Fear is not a strategy

James Dearborn, Head of Municipal Bonds | November 18, 2013

  • As muni bond prices fell and yields soared in recent months, fear and uncertainty kept investors away.
  • Amidst the unprecedented fear-based sell-off, the fundamentals of the muni bond market continue to strengthen.
  • Bypassing muni bonds may mean missing out on today’s attractive long-term buying opportunities.

Tax-free income is a big reason why so many investors have included municipal bonds in their financial plans. In recent months, yields on muni bonds have become more attractive relative to other fixed income securities. Yet, investors are still holding back. Why?

A compelling yield story

Over the past few months, muni bond prices fell and yields soared. The increase in yields on AAA 10-year muni bonds, for example, outpaced the increase in 10-year Treasury yields by over 35 basis points. Also, in many cases, corporate bonds issued in the tax-exempt market (industrial revenue bonds) provided investors with higher yields than taxable bonds offered by the same company.

Investors subject to the top federal tax rate can currently take advantage of muni bond funds offering taxable-equivalent yields above 5.5% in intermediate maturity funds and above 7.5% in long and high yield funds. Compare these yields with what you might expect to earn from dividend-paying stocks, corporate bonds or Treasuries.

Typically, attractive yields grab investors’ attention and can draw them to bond funds like bees to honey. So, what’s keeping investors away from the muni bond market? The answer is a simple four-letter word: FEAR.

Fear-induced selling

Fear drove investors to sell more than $50 billion in muni bond funds through September. Between May and August, the exodus from muni bond funds was the largest in decades and left the market reeling. Also, rumblings from the Fed about taking away the QE punch bowl spooked the market while negative headlines out of Detroit and Puerto Rico fueled investor fears. Not surprisingly droves of muni bond investors headed for the exits.

With the Fed back on the sidelines, September and October saw a return to more normal trading ranges and some lessening of selling pressures. While yields look attractive, fear and uncertainty persist. It may take years for the Detroit/PR stories to play out and investors need to know how exposed their portfolios may be.

Bankrupt Detroit

Detroit’s fiscal erosion has been slow and painful. Decades of financial and economic decline, exacerbated by dysfunctional politics, resulted in the city’s Chapter 9 bankruptcy filing in July. With around 100,000 creditors, including the city’s various pension funds, Detroit is the largest muni bankruptcy in U.S. history. While the filing surprised few muni market participants, news of the bankruptcy and subsequent default heightened uncertainty and investor fear. We believe Detroit’s situation is an exception, not a harbinger of widespread fiscal distress. While we aren’t expecting many more “Detroits” to emerge, investors should remain vigilant toward any municipalities that may be headed for similar fiscal distress.

Puerto Rico bonds

Tempted by the siren song of higher yields and triple tax-exempt income, some muni bond funds made large bets on Puerto Rico. However, the island’s fiscal woes and huge debt load (including underfunded pension obligations) have put PR bonds in troubled waters. Recent news reports indicate that several fund managers are having to defend their sizeable PR positions while trying to ride out what they hope is a temporary period of fiscal distress. Meanwhile, investors who have experienced large losses are asking tough questions, such as why a state-specific fund has such a large and unexpected exposure to Puerto Rico. Columbia Management credit analysts have long seen PR’s general obligation bonds as below-investment-grade credit with high yield characteristics. While prices on PR securities have fallen by more than 20%, we expect no rapid bounce back. More downside risk is possible, especially if the island loses its current investment grade rating.

Reliable, attractive and tax-exempt

Amidst the unprecedented fear-based sell-off of the past five months, the fundamentals of the muni bond market continue to strengthen. In addition, a low and declining number of annual bond defaults portray a healthy muni market. The number of defaults has trended down since 2010 and is on track to be significantly lower again this year. Given this improving story, we believe that most fears regarding widespread credit deterioration are overblown. We also believe munis can be a prudent choice for investors seeking competitive returns and tax-exempt income.

Municipal_Defaults

Summing up

Despite attractive after-tax yields and improving credit fundamentals, fear is keeping many muni investors on the sidelines. Your financial advisor can help you get past the fear and determine if muni bond funds may be right for you based on your specific financial needs, goals and risk tolerance. Bypassing muni bonds may mean missing out on attractive long-term buying opportunities. Investors may be best served by seeking out investment managers with large and experienced credit research teams who manage diversified portfolios and have well-established risk management practices in place.

See more Market Insights from Columbia Management

There are risks associated with an investment in a municipal bond fund, including credit risk, interest rate risk, prepayment and extension risk, and geographic concentration risk. See the Fund’s prospectus for information on these and other risks associated with the Fund. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.

Income from tax-exempt funds may be subject to state and local taxes and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal and state income tax rules will apply to any capital gain distributions and any gains or losses on sales.

Credit ratings typically range from AAA (highest) to D (lowest), and are subject to change.