Q&A: After the muni bond market’s rally, now what?
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The tax-free municipal bond market suffered a brutal sell-off last fall and winter, driving interest rates up to two-year highs amid deepening worries about state and local governments’ finances.
But munis have rallied in recent months, pushing rates down and bond prices up, as investors’ concerns have eased. The rally has recouped half or more of the market’s decline from its late-summer peaks.
Now what? Peter Hayes, who oversees $102 billion in muni bonds at money management giant BlackRock Inc. in New York, talked with Money & Co.'s Tom Petruno about the muni market’s outlook.
Question: Nervous investors pulled $44 billion from muni bond mutual funds from November through April, about 8.5% of assets. What kind of outflows did BlackRock’s funds experience?
Answer: We were in net outflows, but I think on a percentage basis it was closer to between 2% and 2.5%. Relative to the rest of the industry we really fared quite well. I think it’s somewhat the way our funds are sold. Typically our funds are sold through financial intermediaries, like financial advisors. And I think that helped in some of the damage control [with investors] and in explaining some of the negative headlines.
Q. Some small investors were terribly spooked in December and January by talk that a huge number of muni bond issuers might default on their debts in 2011 because of the woeful state of state and local government finances. That idea was pushed by Wall Street analyst Meredith Whitney, who told CBS’ “60 Minutes” in late December that she expected “hundreds of billions of dollars” in muni defaults in a market worth $2.9 trillion in all. Was Whitney largely responsible for the muni sell-off?
A. No. I think probably too much credit is given to that one “60 Minutes” program for causing the outflows. The outflows really began about Nov. 12. That was the day after Standard & Poor’s downgraded the tobacco sector [muni bonds backed by cigarette companies’ payments to states]. So by the time the “60 Minutes” piece aired, we were already about five weeks into outflows. We had a rising interest rate environment so fund [share prices] were dropping, we had year-end illiquidity, we had a rush to market by muni issuers, which again added downward price pressure on the overall market. I think the “60 Minutes” report was one of many factors, but I don’t think it was the defining factor.
Q. The average annualized tax-free yield on very long-term muni bonds nationwide now is 5.36%, down from the peak of 5.95% in January but still up from 4.86% last August, according to the Bond Buyer newspaper’s muni index (charted below). What brought investors back to the market?
A. There’s a couple different dynamics driving the market. One is the fact that the headlines have faded somewhat. I think there’s a greater understanding of municipal credit than there was six or seven months ago, that the world’s not going to end, and there’s not going to be hundreds of billions of dollars in defaults.
Put that together with the fact that you’re seeing some actual positive news, state revenues are up, spending is down, budgets are getting passed in a more timely fashion, with the exception of your home state of California.
So the news is better, and the other factor is the amount of supply [of new bonds]. We’re down about 54% from where we were a year ago, and even as you look forward out the next month or two it doesn’t appear that the new-issue calendar is materializing.
We look at the ‘net supply’ of bonds. The net supply is actually going to be negative for the next two or three months because, for instance in June, about $38 billion is coming out of the market in the form of maturities and bond calls, and if you look at what we’re averaging per month in terms of new issue supply, it’s about $15 billion. So that’s about a $22-billion shortfall in terms of what investors are going to have to reinvest [from maturing bonds]. The same thing occurs on a slightly smaller degree in July and again in August.
Q. But that lack of new issuance also is the reason some analysts are suspicious of the rally in munis this year. They fear that state and local government borrowing could surge in the second half of 2011 and that investor demand won’t be strong enough to absorb it, triggering another jump in yields and drop in bond prices. A. There have been some analysts who have looked at supply and they say, “OK, supply is going to be back-end-loaded like it was last year.” We would argue that that is not necessarily the case. What we’re seeing is a real aversion to taking on debt. So states and cities are actually putting off projects where they have to borrow, just because we’re in this new environment of fiscal austerity.
There’s just not a lot of borrowing that absolutely has to come to market in the next six months. So we’re in the camp that we think issuance is going to probably be on the low side of analyst projections.
Q. How much fiscal danger do state and local governments face as federal stimulus aid is phased out by June 30?
A. This is something that states and cities have known for some time, so they’ve been dealing with it. If you look at state spending, it’s down an unprecedented three consecutive years. And as you look at the budgets that are getting passed around the country, they’re getting done in a variety of ways. New York did it through spending cuts, and not raising taxes. And they did factor in that fiscal stimulus was going to be going away. Connecticut actually is raising taxes and they’re going to maintain pretty much their level of spending.
Also, you’ve seen revenues actually track up -- income tax collections, sales tax collections. So that’s being somewhat of an offset to the loss of fiscal stimulus as well. So we don’t think it’s going to be as bad. It’s something we were concerned about and watching carefully six to eight months ago but it’s something we’re a little less concerned with now.
Q. Some investors figure that, with muni yields down from their January peaks, there isn’t much value left in the market.
A. I think that if you take a look at the after-tax income and you take a look at other fixed-income classes like Treasuries or others, there’s still some pretty compelling value there.
It’s a relative-value question. Some muni sectors that actually are very good [quality], even state general obligation bonds that are very good, highly rated, they’re also in such strong demand that from a relative-value perspective their yields are very low.
Even the state of California is trading very rich right now [meaning yields have dropped]. But we look at the state of California’s economy, very diverse, one of the largest ports in the world, tech, Silicon Valley, tourism, agriculture, its importance to the U.S. economy, so fundamentally we like it. From a relative-value perspective we might not buy it, perhaps it’s trading a little bit expensive, but long term we do like the state of California.
Q. Which muni bond sectors are you avoiding?
A. There are parts of the market that are fairly risky, especially those associated with real estate, which is still in our view in a downturn. Any of those deals that are associated with real estate are going to come under some pressure for the next several years and probably don’t warrant an investment right now.
So we continue to avoid the real high-yield part of the market, certain project-finance deals, land-secured deals and the tobacco sector.
-- Tom Petruno