Second Quarter 2008 Tax-Exempt Municipal Bond Market Review
July 14, 2008
Author(s):
Second Quarter 2008 Fixed Income Sector Returns (Pre-Tax)
Second Quarter 2008 Fixed Income Return per Unit of Duration
The past quarter continued to pose challenges for the municipal bond market. Credit problems surrounding the claims paying ability of the monoline insurers, declining state tax receipts due to a struggling economy and continued heavy issuance as municipalities look to term out their auction-rate debt have all caused investors to pause. While the sector continues to experience extremely low default rates, investors can no longer rely on a AAA-rated insurer for a securities’ rating. During the quarter, Standard & Poor’s downgraded MBIA and AMBAC to AA, while Moody’s downgraded MBIA to A2 and AMBAC to Aa3. In previous years, almost 50% of municipal bond issuance came with insurance as investors demanded the high quality that this insurance offered. This year, only 24% of new issuance has been insured as only FSA, Assured Guaranty and a unit of Berkshire Hathaway are able to offer AAA-rated guarantees.
As municipalities continue to experience a slowdown in tax receipts, the need to borrow to meet the demands of a growing population increases. After a slow start during January and February, issuance in the sector has increased and finished the second quarter at levels similar to 2007, which is meaningful given last year was a record year of issuance. New issuance has also grown as municipalities continue to term out their adjustable rate debt despite an environment where widespread auction and remarketing failures have caused financing costs to escalate. As the need for municipalities to issue additional debt continues and the options for high quality enhancements decreases, the cost of financing this debt will likely increase. This will likely put additional political pressure on the rating agencies to move toward a corporate equivalent global scale rating which will likely result in higher ratings for many state and local governments helping to offset higher financing costs.
As the market continues to attract non-traditional buyers such as hedge funds and broker-dealer accounts, demand for the sector waxes and wanes as the relative value to US Treasuries and other financial instruments changes. Currently, with municipal yields at or exceeding US Treasury yields, demand from these investors has improved, helping to balance supply and demand. Historically, the “muni ratio” (the relationship of municipal yields to Treasury yields) improves in an increasing yield rate environment. Continued strong retail interest, both from direct investments or into mutual funds, has also improved the demand for municipal bonds. Year-to-date through the end of May, municipal bond mutual funds have attracted almost $15 billion in net new cash flows. Historically, municipal bond funds will attract inflows when the equity market has produced lackluster performance, as we have seen this year.
Past performance is no guarantee of future results. Indices are not available for direct investment. This material has been prepared using sources of information generally believed to be reliable. No representations can be made as to its accuracy. Opinions represented are subject to change and should not be considered investment advice nor an offer of securities.
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