Muni market: Some advice on how to keep cool over the summer
Bryan J. Bailey, CFA
Waddell & Reed Advisors Municipal Bond Fund
Waddell & Reed Advisors Municipal Bond Fund – May 2012
With President Obama calling for a cap on municipal bond tax benefits, the muni market appears set for another round of negative headline risk. For long-time muni investors, this is starting to become a disturbing trend.
Last year, of course, the market wrestled with prominent banking analyst Meredith Whitney’s forecast of a wave of muni bond defaults. As we expected, Whitney’s forecast was grossly incorrect. Although the comments had a significant impact on the $3.7 trillion muni market — Lipper noted $20.6 billion in muni fund outflows over a 10-week span ending Jan. 19, 2011 — overall the sector still performed well for the year. Municipal bond funds were one of 2011’s strongest fixed income sectors, with the Lipper General Municipal Debt Index returning 11 percent for the year.
Similarly, the sector’s first quarter performance was also strong. However, with budget battles at all levels of government, we believe negative headline risk may be the new normal for the asset class. With that likelihood, a look at what is going on in Washington and what we are seeing at the state and local levels might prove helpful for muni bond fund investors as we head into what promises to be a politically heated summer.
After making a similar proposal in September 2011, the President this year unveiled a fiscal 2013 budget plan that would limit all tax deductions, including tax-exempt interest paid by munis. Under the plan, taxpayers who currently are allowed to reduce their tax liabilities to 35 percent of income would be limited to 28 percent. That means some muni investors who came into the market because of the federal tax break would be subject to at least a 7 percent tax they did not expect.
The issue, of course, has ramifications not only for investors, but also for state and local governments that issue bonds to pay for public projects. Because municipal bonds offer federal tax benefits, investors are willing to accept lower yields on the bonds. Absent the tax break, municipalities that are already wrestling with tight budgets could face increased borrowing costs as investors seek additional income to offset the lost tax benefit. Given the local budget impact at a time when municipalities are already pinched, and opposition from within both parties, we continue believe that the President’s proposal has little chance of being implemented in an election year.
However, that doesn’t mean the issue won’t continue to make headlines. In late April, Sen. Max Baucus, who chairs the powerful Senate Finance Committee, said that changes to the muni bond tax benefit needed to be considered, suggesting a uniform tax subsidy. There have been reports that others favor totally removing tax exemptions on new municipal bonds. We would note that most municipal maturities are reflecting some degree of concern and have been pricing in problems with yields greater than fully taxable Treasuries.
Investors will recall that similar tax proposals have been previously raised and defeated. We believe that as long as there is a federal debt, the municipal tax exemption will remain vulnerable to potential attack. However, it is our view that any serious consideration is going to have to overcome what may be a significant hurdle known as the Reciprocal Immunity Doctrine. The doctrine relates to an 1895 U.S. Supreme Court decision that found interest earned by investors on state bonds is exempted from federal taxation. Past efforts to overturn the Doctrine have proven unsuccessful and we would expect any new initiatives to meet a similar fate. Before the President’s proposal can advance, we think there will have to be a resolution to this question and we are not currently seeing active discussion on this front.
Related to the federal tax exemption issue, both the President and Baucus have voiced support for a return of the expired Build America Bonds (BAB) program, which the President has been trying to restart since it ended in 2010. Under the program, state and local governments issued bonds with taxable interest. The federal government then paid the municipality a subsidy equal to 35 percent of the coupon interest payment on the bonds to offset the increased borrowing costs.
BABs were not without their own challenges. For investors, the bonds were not as liquid as traditional munis. For the federal government, the program was more costly than expected – the Congressional Budget Office has estimated BABs will cost $26 billion more through 2019 than initially forecast. Because of the unexpected cost issue, critics have argued that the bonds will potentially give the federal government a role in determining which local projects receive funding. In fact, there were reports of some municipalities having difficulty receiving subsidy payments from the Internal Revenue Service during the initial program. Before we see a return of the BABs, we believe the federal cost issue will have to be addressed, especially given the current political and economic environment.
… and local
Although state and municipal governments continue to wrestle with tight budgets, total state and local tax revenues for calendar 2011 were actually at a record high. According to Census Bureau data, combined state and local tax revenues totaled nearly $1.35 trillion for the 12 months ending Dec. 2011. The figure was up 4.5 percent from the $1.29 trillion for the 12 months ended Dec. 2010 and also above the previous record of $1.32 trillion for calendar 2008.
Although the overall revenue numbers are improving, we expect municipal issuers to remain austere in the current environment. Property taxes, which have historically accounted for about two-thirds of local tax revenue, lag the declines in property values and combined property tax revenues received by state and local governments have declined annually since 2009.
On the spending side, given that fiscal imbalances have built up over many years in all levels of government, we believe it is likely that additional cuts to programs and services, as well as pension reform, will continue to be necessary. We expect these cuts will free funds for municipalities to continue meeting their debt service obligations.
Municipal issuers have traditionally experienced lower default rates than corporate issuers. We expect that trend to continue and that municipal defaults will remain lower than any other fixed income alternative in the U.S. except Treasuries. However, we do expect defaults to increase modestly, but remain largely confined to the high-yield sector. While defaults have increased since the recession — there was an average of 5.5 defaults per year on long-term bonds rated by Moody’s in 2010 and 2011 compared with an annual average of 2.7 from 1970-2009 — these have largely been cases where the defaults were widely expected within the market long before they actually occurred.
We expect the heightened sense of nervousness among muni investors to continue, influenced by these factors and that absolute yields are hovering around all-time lows.
However, we also believe that investors’ views should be tempered by a few facts. Importantly, the municipal-to-Treasury ratio is greater than 100 percent on maturities of more than 10 years. We also believe that while the long bull market in bonds may be nearing its end, we do not see a bear market as being imminent in the short run. Given Federal Reserve policy and the current environment, bond yields could stay in a low and narrow range for the remainder of the year and into 2013, if not longer.
The opinions expressed in this commentary are those of the fund managers and are current through May 22, 2012. The managers’ views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results. The Lipper General Municipal Debt Index is an unmanaged index considered representatives of general municipal debt funds tracked by Lipper. It is not possible to invest directly in an index. Lipper Mutual Fund Bond Categories do not constitute and are not intended to constitute investment advice or an offer to sell or the solicitation of an offer to buy any security of any entity in any jurisdiction. As a result, you should not make an investment decision on the basis of this information. Rather, you should use Lipper Mutual Fund Bond Categories for informational purposes only.
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