I’m always on the hunt for munis to buy. Not because I’m a wealthy individual looking to earn tax-exempt income but because I work for an insurance company that invests in municipal bonds. One day I hope to be in higher tax bracket so munis will come in handy. A strange thing to hope for…
I haven’t been on many actual hunting trips – the kind where you sit in a deer stand or duck blind and wait for something to shoot at. It’s just not my thing. The worst part about it is going home empty-handed or even worse, not seeing anything to shoot at! That’s what it feels like hunting in the muni market lately. There’s just not much value to be found as a buyer as muni yields have hit the lowest of the year.
But for foreign investors barely earning a positive yield on their 10 year sovereign bonds, the U.S. muni market should look attractive to them.
Low Yields Lead Foreign Investors to Municipal Bonds
Yields on the German 10 year Bund and Japanese 10 year JGB remain incredibly low. I can’t imagine having to manage money or invest as a retiree in that kind of interest rate environment. The 10 yr German Bund (orange line) yields 36 bps and the Japanese 10 yr is at 3.5 bps which is quite the increase from the end of July when it was near negative 30 basis points.
Yields that low make our 10 year treasury look very attractive at 2.24%. For a foreign investor not able to receive the tax-exemption on munis, taxable munis offer an even higher pick-up in yield than treasuries. That is of course for foreign investors able to invest in muni bonds.
That is one of the side-effects of monetary stimulus from the ECB and the Bank of Japan. Investors take on extra risk – even currency risk – by investing overseas to try to generate a return on their investments.
This attracted some foreign investors to the muni market and given the historically low default rate in munis, Puerto Rico not withstanding, it’s not a bad idea.
Holders of Municipal Bonds
This report from the Securities Industry and Financial Markets Association (SIFMA), provides a summary of groups who own the muni market.
Individual investors still account for the largest group holding municipal bonds but the percentage of the muni market they own is decreasing.
Source: SIFMA Report
Over the last 4 years, individual holders of the muni market fell from 46.8% in 2012 to 42.9% in 2016. Mutual funds also declined and a large portion of that went to banks and insurance companies. The “other” section includes non-financial corporate businesses, non-financial non-corporate businesses, state and local governments and retirement funds, government-sponsored enterprises and foreign holders.
Of the groups included in the “other” section, foreign investors are the ones I suspect would be most attracted to the muni market due to their lower yields. Overall, that’s a $28.9 billion increase in the “other” group from 2012 to 2016 and I suspect a large portion of that was from foreign investors.
The percentage of the market foreigners own it still relatively small. As long as yields stay low overseas, that means there is another group potentially bidding on muni bonds that might otherwise yield more.
Muni Yields at 2017 Lows
This chart shows just how far munis rose after the election and how far they have fallen over the past 2.5 months. The 10 year Bloomberg muni benchmark closed the week at 2% – the lowest of the year. A great time to be a seller….not a buyer.
Then again, maybe there’s still more room to run. This article indicates the muni market will shrink by $39.5 billion over the next 3 months as more bonds mature than are issued. Of course, issuance could rise if municipalities are enticed by the lowest yields of the year to issue more debt.
It’s hard to see any catalyst in the near term sending muni yields higher. Any potential tax reform seems to be further away each time Trump tweets which happens early and often.
Ratings Downgrades in Connecticut
The State of Connecticut had a rough week. The State was first downgraded by Fitch on 5/12/17 to A+. Then on Monday, Moody’s downgraded them to A1 and S&P followed up on Wednesday by downgrading them to A+ as well.
The downgrades reflect continuing erosion of Connecticut’s finances, evidenced by the pending elimination of its rainy day fund, growing budget gaps and rising debt levels. The pressures created by growing fixed costs, coupled with weak economic performance, are unlikely to relent and will raise the risk of credit-negative actions such as deficit borrowing or backloaded financings. The affirmation of the A1 Connecticut Development Authority’s economic development bonds reflects a change in our assessment of the strength of the state’s guarantee of the bonds.
In addition, not mentioned in that clip from Moody’s report is the $38 billion in unfunded pension liabilities and OPEB the wealthiest state per capita is on the hook for.
Hartford, the capital of Connecticut, was also downgraded last week by S&P to BBB- and they maintain a negative outlook. Moody’s already rates Hartford below investment grade at Ba2.
Add Connecticut and Hartford to the avoid list with Puerto Rico (if they weren’t already there). Things will get worse before they get better. I’ll post more about these two municipalities soon.
For now, I must prepare for another week of hunting…