06-11-2014 12:48 PM
By Diederik Olijslager, co-portfolio manager of tax exempt funds
In 2013, demand for municipal bonds tanked. Investors were sure interest rates would soon be heading up, maybe even sharply, so it made sense to not rush out and buy assets whose price, in their view, would almost certainly be falling. In that environment, munis turned in their worst performance in two decades.
This bit of recent history is worth knowing when considering the municipal bond market of 2014 and perhaps into 2015 as well. The current situation is the polar opposite of last year: Demand for munis is strong, new supply is running dry, and there is no clear consensus in the market on when rates will be rising or by how much. Through the end of May, the Barclays Municipal Bond Index was up nearly 6 percent for the year.
So there’s not much to buy, and what’s out there is expensive. This presents a challenge for us as bond buyers, given that the focus of our muni bond funds is on generating current income for our shareholders. On top of that, reinvestment of principal from maturing bonds is coming at a lower yield.
Historically, municipal bond issuance in the U.S. has been positively correlated to GDP growth. When the economy is expanding, local and state governments expect that they will be collecting more tax revenue, and thus they have more confidence that they will be able to pay the interest and principal on new debt.
The national economy seems to be strengthening, but still we’re not sure that the pace of growth after a debt-driven recession will pick up enough to start the desired virtuous circle. Belt-tightening by municipal governments has been a central feature of the recovery, and forecasted GDP gains of 3 percent or so per year may not create enough momentum to change the muni bond supply-demand dynamic, at least not any time soon. It’s true that spending on new projects and on maintaining existing infrastructure can’t be put off forever, but it can be deferred over the short or even medium term.
Another concern is the lack of volatility in the muni market. In our view, overconfidence bred by current conditions is leading to too much investor money chasing too few bonds, which has bid up prices and dramatically narrowed yield spreads. The result is that we don’t think investors in many of these new deals are being properly compensated for the risk they are taking on. This is a trend that’s been in place in the broader bond market for quite some time, and now we’re seeing it in munis as well.
At this point, we don’t see anything in the near future that stands to change the imbalance in supply and demand of muni bonds. Volatility could jump if the Federal Reserve, for whatever reason, slows the tapering of its quantitative easing program or moves to raise short-term interest rates sooner than expected, which is now well into 2015. On the other hand, if the European Central Bank comes out with a QE program of its own, the impact could be a further rise in muni prices and more yield compression.
Despite the recent rally, we believe that munis on the whole are still attractive compared to other fixed-income assets, particularly when you take into account their tax-exempt status. We remain disciplined in our pursuit of the best relative value for a given level of risk. Our approach during this novel time is to seek out high-quality issues and to maintain liquidity so we are ready in the event that a pickup in volatility presents buying opportunities.
USAA Investments Managed Portfolio Outlook
Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. While signs point to continued recovery of the U.S. economy, valuations are no longer cheap, and profit margins are near record highs.
We are tactically underweight fixed income, primarily to fund a deployable cash position. Within fixed income, we prefer areas of the market that are more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate bonds and high-yield bonds. The USAA Intermediate-Term Bond Fund and the USAA High Income Fund fit this profile.
We are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund provides potential protection against the risks of long-term inflation.
We are overweight non-U.S. developed markets and emerging markets based on relative valuations. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. Along with compelling valuations, they offer an interesting long-term prospect for growth. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for your individual goals, objectives, risk tolerance and time horizon.
This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.
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