Who Fled the Muni Market?
You'd think the first bonds shed would be from mangy issuers and then proceed from the longest-dated issues down to short-dated paper. But you'd be wrong on both counts.
So it is with the recent experience in the municipal bond market. You might think the first bonds to be shed would be from mangy issuers such as my home state of Illinois (inscribed on the Illinois Memorial at Vicksburg: Not without thy wondrous story / can be told the nation's glory) and would proceed from the longest-dated issues downward to supposedly less-risky short-dated paper, but you would be wrong on both counts.
Volatility data are available for general obligation municipal bond indices ranging in maturity from three months to 30 years and from credit ratings ranging from AAA to BBB. The paths of volatility across the dimensions of time and maturity are illustrated below for two of these indices, AA+ and A-. Every picture tells a story, and this one is simple, direct and counter-intuitive.
In the AA+ picture as well as for AAA-rated bonds, we see a large jump in short-dated volatility in mid and late 2010; long-dated volatility levels declined. For the A- and BBB issues, short-dated volatility peaked in mid-2009 and fell in 2010.
What can explain this odd mix? Three factors in addition to the dreadful state of municipal finances came into play in 2010. First, the expectation for much of the year was the 35% top marginal tax rate would revert to 39.6%. Second, the expectation was the preferred tax treatment for dividends and capital gains might expire. Third, many held out hope for an extension of the Build American Bonds program. None of these factors came to pass after the November election; the result was an expected increase in municipal issuance to offset the BABs, the absence of a higher tax rate and continuation of preferred tax treatment for equity-derived income at a time when the Federal Reserve was goosing all risky assets. Small wonder municipal investors headed for the exit.
At the head of the line out the door were the most risk-averse coupon-clippers, those whose intentions were to buy the highest-quality bonds with the least interest rate risk. Once these bonds became less valuable and general interest rate risk began to rise, they decided not to play the game anymore.
What about those who stayed put at the long end and for lower-rated issues? They knew the risks they were taking and probably felt that when push came to shove, the federal government would bail out miscreants such as Illinois. Where would they ever get such an idea, that the federal government would reward the irresponsible at the expense of the prudent? The world wonders; I do not.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.