Municipal bond prices have taken a beating lately and I don’t believe that the downward move is justified. As Jon Rocafort of Eaton Vance points out in his blog post below, this might be a great buying opportunity!
Jon Rocafort, Co-Director of SMA Strategies at Eaton Vance
We think the extreme move in the municipal bond market after the U.S. election may offer an attractive entry point for investors.
Let’s start with some historical context on the recent spike in muni yields, which has sent bond prices lower. The BofA Merrill Lynch Municipal Master Index lost 3.7% in November, its largest one-month decline since 2008. Zooming out a bit, we have witnessed one of the largest five-month increases in yields on record.
Our view is that this historic move has created an emerging opportunity to lock in higher yields and potentially generate higher future returns. For investors lamenting the “sticker shock” of low muni yields recently, this could be their chance to enter the sector or add to existing holdings.
The chart below illustrates the resilience of the municipal market and demonstrates that sharp increases in municipal yields have created buying opportunities and rewarded investors with strong returns in subsequent months. Although as always, past performance is no guarantee of future results.
The noticeable yield upswings in 2008, 2010 and 2013 all offered investors the chance to buy munis at not only higher yields, but also at attractive valuations. For example, the 2010 scare was driven by analyst Meredith Whitney’s prediction of hundreds of billions of dollars of muni defaults – that never materialized. Also, during the 2013 “Taper Tantrum” both Treasury and municipal yields rose sharply after the Federal Reserve said it would start slowing its bond purchases.
We may be witnessing another overreaction in the bond market. Many of Donald Trump’s plans, including tax cuts and fiscal stimulus, would come with very high price tags and likely be challenged by fiscal hawks in Congress. At this point, it’s extremely difficult to predict what will actually be passed, in what form, and over what horizon. In our view, the “Trump rally” in stocks and the sell-off in bonds are based on very little detail on the President-elect’s policy initiatives, and seems driven more by speculation.
And even if the Trump administration succeeds in reducing personal income tax rates, muni yields still look attractive. First, the ratio of 10-year AAA muni yields versus 10-year U.S. Treasury yields has risen from 93% before the election to about 105% (higher ratios indicate cheaper muni valuations). Also, as we have discussed recently in a separate blog, historical changes in the highest marginal tax bracket have not had a material impact on the relative valuation of muni bonds over the medium to long term.
Bottom line: Treasury and municipal bond yields have seen an extreme short-term reaction after the U.S. election. It is surprising what has taken place without more actual detail. The move could be an overreaction that gives investors a chance to scale into munis at higher yields and cheaper valuations – an opportunity similar to what developed following 2008, 2010 and 2013.
An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Rising interest rates could reduce the value of the bonds in the portfolio, thus adversely affecting the value of the overall investment.
Source: Eaton Vance