Investments

The municipal bond market is currently experiencing substantial liquidity-driven turmoil, as prices have fallen for 14 consecutive days and February was the worst monthly performance for municipal bonds in 19 years.  The selling pressure has been broad-based, from high-quality AAA-rated bonds to high-yield bonds.  However, unlike the subprime mortgage crisis, the selling in the municipal bond market has not been caused by problems with credit quality.  As a result, this market dislocation has created a major opportunity for investors to take advantage of historic tax-exempt yields relative to Treasuries.

In normal times, tax-exempt bonds offer yields that are lower than comparable maturity Treasury bonds, because the interest earned is exempt from federal income tax.  In fact, munis typically trade at an average yield of about 82% of the Treasury yield.  On Monday, February 25, 10-year AAA munis traded at 92% of Treasuries. By Friday, February 29, 10-year AAA munis yielded 110-115% of Treasuries.  On the shorter end of the curve, two-year munis traded at 170% of two-year Treasury yields.  In these instances, even those investors that don’t pay income tax, such as pension funds, would earn a higher yield by buying tax-exempt municipal bonds.

There are three primary factors that have caused this substantial rise in municipal bond yields:

1.      Current and Expected Supply of Municipal Bond Issuance has Surged – Due to the failure of many auctions to clear in the Auction Rate Securities market, municipalities are in the process of refinancing this debt with long-term bonds.  Estimates of the amount of new issuance top $200 billion, which is half of 2007’s total municipal bond issuance.  This huge supply drives up bond yields and reduces the price investors are willing to pay.  Supply is likely to remain an issue for several months.

2.      Leveraged Investors Forced to sell – Many hedge funds and closed-end funds borrow funds to leverage municipal bond portfolios.  As yields have risen, collateral values backing the funds’ borrowing have declined, causing a margin call.  In addition, many banks are reluctant to lend and have refused to roll over short-term loans to these funds.  As a result, these funds have been forced to liquidate their holdings of municipal bonds, regardless of credit quality.  

3.      Redemption from High-yield Muni Funds – In recent days, many have redeemed investments from high-yield municipal bond funds, forcing the fund managers to liquidate holdings.

It is clear that this is a liquidity-driven event, not a credit quality issue.  There have been no significant credit issues or defaults in the municipal market, and concerns over the bond insurers have begun to ease somewhat.  Exacerbating the issue is the ongoing flight to quality in the Treasury market, which is driving yields down.  

So what is the bottom line? For long-term investors with cash available, this is an excellent opportunity to construct a high-quality municipal bond portfolio at very attractive yields relative to Treasuries.