Is the muni bond apocalypse here?
Municipal bond prices have tumbled this month after a yearlong rally, raising fears that the tide has finally turned in the debt markets.
Some funds that buy tax-exempt muni bonds have dropped as much as 8% in just two weeks. Funds that regularly traded at a modest premium to net asset value lately fetch a sizable discount. The rout has unfolded even as inflation, unemployment and economic growth data changed little.
“This has all the makings of a rate panic,” said Tom Graff, a member of the fixed income team at Brown Advisory in Baltimore. “Retail investors are panicking because suddenly they think interest rates are moving much higher.”
But Graff and other bond investors say this selloff isn't the big one. They say the dynamics that pushed up tax-exempt bond prices for most of 2010 – such as recovering household savings, bond demand fattened by Fed buying and the prospect of higher taxes in the future -- will likely reassert themselves in coming months.
“We’re in there buying with both hands,” said John Mousseau, a muni portfolio manager at Cumberland Advisors in Vineland, N.J. “My only regret is we don’t have more chances to buy at these prices.”
Even so, it's not clear the muni market's problems are over. Dozens of issuers are lining up to sell tax-exempt and taxable bonds, amid uncertainty over the fate of the federally subsidized, taxable Build America Bonds program that is set to expire at year-end. That crush, along with continued jitters about aggressive Federal Reserve policy, may make it costlier for cash-strapped governments to raise money.
California, for instance, is aiming to sell some $4 billion of taxable and tax-exempt general obligation bonds starting Friday, at higher rates than it would have paid just last month.
“The calendar has gotten so immense that it has put trepidation into the buyers and the underwriters,” said Burt Mulford, a municipal portfolio manager at Eagle Asset Management in St. Petersburg , Fla.
For evidence of that trepidation, Graff points to the action in closed-end municipal bond funds. As a group their shares were trading at about a 1% premium to their net asset value on Nov. 5.
But the selloff in the two intervening weeks has left the group at a 5% discount to its collective net asset value. Among the big decliners are funds such as the Nuveen Premium Income Municipal fund, whose price has dropped 7% in two weeks (see chart, right), leaving it trading at a 3% discount to its asset value.
Mulford notes that "clients have been calling in a lot all the sudden" after months of quietly collecting surprisingly strong returns. Indeed, even after the recent plunge, the Nuveen fund remains up 1.5% for the year.
But shocked by the shift, many investors suddenly are fleeing munis at any cost, Graff said.
“Right or wrong, that is a panic,” Graff said.
Graff says the biggest driver is the turnaround in Treasury yields. They spent most of the past seven months in free fall before swinging higher in the first week of November (see right), following the Federal Reserve’s announcement it would buy even more Treasury bonds to prop up the economy.
The yield on the 10-year Treasury note closed as low as 2.53% on Nov. 4 before jumping to a recent 2.9%. Rising yields on the benchmark Treasury bonds tend to push up yields, and reduce prices, on all sorts of bonds, and munis are no exception.
There are also technical factors, such as a Standard & Poor’s downgrade last week of tobacco bonds widely held by high-yield muni funds, Graff said.
And then there is plain old fear, which has reasserted itself this month after about six months on the sidelines following the last European funding crisis. Mulford said he believes the near meltdown in Irish bond markets has exerted only a minimal influence on munis, because muni bonds are typically purchased by buy-and-hold retail investors.
“We don’t have a lot of hot money in here,” he said. Still, he adds, investors can’t help but note the reports of defaults on certain small muni deals -- even though those haven’t come on what he describes as the bread and butter of the muni markets, high-grade bonds sold by states and local school boards, for instance.
So is now the time to jump in and buy high-quality muni bonds? Mousseau says yes, arguing the sector is the “cheapest that tax-free bonds have been in over a year.”
But Graff says retail investors would do well to wait before the selloff plays out to start buying municipal bonds again. After all, few would have expected to see prices run up as they did, so it is not exactly shocking that no one can figure out exactly how far the decline may go before it bottoms out.
“I’m not worried that the big move up in interest rates is here yet,” said Graff. “But I would wait till the momentum turns rather than try to be a hero and step in now.”