There is big risk to the muni bond market that you are probably aren’t thinking about. That risk is how increasingly frequent weather-related calamities are befalling US cities as the climate changes. The market is already starting to price these risks, and according to BlackRock, many current muni bond issuers could see 1% knocked of their economic output. According to the head of muni bonds at BNY Mellon, “The risk has been identified by market participants … Looking at the severity of storms picking up . . . it will start to be factored in”. When choosing bonds, investors need to start demanding or checking on plans from issuers. “What plans are they making? Are they hardening their infrastructure . . . are they trying to insulate central services? If they’re just stating the obvious, that’s not sufficient”, says BNY Mellon.
FINSUM: This is an important consideration for all those that hold munis. Think of the weather-related calamities that have happened lately and consider the implications (e.g. Houston).
The muni market has traditionally been a safe haven for investors seeking steady returns. However, things are beginning to change. The huge drop in yields is fueling some very risky behavior in certain corners of the muni bond market. With yields on even the riskiest munis down to about 4%, highly speculative borrowers, such as those building risky mall developments or far-away housing projects are raising muni money through governmental agencies.
FINSUM: Investors need to look out for these kind of deals. However, what could be more troublesome is how they will inevitably end up in many popular funds without investors even having awareness of them.
The muni market seems healthy. Other than the cases where budgets are exploding, the market as a whole has characteristically low yields and looks stable, especially because of excess investor demand from the recent tax changes. However, there are structural concerns about the market. Nuveen and Vanguard have come to dominate the market through their funds, sucking up to two-thirds of all the Dollars flowing into the market in the last decade. This is because investors have been increasingly buying muni funds, not individual securities. However, according to UBS, this is a big risk. “When everyone runs for the exit at the same time…no one wants to be the buyer of last resort … The concentration in large municipal asset managers will have ramifications during volatile times in that it will make the swings greater one way or another”.
FINSUM: Everyone has been warning about big runs on fixed income funds in a market downturn, but evidence of such has yet to materialize.
The muni bond market is in a difficult place for investors. Demand is far outstripping supply, which means prices are high and yields low, leaving investors few opportunities to find value. However, few does not mean none, so here are some places to find good value municipal bonds. Airport muni bonds can be a good choice, as they tend to fair well in recessions and have very defensible funding sources (e.g. state and local governments). Toll-road bonds are another good choice, as they have very strong credit characteristics (only two have defaulted since 1970). Toll roads in San Francisco, New York, Oklahoma, and Maine are particularly good bets as there are few options for drivers to avoid them.
FINSUM: These seem like well-thought out and defensible choices.
Investors beware, the muni bond market has gone through some dramatic moves over the last year, and the market looks like it might be headed for a downturn. Changes to the US’ tax policy have caused massive inflows to muni bonds as investors try to minimize their taxes. This has caused yields to plunge and spreads to Treasuries to widen. The average ten-year muni yield is now just 1.965% versus 2.6% in 10-year Treasuries, the widest gap since at least 2009. Munis in high tax states have plunged even further, with a recent California issuance having a yield of just 1.73%. One portfolio manager warns investors that they need to be responsive, saying “The best place for investors to be is shorter duration, higher-quality credit, so when opportunities present themselves, they have the flexibility to take them … You can’t really set it and forget it”.
FINSUM: This is a hard situation to call. On the one hand, the rapid fall in yields is worrying and the market seems overbought, but on the other hand, you have somewhat artificial demand being created by the government, which makes the behavior less risky and more sustainable in our view.