Misinformation drives muni malaise

Technical supply-and-demand factors created uncharacteristically high levels of municipal market volatility in the fourth quarter, particularly between mid-November and December.

Muni bond supply, which typically is high at year-end, was much greater than normal due to legislative uncertainties that caused municipalities to push up future issuance. The expiration of the popular Build America Bond program was the main driver behind the issuance rush.

At the same time, retail demand for munis became increasingly tepid amid overall uncertainty in the market, partly due to open legislative items of taxes and the potential extension of BABs, and also due to growing concern over market volatility.

At the time, we expected that January would be a period during which technical conditions might improve, with lower-than-normal new-issue supply expected combining with strong seasonal coupon reinvestments to bolster upside market pressure.

Although these conditions certainly were a net positive for the market last month, unprecedented muni bond fund outflows — totaling nearly $12 billion in January, according to the Investment Company Institute — overwhelmed the positives, resulting in even lower prices at month’s end.

In fact, more than $33 billion was removed from muni bond funds from November through the end of January, an exodus that wiped out all of the net inflows experienced in the first 10 months of 2010.

What drove the outflows en masse? In our view, headlines are largely to blame.

The media play a more powerful role in the muni bond market than perhaps any other fixed-income class. That’s because demand for muni bonds, unlike any other major asset class, is heavily weighted toward individual investors, accounting for two-thirds or more of all muni market assets.

Over the past several months, the increasingly negative media spotlight on the muni market — much focused on a Draconian muni research report published by a non-muni-expert equity analyst — exacerbated outflows. Negative media reports, most of which we find undersubstantiated half-truths at best and dramatically misguided at worst, helped combine with falling bond prices to lend rather uninformed credence that “something must be wrong” in muniland.

Selling, of course, caused falling prices, and falling prices stoked investor worry and further selling, all forming an unfortunate negative-feedback loop.

LONG-TERM CHALLENGES

As to muni credit quality, it is clear that issuers face many long-term challenges. Underfunded pensions and other post-employment benefits, for example, are widespread problems; however, we anticipate that the majority of municipalities will address these issues through long-term budget solutions.

Tax increases and budget cuts have become the norm for issuers, and we think this trend will continue for years to come. It is important to note that muni budget challenges generally are not near-term debt service issues.

Debt service for most municipal issuers is a small fraction of their overall budgets, which means that they have little to gain by defaulting on their bonds.

Neither overall debt levels nor regular debt service payments are major problems for municipalities. Rather, the challenges are dealing with long-term entitlements, and we see these as being addressed by issuers.

Any panic presents opportunities. Recent events have resulted in robust muni yields, with high-quality muni bonds yielding more on an after-tax basis than junk-rated corporates and emerging-markets debt.

Investors should remember that most of the recent volatility came from mark-to-market pricing of muni bonds, which reflected the imbalance of buyers and sellers in the market, not from credit events, defaults or bankruptcies.

Although we expect a return to normalcy at some point, we can’t predict when. As long as outflows continue, we expect to see continued mark-to-market price volatility.

And while things may get worse before they get better, we think that fundamentals will prevail when the dust settles and that those who remain in the market will be rewarded.

Thomas Metzold is co-director of the municipal bond department, and Christopher Remington director of fixed-income product management, at Eaton Vance Investment Managers.

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