“No Taper” Means Munis Are Still Priced To Buy

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September 23, 2013 12:47pm NYSE:MUB NYSE:TFI

market bondsFixed income markets have been hanging on the Fed’s every word. In many ways, it has transformed the municipal bond market into a rates market. In fact, performance in the tax-exempt space has been driven almost exclusively by rates action

since late May when Fed Chairman Bernanke first hinted at slowing its stimulative bond-purchase program. Even the largest-ever municipal market bankruptcy caused less disruption than the Fed’s hints of “taper.”

So what did the Fed’s September 18 announcement that it wouldn’t, at least not yet, begin to taper its bond-buying program do for the municipal bond market? It created more value.

Let’s take a look at the series of events since Fed Chairman Bernanke first hinted at tapering back in May:

  1. Rates rose dramatically for fixed income assets, including munis, in May and June. The 10-year muni yield rose 94 basis points (bps) between April 30 and June 21. I’m not alone in my view that the markets overreacted to the Fed at that time, ignoring the slow-growth economy (and, thus, the very real potential that stimulus would stay in place).
  2. Since then, many investors have shed duration risk — that is, they stayed away from the long end of the yield curve in favor of the shorter end as they watched and waited for the Fed’s (and interest rates’) next moves.
  3. Municipal bonds became bargain priced. Yields have risen (and prices fallen) to levels not seen since early 2011. This comes at a time when fundamentals are stronger than they have been in five years.

So what should investors expect post-September 18? More of the same.

The Fed meets again in late October and mid-December, and the market will likely regenerate some taper uncertainty. Add to that the more imminent focus on the debt ceiling and questions over the new Fed head and we’re likely in for continued volatility. With no obvious catalyst for a rate drop (and price spike), I feel it remains a very good time to buy munis at attractive levels. As I said in my prior post, fundamentals are in investors’ favor. Patient investors are very likely to be rewarded down the road, looking back at the current time as a muni buyers’ market.

Our advice for muni investors, perhaps especially those on the fence, is this:

Refocus on income: The asset class is offering significantly more income now than it was three months ago for the same level of risk. Holding cash and low duration fixed income doesn’t pay.

Observe the curve: The municipal yield curve is steep (steeper by 140 bps year-to-date between 2- and 30-year maturities.) This means investors are getting paid for extending maturities.

Look beyond headlines: Headline noise (especially around Detroit and Puerto Rico) continues and has added to underperformance. It’s also added to the value proposition. If you believe in the underlying strength of the broader asset class, as I do, then there’s much more opportunity than risk.

Take advantage of professional management: Especially if you’re worried about credit events, a diversified portfolio of investments may offer more protection than owning single bonds. Professional managers also have the ability to source bonds at a time when supply is low and good deals are hard to find.

Source: S&P, Municipal Market Data

Peter Hayes, Managing Director, is head of BlackRock’s Municipal Bonds Group, and a regular contributor to The Blog. You can find more of his posts here.

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