Recently, I was asked what I thought was the biggest risk to the municipal bond market over the next 12 months. Interest rates rising? A credit event? Retail outflows? Supply? Or liquidity? I chose retail outflows. I think the biggest risk to the municipal market is more on the demand side than the supply side. Muni rates follow rates in general over the longer term; however, given it is a much smaller market and dominated by retail investors, technical factors, i.e. supply and demand, can greatly impact its relative performance over shorter time horizons.
Right now, I think the risk of outflows due to rate concerns is a bigger risk than a credit event (although this seems to change daily as new economic data is published). Most forecasts are not expecting dramatically higher rates, but changes in rate outlooks due to economic data or Fed actions/guidance could drive changes in asset allocations, which in turn, could trigger large retail outflows.
Credit events can also trigger outflows, particularly retail outflows. Because retail investors tend to be more reactionary to headlines, credit events similar to Detroit and Puerto Rico can trigger outflows. However, I think that the headline risk is lower than in recent years because even retail investors have come to see credit events as one off events not necessarily impacting the broader municipal market. Although our credit team worries a bit that we’ll start to see a lot of negative headlines due to the implementation of new pension disclosures for state and local governments. It remains to be seen if this will impact the broader market because it may not be as isolated as more recent credit events.
Given the relative size of the municipal market to other fixed income classes, retail outflows have a major impact on liquidity and therefore, municipal bond prices. This impact is exasperated by that fact that since 2008, the street no longer makes much of a liquidity commitment to the municipal market. Thus, outflows translate into heavy selling without the street taking inventory. Liquidity dries up very quickly and strains valuations as sellers are forced to take prices that reflect oversold conditions. Periods of illiquidity generally become a buying opportunity for buyers not constrained by retail flows, particularly crossover buyers. The oversold valuations eventually correct as crossover buyers come into the market to take advantage of the cheap muni yield ratios. This situation was best illustrated in December 2010 and early 2011 with Meredith Whitney’s infamous call for “hundreds of billions of dollars” in municipal bond defaults. Muni/treasury ratios rose to extraordinarily cheap levels as retail investors sold their muni bond funds. Eventually, institutional crossover buyers were attracted to the cheap valuations and bought munis; which meant that over time, the ratios reverted to more normal levels. It proved to be one of the most lucrative times to buy municipal bonds.
Of course, while I think the risk to municipals is more on the demand side, the supply side has risk as well. There are two types of municipal supply—refunding (refinancing at lower rates) and “new money.” In low rate environments, like we are now experiencing, refunding volume tends to increase. For instance, year to date we have seen increased volume relative to last year due to refunding transactions. If rates remain low there is some risk of increased supply that could weigh on municipal bonds. However, while that risk may result in more volume than last year, supply would still be moderate from a historical perspective. Also, while the increased supply could negatively impact municipal valuations, I believe the impact would be minimal as buyers could view periods of heavy supply as buying opportunities. I see new money volumes as continuing to be constrained by political factors; politicians are still very reluctant to explain increased debt levels to voters.
The good news regarding these technical factors is that while it produces risk, it also produces opportunity. And that’s why non traditional municipal buyers keep a careful eye on municipal ratios.