MSSB: Muni bond rally has run its course

The following is excerpted from Morgan Stanley Smith Barney’s Global Investment Committee report for February. To read more from the committee, click here.

The impressive rally in municipal bonds that started in mid October has run its course, in our view. For the past six weeks, the market has been trading sideways as inflows to municipal bond funds have offset an increasing supply of new issues. Now, the market is facing some headwinds, including diminishing relative value, proposed tax changes that could reduce the attractiveness of muni bonds and a seasonal weakness in advance of the April 17 income-tax filing deadline.

LOWER RELATIVE VALUE. In a sense, the muni bond market is a victim of its own success. As benchmark US Treasury yields fell in recent months, investors flocked to municipal bonds, driving tax-exempt yields even lower. As a result, the relative-value ratio—or the muni yield as a percentage of the comparable US Treasury yield— declined as the market. All things being equal, that makes tax exempts less attractive.

The next headwind is political. President Obama’s 2013 budget, released Feb. 13, has features that could affect the demand, and thus prices, for municipal bonds. Two proposals that raise tax rates would make tax-exempt bonds more attractive: replacing the alternative minimum tax with a “Buffett Rule” 30% tax that applies to those making more than $1 million annually, and allowing the Bush tax cuts to expire for individuals with taxable income in excess of $200,000 and married filers over $250,000. Another proposal, the revival of the Build America Bonds (BAB) program that was active in 2009 and 2010, and encouraged municipalities to issue taxable bonds with interest subsidies, could also be seen as positive; in its previous incarnation, the BAB program bolstered the tax-exempt market by holding down supply.

LIMITED INTEREST. A proposal more troubling for the muni market is one that limits the value of tax-exempt interest for the $200,000/$250,000 group to that available to taxpayers in the 28% bracket, essentially applying a 7.0% tax to income that is now fully exempt. Should the top tax rate return to the pre-Bush 39.6%, then the size of this additional tax rises to 11.6%.

While these proposals certainly leave much to consider for municipal market participants and bondholders, the minimal market reaction was appropriate, in our opinion, since passage seems highly unlikely as currently written. However, even if these proposals do not get far collectively or individually in the near future, their mere existence supports the notion that “tax-code risk” in the form of the longevity of the current federal tax exemption will likely shroud the market through and beyond the November elections.

TAX-TIME SALES. Finally, the calendar presents a predictable stumbling block. Every year, as the April tax deadline approaches, the muni market comes under pressure from investors selling bonds to raise cash for taxes. Given near-record-low yields, relatively high prices and the availability of a favorable capital-gains tax rate, tax-related sales could be especially attractive this year. Finally, the trend of credit-rating downgrades continues unabated and may endure for the next 12 to 18 months.

While we hold a long-term constructive view of the municipal market, we believe it is time to consider some selective selling. Accordingly, we advocate lightening up on 25- to 30-year debt with sub-5% coupons, as well as low-BBB-rated and sub-investment grade paper where demand from yield-hungry investors has been robust.

For buyers, we prefer state-level general obligation bonds, state-level appropriated paper, local general-obligation bonds and essential-service revenue bonds with mid-tier A ratings and higher, as well as AA-rated hospital debt within a maturity band of six to 14 years. We also suggest holding bonds that have above-market coupons throughout for their defensive attributes, as well as to bolster tax-exempt income.