MSSB: ‘Sprinkle’ of high-profile muni defaults won’t lead to downpour

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

The price performance of the municipal bond market has been anything but sedate thus far in 2012. Much of munis’ recent volatility stems from the price action of the broader US Treasury market, but factors such as supply and demand, relative-value metrics and credit quality are playing a role, too. To put this price volatility in context, consider that 10-year AAA-rated benchmark yields rose more than 60 basis points between mid January and early March, only to reverse course weeks later with yield declines that recaptured more than 30 basis points. The year-to-date total return for municipals stands at 0.88% and -0.25% for US Treasuries, according to Barclays Capital (as of April 17).

More credit sensitivity

Outsized volatility such as this continues to support a more tactical approach to what has historically been a much more staid market. Furthermore, continuing negative credit developments at the local level suggest that the muni market is well into its multiyear process of becoming an idiosyncratic, credit-sensitive market more akin to US corporates. This change requires a prudent focus on issuer credit quality for every purchase. To be sure, some high-profile defaults have come to the fore and headwinds remain for many local issuers. Still, we do not believe that this sprinkling of defaults will turn into a downpour. To put it in context, Moody’s reports that the average number of defaults essentially doubled in 2010 and 2011, rising to 5.5 out of 17,700 rated issues as compared with 2.7 per year in the 1970-to-2009 period. The 10-year cumulative default rate stands at 0.04% for all A-rated bonds versus 0.13% for all rated bonds.

Favorable ratio

With our tactical approach in mind, we see relative value in the. The ratio of muni to US Treasury yields is 97%, which we view as compelling. The slope of the municipal yield curve—at approximately
311 basis points—remains steep, allowing investors to pick up incremental yield when judiciously venturing further out on the curve. The forward supply appears manageable. After beginning the year at approximately
$4 billion in new issues per week, the market appears to be handling the uptick in primary supply, which is now around $7 billion per week. We expect this healthy appetite for bonds to continue, though a further acceleration in issuance could challenge the market. However, if a pullback materializes, it could provide a favorable entry point for investors. In addition, seasonally strong bond redemptions should give the market some support in coming months, as participants usually reinvest this cash.

Selective buys

We advocate a blend of general-obligation and essential-service revenue bonds with maturities in the six-to-14-year range. Credit quality should center on bonds with ratings of mid-to-upper A and higher, as well as AA-rated hospital bonds. We also favor above-market coupons—bonds selling at above-par prices—for the income and their defensive qualities. For investors interested in shorter maturities, the relative-value of pre-refunded bonds looks attractive, trading at 95%-to- 100% of corresponding maturity US Treasury yields.

Related Topics: Morgan Stanley Smith Barney (MSSB)