Beyond Bulls & Bears

Where Munis and Government Budgets Meet

In the realm of municipal bonds, if you had been focusing on the bankruptcy filings or threats facing a few California cities that dominated the news headlines earlier this year, you couldn’t have been blamed for concluding that the sector was a minefield. But then, as year-end approached, the state and local government story became more upbeat, and investors were flocking to the municipal market. They flocked in such great numbers, in fact, that by the fall some were even talking of a possible “muni-bubble” building. Rafael Costas, co-director of the Franklin Municipal Bond Department, has ridden this kind of headline carousel before and he’s used to seeing these types of stories cycle through. 

Rafael Costas

“In 2012 there were a lot of stories, rightfully so, about the growing issue of pensions and retirement benefits of the public employees which are starting to take a bigger and bigger bite of municipal budgets. That was a headline that seemed to us was overblown relative to the actual story, but it’s something that we have to deal with and will be dealing with for a while. We expect a continued focus on how each state and each city is going to be dealing with its pension and retirement issues, and we will continue to monitor talk about considering bankruptcy or not. We hope not, but that remains to be seen.”

A Muni Bond Bubble?

Through mid-December, the S&P Municipal Bond Index had returned more than 8% year to date,1 performance which had attracted more investors and even prompted talk of a “muni bubble.” The market pulled back a bit in late December, but regardless, Costas doesn’t buy into the bubble story.

“I’m not a big fan of the word ‘bubble’ as it applies to the muni bond business. As opposed to the equity markets where it’s generally tied to inflated or unrealistic earnings expectations, munis don’t have earnings. Municipalities generally raise and impose taxes to pay for expenses and infrastructure. So, in that sense, we think the fundamentals of supply and demand are what really dictate what the prices are going to be. [perfect_quotes id=”1534″]

We are anticipating that at some point we might see a little correction in the muni market, as people maybe temper their expectations a little more to the historical average and focus on what munis really can offer: tax-free income, and the potential for diversification, which of course, doesn’t guarantee a gain or protect against loss.”

A potential downside to voluminous positive flows is finding attractive places to put that cash.  If Costas has any complaints, this appears to be where they are.

“Net new supply was a little lower than we expected in 2012, and so that caused problems for our team in terms of finding a lot of good deals on bonds out there. For the coming year, investment bankers are projecting supply to be at or better than what we had this year. We will see.”

Looming Tax Changes – and Unknowns

Nearly all states and municipalities are generally required to keep their budgets balanced, but that doesn’t mean it’s easy to do, and state and local governments are facing numerous challenges.

“We are seeing state and local governments dealing with budgeting problems that are unpleasant. The U.S. economy is recovering a little bit, but at the same time, we expect that for the next few years, it’s going to still be tough for local governments because they could be getting fewer federal dollars. They’re going to have to make some decisions based on that and at the same time try to control growing expenses.”

As the federal government debates the possibility of raising taxes for some (higher-income) households, Costas says the change could have an impact on the municipal bond market, which many investors like for the preferred tax treatment. But there are still a lot of unknowns.

“We think a higher tax rate by itself could mean higher investment appeal. There could be more people who are more open to the proposition of investing in a tax-free fund because their tax liability is going to go up.

Near year-end, Congress and the Obama administration were in intense negotiations to avoid what is commonly referred to as the fiscal cliff, so it is hard to assess near-term prospects with a high degree of confidence. The tax-exempt status of municipal bonds is an item that has been discussed as part of the negotiations, and we feel there is a chance that some form of cap could be applied to municipal interest. At the same time, there has been an expectation that income tax rates will increase for at least the top earners, which would tend to increase the value of a municipal bond’s tax-exempt status, whether its interest income is capped or not. Several states also have increased their tax rates (California being one example). We are not sure right now what will win out, the effect of a possible cap, or higher taxes.”

Interest Rates and the Road Ahead

While the Federal Reserve hasn’t indicated any plans to raise interest rates anytime soon given the currently fragile state of the economy; with rates as close to zero as they currently are, the only direction they can go is up.  The questions are when, by how much, and how quickly will that happen. While higher tax rates could add to municipal bonds’ appeal, Costas cautions that a rapid surge in interest rates could have a negative effect on the municipal bond market.

“You can have higher taxes but if rates increase at the same time, it can hurt performance, which then will hurt demand. My hope is that the economy starts growing a little faster. A lot of it depends on what’s happening in Washington, D.C., but if we see better economic growth, and a gradual increase in inflation and interest rates, that’s manageable; people can plan and maintain their exposure without sending the markets into a tailspin.”

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What Are the Risks?

All investments involve risk, including possible loss of principal. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in a portfolio adjust to a rise in interest rates, the portfolio’s value may decline. For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable.

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1. S&P Dow Jones Indices, year-to-date as of Dec. 13, 2012. STANDARD & POOR’S, S&P, and S&P 500 are registered trademarks of Standard & Poor’s Financial Services LLC. Past performance is not indicative of future results. Indexes are unmanaged and one cannot invest in an index. 

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