As the economic turmoil of the third quarter continued into the fourth, the domestic equity markets produced one of the worst 12‑month periods in decades. Slowing global growth, falling commodity prices, and a crumbling financial industry all weighed on stock prices, sending important indices down 34% to 42% across the board. No surprise, then, that for the 12 months ended Oct. 31, U.S. Treasuries were the best performing segment of the market.
However, this stretch of outperformance has left Treasuries with little room to improve across the coming year. As it is, one-month T-bills are returning a whopping 12 basis points (annually) while the one-year note is priced to yield less than 1.5%—both of which result in a sharply negative real return. But outside of Treasury bonds, there remains one area of the fixed-income market with pleasant potential, and it’s one regularly skipped by institutional investors: municipal bonds. In our view, tax frees just might be one of the solid growth areas for 2009.
Fixed income as an asset class was particularly erratic in 2008, reaching a level of volatility not seen in decades. After several years of ever-narrowing spreads and lower and lower interest rates, the sub-prime crisis in late 2007 literally shocked the system as investors demanded to be paid for the “sudden” realization of the risk involved in non-Treasury issues. For its part, the municipal market was saddled with an estimated $50 billion in supply as the crisis played out into the first months of 2008, driving tax-free bond prices down and yields up. In fact, at the end of the first quarter, 30-year Treasuries were yielding 4.29% while comparable municipals were trading over 5.00%—a tax-equivalent yield well over 7.00% for an investor in the 30% tax bracket. A good deal of that tax-free stockpile was the result of a number of highly leveraged hedge funds that were forced to de-leverage in a hurry, and municipal bonds were the most liquid securities in their portfolios.
While the muni market did normalize a bit before the end of the second quarter, yields fell on Treasuries and rose on high-grade municipals throughout the third quarter. This has created a significant premium for municipals…and for good reason. At the end of the third quarter the markets still had not absorbed the excess supply. Some bond managers are now estimating that it may be another six to nine months before the overhang is removed from the municipal marketplace. And until then, municipal bonds will trade primarily on supply and demand fundamentals, rather than anticipated interest rate movements.
This doesn’t mean that municipal bonds should be considered risk-free (as too many investors believe Treasuries to be). Municipal offerings, while not exposed to the same types of credit risks as corporate bonds or mortgage-backed issues, are most definitely exposed to economic risk. Since most municipal bonds are backed by either the tax revenues of the issuing state or the direct revenues of the project they finance, any forecasted drop in these revenues will normally be reflected in an increase in credit risk, which is normally reflected by a drop in price. We suggest this credit risk can be managed in much the same way that company-specific risk is managed with equities—through diversification and professional management. In the meantime, the reality that municipals are still trading at significant premiums to Treasuries could be a tremendous boon for taxable and non-taxable investors alike.
J. Gibson Watson III is president and CEO of Prima Capital (www.primacapital.com), a Denver-based firm that conducts objective, institutional-quality research and due diligence on SMAs, mutual funds, ETFs and alternatives.