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Municipal-Bond Landscape Shifts

Correlation with Treasuries is climbing back to precrisis levels, which should concern muni investors.

Eric Jacobson, 08/20/2012

One of the most notable effects of the 2007–09 financial crisis was the dramatic disconnect that developed between the municipal-bond and U.S. Treasury markets. Intriguingly, munis and Treasuries have recently begun to converge. That’s been good news for muni investors, but it signals some potential risks.

The Landscape, Precredit Crisis
Before the crisis, most investors rightly viewed the top tiers of the muni market as highly correlated with Treasuries. For many years, the majority of new muni-bond issuance had been rated AAA. With a discount owing to the tax-advantaged status of municipal interest payments, the average yield for an AAA municipal bond was typically even lower than that of a comparable Treasury bond. So, even though institutional investors didn’t typically benchmark municipal yields directly to those of the Treasury market, shifts in the latter almost always had a direct impact on the former. It’s fair to say that most individual investors even viewed AAA munis and Treasuries as substitutes for one another.

Much of that AAA municipal issuance was blessed with the pristine rating thanks to third-party insurance. If municipal entities purchased insurance from highly rated companies to support their bond issues— thereby offering additional guarantees to investors that their interest and principal would be paid—they could issue bonds at lower rates than they would have otherwise. This was such a common practice that well more than 50% of new bond issues came with insurance in any given year. By 2005, nearly 70% of the market value of the Barclays Municipal Bond Index garnered AAA ratings from outside agencies.

Credit Crisis Alters Landscape
Everything changed after the onset of the financial crisis. Initially, one issue was the overall deleveraging taking place among investment banks and large investors around the globe. Indiscriminate selling of anything that wasn’t a U.S. Treasury bond was the order of the day, and the muni market wasn’t immune. In particular, many hedge funds were reported to have unwound highly leveraged trades in the muni market, and their sales pummeled the prices of even the most highly rated bonds.

Just as critical was the sudden lack of faith in bond insurance. Eager to increase revenues and profits, AMBAC and MBIA, the leading providers of third-party muni-bond insurance, had branched out into other sectors of the bond market, writing massive amounts of insurance on mortgage securities that weren’t guaranteed by government agencies. When it became clear that these insurance companies had overex- tended themselves, they were downgraded by the ratings agencies. That shock left billions of dollars in bonds without the perceived protection of the insurance companies. Not only did the ratings on insured munis typically fall to match the credit of their underlying issuers, but in the resulting panic, investors also marked many bonds’ prices down further, even below where the new, lower ratings implied they should be.

Within a relatively short time frame, the entire face of the muni market changed. Whereas AAA bonds had dominated the space as recently as 2007, their share of the market tumbled as bonds were re-rated into lower tiers (see Exhibit 1 below). The AA and A rated cohorts were the largest beneficiaries of the shift, with the former taking up more than 50% of the market by March.

The Aftermath
The credit-crisis deleveraging has had a long-term impact as well. Many fixed-income mutual fund managers report that liquidity has declined across the bond market from precrisis levels. One culprit seems to be investment banks’ decisions to cut risk and commit less capital to market-making activities. Many banks also argue that these moves are necessary to comply with new laws and banking rules that are expected to be enacted. Whatever the catalysts, the trend is clear: The Municipal Securities Rulemaking Board reports that trades (by par amount) declined by more than 41% between 2008 and 2011.

At the same time, the assumption that the highest-quality municipals were comparable to U.S. Treasuries has been effectively crushed. Mark Sommer, the manager of Fidelity Intermediate Municipal Income FLTMX, says that many players in the market had bad experiences around the time of the financial crisis. The perceived equality between municipals and Treasuries before the crisis led many to use the Treasury market (or proxies thereof) to hedge risk in the municipal market. That turned out to be a disaster for some, as municipals sold off during the crisis while Treasuries rallied, killing the hedges as well.

In fact, the correlation of returns between municipal bonds and Treasury securities plummeted during the financial crisis (Exhibit 2). After hovering at close to 1.0 for some time (meaning their prices essentially moved in sync), correlation between the Barclays Municipal and Treasury indexes (on a rolling 36-month basis) began to decline in late 2007 and reached negative 0.11 by mid-2009. The idea that municipal-bond returns displayed a negative correlation to Treasuries, even if only by a modest margin, was remarkable.

That’s about where things stayed until the 36-month trend began to reverse in late 2010. It started a slow, shallow climb from that point forward and then jumped sharply at the end of 2012. By the end of April, the trailing 36-month correlation between the two indexes had risen back to 0.55. The increase in correlations may be driven as much by supply/demand factors in the muni market as anything else.

Guy Davidson and Terry Hults, managers of Bernstein Diversified Municipal SNDPX, have observed that supply in the muni market has been light at the same time that demand for municipals has been growing strongly. That has been no small phenomenon, either: Municipalbond funds began seeing big inflows starting in September 2011, and the trend has accelerated. After suffering more than $10 billion in net outflows for 2011 as a whole, the sector saw more than $18 billion of inflows in 2012’s first quarter alone. Meanwhile, Davidson and Hults note that, in recent months, investors have become far less concerned about municipal credit quality. That has driven the yields of highly rated AA and AAA munis much closer to those of Treasuries—and thus likely making them more sensitive to moves among the latter—than they had been at the end of 2011.

True, the two markets remain far less closely correlated than they were before the financial crisis. However, should the correlations between municipals and Treasuries continue to climb, a Treasury sell-off could affect the muni market more than at any time in the past few years. Meanwhile, the low level of yields itself argues in favor of more vigilance. That’s not a recommendation for investors to dump their muni funds. It is a suggestion, however, to step back and take a broader look at one’s portfolio. Holding a large allocation to municipals may have meant something very different over the past few years than it does today.

Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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