March 17, 2016
Headline risk from Puerto Rico’s ongoing financial distress continues to drive volatility in the broad municipal bond market. Despite efforts to improve Puerto Rico’s financial position, little has helped the struggling commonwealth. Various Puerto Rico debt-restructuring ideas have been circulated recently, including a proposed role for the U.S. Treasury, but this part of the process continues to evolve. The issues surrounding Puerto Rico, credit downgrades involving Chicago and its sister agencies, and challenges facing New Jersey combine to create an alarming picture, but aside from these and a few other well-known problem children, fundamentals continue to improve across state and local governments. Political pressure has forced municipalities to cut spending and balance budgets. State and local tax receipts have rebounded, and most states are enjoying surplus revenues, allowing them to replenish their politically sensitive ‘rainy day’ funds; however, the growth of tax receipts has slowed recently, creating challenging budget sessions as states plan for fiscal year 2017.
As investors pulled assets from fixed-income funds, they moved into municipal mutual funds in a flight to safety. Through 2015, investors added $15 billion to municipal mutual funds, compared to outflows of $42 billion from taxable funds.
Source: Investment Company Institute, Guggenheim. Data as of 12.31.2015.
In light of improving fundamentals and favorable fund flows, municipal bonds were among the best performing fixed-income asset classes in 2014 and 2015. Last year, the Barclays Municipal Bond Index recorded a gain of 3.3 percent, outperforming Treasury and investment-grade bonds by 2.5 percent and 4 percent, respectively, and research from our Macroeconomic Research Team indicates that municipal bonds are likely to continue to outperform Treasuries in 2016.
The areas we find the most attractive generally are revenue bonds—those supported by dedicated revenue streams, such as state-level transportation bonds, public healthcare, and utilities. With respect to rating, A-rated bonds look attractive versus AA-rated and AAA-rated bonds on a risk-adjusted basis. Finally, although investors often overlook the 10–15-year portion of the curve, we feel that there is a higher likelihood of price discrepancies in this space because of the lack of a natural buyer—individual investors typically focus on shorter maturities, while institutional buyers favor ultra-long maturities.
Tax-exempt municipal bonds look attractive relative to Treasurys. For example, the ratio between 10-year A-rated general obligation bond yields and 10-year Treasury yields is currently 126 percent, above the historical average ratio of 111 percent and above the average pre-crisis ratio of 89 percent. As these ratios revert to their mean, municipal bonds across the rating spectrum should outperform Treasurys.
Source: Municipal Market Monitor, Guggenheim. Data as of 12.31.2015.
—James Pass, Senior Managing Director; Allen Li, CFA, Managing Director
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment-grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating-rate senior-secured syndicated bank loans and other floating-rate securities involve special types of risks, including credit risk, interest-rate risk, liquidity risk and prepayment risk.
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