04-09-2014 02:35 PM
By John Bonnell,
Assistant Vice President of Mutual Fund Portfolios
After a not-so-great 2013, municipal bonds bounced back big in the first quarter of 2014. The Barclays Municipal Bond Index gained 3.3% in the three-month period, which more than made up for last year’s loss. In fact, the January-to-March return was one of the best first-quarter showings for muni bonds in the past two decades.
There are a number of reasons why muni bonds have done unexpectedly well so far this year, and by “unexpectedly” I mean that they had strong performance even as the specter of rising interest rates grows larger. Rising rates are generally viewed as negative for bonds; when bond yields go up, their value goes down. The reliability of that inverse relationship was seen in the second half of 2013, after the Federal Reserve first hinted that it would soon start tapering its monthly bond-buying program. The response was a panicky interest rate spike that hammered bond prices.
The tapering began in January and has since accelerated on a percentage basis. And last month, new Fed Chair Janet Yellen suggested that the other policy shoe — keeping short-term interest rates near zero — might drop sooner than investors had expected. The muni bond market, so excitable just nine months earlier, responded to both the taper and the rate-hike news with a yawn.
What’s different this time around?
The key reason is a basic supply-and-demand imbalance. In the first quarter, the dollar value of newly issued bonds was more than 25% below the same three months of 2013 and had not even kept up with the value of maturing bonds. Refinancings of existing bonds also dropped considerably during the period. At the same time that supply has tightened, more investors have come into the market looking to buy muni bonds.
The strong demand is being driven by muni bond yields that are attractive compared to other sectors of the bond market. They have outperformed Treasuries, and their yields are comparable to similarly rated corporate bonds but with less risk. Interest income from muni bonds is exempt from federal taxation, which further enhances their appeal to investors. The tax exemption also applies to the new 3.8% investment income surtax for high-earning Americans, which could be an additional demand driver this year.
When the Fed starts raising short-term interest rates, muni bond prices will likely go down in the short term. Over the longer term, however, there will be a significant benefit for investors seeking current income, as principal returned from maturing bonds is reinvested at higher rates that generate higher returns.
It’s also not clear how an increase in rates at the short end of the yield curve may affect yields at the long end. Rising rates are a reflection of growing confidence in the U.S. economy and a demonstration of the Fed’s commitment to heading off potential inflation. If investors are comfortable with the idea that inflation will be subdued and that credit quality will improve along with the economy, yields at the long end may not rise much at all.
Another test will come when new issuance of muni bonds reverts back toward the long-term average. States and local governments are still licking their wounds from the financial crisis and thus have been wary about taking on new debt. But they can only overlook their infrastructure needs for so long; eventually, they will start borrowing again to finance new bridges, school buildings and the like. At least through 2014, however, we expect the muni bond supply to remain constrained, which could continue to support prices.
USAA Offers a Range of Municipal Bond Funds:
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