Laurie King

What’s ahead for munis?

AdvantageVoice® Blog—12-13-12
Laurie King

We recently had a chance to talk with Robert Miller, senior portfolio manager on Wells Capital Management’s Tax-Exempt Fixed-Income team, about the main drivers of municipal bond returns, especially in light of the fiscal-cliff discussions and the low interest-rate environment on Tuesday, December 11.

Yields have been at all-time lows all the year. What caused interest rates to reach these levels, and how long do you think they’re going to stay low?
It is interesting that interest rates are at all-time lows across the entire yield curve. Ten-year municipal bond yields are about 1.50%, and long-term municipal yields are about 2.5%. In fact, these yields even surpass the low yields experienced in 1946.

There are some global reasons for low yields. Municipal yields tend to follow U.S. Treasury yields with a lag, and Treasury yields have rallied because of accommodative monetary policies, geopolitical events in the Middle East, economic uncertainty in Europe, and anemic economic growth in our own country.

Technical supply/demand factors are also responsible for driving down municipal yields. For the past two years, we have had net negative supply, meaning that there are not enough new bonds being issued to absorb all the cash from coupon payments and maturing bonds. One reason few new bonds are coming to market is due to austerity measures at state and local governments. At the same time, municipal bond funds have had about $55 billion in new money flow in this year, the second largest annual flow ever. Strong demand for municipal bonds and significantly reduced supply has resulted in an imbalance that has driven down municipal yields. There is nothing in the foreseeable future that we see changing the strong technicals in the municipal market.

The fiscal cliff is only a few weeks away, and we’ve heard rumblings that perhaps municipal bond interest and income will become taxable. What should municipal bond investors be paying attention to?
First of all, we don’t believe we’re going to fall off a fiscal cliff, but we certainly could roll down a fiscal hill. There is a lot of noise because there are several different proposals. Regardless of what happens legislatively, however, we believe municipal bond prices over the long term will be driven primarily by macroeconomic fundamentals and the direction of interest rates. In terms of prospects for proposals that are out there, we know that taxes are going up. We also know that some expenditures are going to get cut. These are both potential drags on the economy. This drag may not send the economy into a recession the way falling off the fiscal cliff would, but a drag on growth does support a low interest-rate environment.

The deficit-reduction proposals that deal with municipals are essentially about taxing them in some form. Of several proposals, the one bantered about the most is a 28% limit on deductions. For example, if the top income tax rate was 35%, and 28% of the income was excluded, you would have to pay taxes on 7% of your municipal income. This obviously is a negative for municipal bonds. Our sources in Washington, D.C., tell us that the state and local governments are lobbying pretty hard against this. 

The interesting thing is that municipal bonds may not trade off as much as some anticipate because the tax advantage of municipal bonds would still be attractive for many investors. The exemption of municipal bond interest is only one of several tax code expenditures that may be limited in a plan that caps the amount of total deductions. Possible limits may be put in place for deductions on items such as mortgage interest or state and local taxes. The majority of municipal bonds are owned by individuals, and a 28% shield on income is still likely to be attractive to many of these investors. Therefore, while yields are likely to rise if the tax benefit is reduced, we do not expect a dramatic increase in yields.   

Where do you see the best opportunities and possible threats during the next year?
We see two main investment opportunities: avoiding interest-rate risk and investing in lower-rated investment-grade credits. Regarding duration risk, we would not encourage anyone to take excessive interest-rate risk now. We think that the current yield levels show an asymmetric risk toward higher interest rates, though technical factors will likely keep rates in a lower trading range for quite a while. Interest rates could back up by 50 or 100 basis points (bps; 100 bps equals 1.00%) and we’d still be in a low interest-rate environment. We are finding opportunity in yield-curve positioning along the short and intermediate part of the yield curve, and we especially like the 10-year area because it is a potential area to capture the roll, or the natural decline in yields as maturities shorten.

Municipal credit remains cheap on a historical basis. Even if growth slows due to a drag from higher taxes and less spending as we enter 2013, economic growth would still be positive and municipal credit could continue its slow improvement. As municipal credit quality improves, credit spreads tend to tighten. The credit spread between AAA- and BBB-rated municipal bonds is more than 200 bps, which compares with the long-term average of about 123 bps. Lower-rated investment-grade municipal credit appears to be a prudent place to find income in a low-yield environment.

The views expressed are as of 12-13-12 and are those of Laurie King, Robert Miller, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.


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