— Guest post from Peter Essele, senior investment research analyst
After the large uptick in rates and subsequent outflows from fixed income funds, the waters seem to have calmed recently, and investors are now beginning to move back into the space. One area, however, has continued to see outflows. While the taxable side of things only witnessed 4 weeks of outflows before a return to positive flows, the municipal bond category has recorded 13 straight weeks of outflows. Why is this happening?
Well, for one, the municipal market is primarily made up of retail investors, who often dive for the trenches when volatility shows its ugly face. Performance has been relatively lackluster in this space relative to a lot of other areas, so safe-haven investors appear to be moving monies elsewhere.
Second, the Detroit bankruptcy announced a couple of weeks ago was the coup de grâce, resulting in lower prices and higher yields across many sectors. Fortunately, this can create a great opportunity for astute investors.
To address the relative value of municipal securities to other fixed income securities, we have constructed the chart below, which shows the yield difference between the Barclays Aggregate Municipal Bond Index and the Barclays Aggregate Credit Index. Essentially, it’s the yield you get on an average municipal bond minus the yield you would get on a corporate bond. As the chart shows, the yield for municipal bonds is hovering right around the yield you’d get on a comparable corporate bond. If you factor in the tax advantage of municipals, your after-tax yield would actually be much higher. The last time we saw relative yields in this range was during the “Meredith Whitney era,” when municipal prices took a nosedive following erroneous predictions by an analyst who wasn’t at all familiar with the municipal landscape.
We’re not necessarily predicting that investors who enter this space will see outsized returns like they did during the buying frenzy in the aftermath of Whitney’s comments, but, on a relative basis, municipal securities certainly look attractive. My impression is that valuations will revert to post-crisis levels sometime in the near term, which either means that municipal prices will be bid up or corporate bonds will sell off.
Source: Barclays/Commonwealth Investment Research
Corporate bonds contain elements of both interest rate risk and credit risk. Municipal bonds are federally tax-free but may be subject to state and local taxes, and interest income may be subject to federal alternative minimum tax (AMT). The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.
The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. Barclays Capital Global Aggregate Credit Index (Hedged USD) is an unmanaged Index that provides a broad- based measure of the global investment- grade fixed income markets. The three major components of this index are the U. S. Aggregate, the Pan- European Aggregate, and the Asian- Pacific Aggregate Indices. This index excludes Government and Securitized Securities. The index also includes Eurodollar and Euro- Yen corporate bonds, Canadian securities, and USD investment grade 144A securities.
