonds, but when held, the bond s market price tends to rise (to a point) as it rolls down the steepest portion of the curve. Also, they have had considerably less volatility than long municipal bonds. For example, as of June 30, 2013, AAA-rated general obligation bonds with 15 years to maturity picked up nearly 85% of the yield of 30-year bonds with 50% of the maturity. (Figure 4) 1 A ratio used to assess the relative cheapness or richness based on yield of a AAA-rated municipal bonds relative to the yield on a US Treasury bond of similar maturity. 2 Roll down refers to the price appreciation a bond experiences as it rolls down the yield curve toward maturity and approaches the steepest part of the curve where the market demands lower yields. As a result, a bond paying a constant coupon greater than what the market is currently pricing in will see its price increase. Strategy Insights: Municipal Bond Market Update 5

6 Figure 4 Intermediate-Term Municipal Bonds May Experience Price Appreciation as They Get Close to Maturity AAA General Obligation Yield Curve Yield (%) Maturity Year Rolling down the yield curve = price appreciation Shorter bonds typically yield less than longer bonds as you hold a bond its market value rises (to a point) as it rolls down the curve As a bond rolls down the curve, toward maturity, it approaches the steepest part of the curve, where the market demands lower yields (e.g. 26 basis points (bps) roll down from 9 to 8 years and 25 bps from 8 to 7 years). Therefore a bond paying a constant coupon greater than what the market is currently pricing in will see its price increase Source: Thomson Municipal Market Data (MMD) as of June 30, Past performance is not a guarantee of future results. A basis point is the movement of interest rates or yields expressed in hundredths of a point. One basis point is equal to 1/100th of 1%. Ratings allocations are based upon ratings assigned by Standard & Poor s. A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. For more information on Standard and Poor s rating methodology, please visit standardandpoors.com and select Understanding Ratings under Rating Resources on the home page. The case for high yield municipal bonds High yield municipal bonds are trading at historically wide spreads versus investment-grade municipal bonds, and absolute yields on these bonds are relatively high. Credit fundamentals continue to remain strong, and default rates have continued their downward trend. The protracted low rate market environment coupled with existing wide spreads in the A and BBB credits may be advantageous for those seeking yield. As of June 30, 2013, high yield municipal credit spreads were at 325 basis points versus their historical average of 284 basis points, signaling that opportunities continue to exist in the high yield municipal market as shown in Figure 5. Absolute yields for high yield municipals are over 300 basis points higher than that of their investment-grade counterparts. It s important to note that high yield bonds are subject to greater risk than investment-grade securities. Figure 5 High Yield Municipal Spreads Remain Wide Relative to Their Historic Average June 1997 to June 2013 Spread between Investment Grade Municipals and High Yield Municipals Spread in basis points (bp) Average spread 700 6/97 6/99 6/01 6/03 6/05 6/07 6/09 6/11 6/13 Minimum Spread: 113 bps Average Spread: 284 bps Standard Deviation of Spread: 111 bps Maximum Spread: 636 bps 6/30/13 Spread: 325 bps Past performance is no guarantee of future results. Source: Barclays. The graph illustrates the spreads between the Barclays High Yield Municipal Bond Index and Barclays Municipal Bond Index. It is not possible to invest directly in an index. Spread: The difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another. Standard Deviation: A measure of risk that represents the degree to which an investment s performance has varied from its average performance over a particular period. The higher the number, the greater the risk. 6

7 The case for single-state municipal bonds: double tax exemption Single-state municipal bonds are issued by a specific state and/or its local governments. The income from these bonds is generally exempt from federal and state taxes in the issuing state. Those who invest in single-state municipal bonds in the state of their residence may benefit from double tax exemption on their income. Single-state bonds are especially attractive in states such as California and New York, where the total effective income tax rates are some of the highest in the nation (Figure 6). 1 Figure 6 Total 10 Top Effective Rates by State 1 Tax Year 2013 (%) California Vermont New York City Maryland Hawaii New York State New Jersey Maine District of Columbia Minnesota Source: Fidelity Capital Markets as of March Municipal market outlook and positioning Following a technically-driven selloff at quarter end, we believe high yield municipal spreads again have some room to further contract, as forward-looking high yield municipal bond supply remains light and the municipal/treasury yield ratio continues to become increasingly more attractive. We expect the recent rise in interest rates to be constructive in rebuilding the distribution yields for all of the Invesco municipal funds. Since the interest rate rise our portfolio managers have been have been able to invest in yields that are materially higher than where they were during the first quarter of On Jan. 1, 2013, 13 substantial tax increases went into effect, including a 3.8% surtax on investment income. Interest income from municipal bonds is exempt from this increase. As a result, on an after-tax basis, the income earned this year from a municipal bond will be more valuable than it was last year. Figure 7 Provisions That Took Effect for 2013 Under the American Taxpayer Relief Act Provision Rates and amounts in effect for 2012 Rates and amounts in effect for 2013 Ordinary income tax rates (%) Capital gains top rate (%) Dividends top rate (%) Personal exemption phaseout (PEP) and itemized deductions limitation (Pease) Repeal of PEP and Pease limitations in place Restored for single and joint filers with AGI above $250,000 and $300,000, respectively (thresholds indexed for inflation) Top rate: 40.0% Exemption: $5 million (indexed for inflation) $50,600, indexed for inflation (single filers) $78,750, indexed for inflation (joint filers) Estate and gift taxes Top rate: 35.0% Exemption: $5 million (indexed for inflation) AMT exemption $33,750 (single filers) $45,000 (married filers) Net investment Income Tax 0.0% 3.8% 2 (Patient Protection and Affordable Care Act of 2010) Source: Deloitte. As of Jan. 2, The total effective marginal rate for the top state tax bracket by taking into account the new federal rates effective Jan. 1, 2013 under the American Taxpayer Relief Act of The federal rate includes the 3.8% tax on investment income enacted as part of the Patient Protection and Affordable Care Act of 2010; the state rate excludes all state tax changes effective Jan. 1, Investment income earning from municipals is exempt. Strategy Insights: Municipal Bond Market Update 7

8 We continue to monitor the macro economy for headline risk and external shocks that may impact the broad fixed income market and the municipal market in particular. General uncertainty and market volatility can potentially create buying opportunities and opportunities to sell declining credits with lower coupons. Overall credit concerns in the municipal market have continued to diminish as the fiscal picture at the state and local government levels has improved. We continue to actively monitor the market for deteriorating credits. We believe that municipal bankruptcies are not a systematic phenomenon, but rather that they are idiosyncratic occurrences that will likely remain isolated in the foreseeable future. Tax advantages of municipal bonds 1 Municipals bonds offer investors tax-exempt income, meaning the interest income payments from municipal bonds is exempt from federal income taxes and may also be exempt from state income taxes. In some circumstances, investors may also be exempt from local taxes. With expectations of continued low rates, municipal bonds may offer investors the opportunity to benefit from monthly tax-exempt income at attractive yields. Invesco s municipal capabilities In this environment, we continue to emphasize the importance of bottom-up fundamental credit analysis. At Invesco, we have a staff of 30 municipal investment professionals with an average of over 20 years of experience continuously monitoring our portfolios. Our staff includes nine portfolio managers and 16 municipal credit analysts dedicated to reviewing and rating each and every credit we hold. Team members are located in five locations around the US, allowing flexibility for due diligence and site visits. About risk Municipal securities are subject to the risk that litigation, legislation or other political events, local business or economic conditions or the bankruptcy of the issuer could have a significant effect on an issuer s ability to make payments of principal and/or interest. Municipal securities can be significantly affected by political changes as well as uncertainties in the municipal market related to taxation, legislative changes or the rights of municipal security holders. Because many securities are issued to finance similar projects, especially those relating to education, health care, transportation and utilities, conditions in those sectors can affect the overall municipal market. In addition, changes in the financial condition of an individual municipal insurer can affect the overall municipal market. Credit risk is the risk of loss on an investment due to the deterioration of an issuer s financial health. Such a deterioration of financial health may result in a reduction of the credit rating of the issuer s securities and may lead to the issuer s inability to honor its contractual obligations, including making timely payment of interest and principal. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. Lower rated securities may be more susceptible to real or perceived adverse economic and competitive industry conditions, and the secondary markets in which lower rated securities are traded may be less liquid than higher grade securities. Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest. Not all strategies are available to all investors. Contact your financial adviser for more details. 1 Income exempt from regular federal income tax may be subject to US federal alternative minimum tax as well as state and local taxes. For US USe Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their advisors for a prospectus/summary prospectus or visit invesco.com/fundprospectus. The opinions expressed are those of the portfolio managers, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. The Barclays Municipal Bond Index is an unmanaged index considered representative of the tax-exempt bond market. The Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds. An investment cannot be made directly in an index. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. Client portfolio managers (CPMs) are integrated with Invesco s investment teams and involved in the ongoing research matters of their respective team s portfolios. The primary responsibilities of the CPM are to represent the portfolios in the marketplace and to manage the business responsibilities of the investment team. The CPM does not manage fund assets Morningstar, Inc. All rights reserved. The information contained herein is proprietary to Morningstar and/or its content providers. It may not be copied or distributed and is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. invesco.com/us MUNIMKT-INSI-1 08/13 Invesco Distributors, Inc