A perfect storm of austerity, low interest rates, and rebounding tax revenues are causing US municipal bond yields to plummet.
The first part of 2014 was strong for municipal bond markets, but it is unlikely the outlook will remain optimistic. Spending cuts in state and local governments across the US over the last four years have begun to cut into the supply of outstanding municipal bonds since more balanced budgets mean maturing bonds are not replaced with new ones. With shorter supply, the yield on municipal bonds – or muni’s – has shrunk.
The trend has only been intensified in recent months by the continued low rate environment from the Fed and rebounding tax revenues. These low muni yields are not likely to rise any time soon either. The traditional muni investors, retirees looking for safe and tax-free investments and mutual funds, have begun to shift away towards other investments. They may continue if certain tax reforms are enacted.
Shrinking supply
Inflation-adjusted municipal bond issuances peaked just before Tea Party politicians took office after sweeping the 2010 midterm elections. As soon as they did, budgets were cut and new spending limits were put in place.
Projecting forward based on the first half of the year, new municipal bond issuances in 2014 will be more than 15% smaller than last year. Of those projected $284 billion of municipal bonds, less than 50% will fund new capital projects. Additionally, the amount of total outstanding municipal bonds has shrunk since 2010.
2014 issuances projected based on figures through July at historical monthly issuance rates. 2014 total outstanding based on Q1 figures. Sources: SIFMA, BLS
The smaller supply of municipal bonds is pushing prices higher, meaning lower yields. Yields have fallen 62 basis points since January, and are now lower than the 10-Year Treasury Note. Accentuating those low rates are the Federal Reserve’s commitment to historically low interest rates to kick start a high unemployment and low inflation environment.
Another implication of austerity may be that the spread between the municipal bonds and the risk-free rate could remain depressed for a long period. Since the average maturity of municipal bonds is just under 17 years (as of July 2014), the austere decisions of the last four years will continue to exert downward pressure of bond supply, and therefore yields, for the next decade.
Interest rates will begin rising sometime next year, which will give muni yields some more breathing room, but a healthy economy will cut further into the supply of new muni’s as tax revenues rise.
Source: Newfleet Asset Management
As state and local governments see increases in tax revenue, their need to rely on debt for operating expenses will decrease independent of austere budgets. Not only will their revenues increase, but automatic fiscal stabilizers in the form of unemployment insurance and poverty assistance will fall, further improving state balance sheets.
As municipal bonds have become less attractive to individual investors (which has not been helped by Detroit’s default and Puerto Rico’s near default), they have held fewer and fewer of them. Since 2004, the portion of municipal bonds held by individuals or mutual funds has fallen from 79% to 72%.
The individuals typically holding municipal bonds are retirees who are looking for a relatively low-risk and tax-free investment. But the super low rates of return have been too much of a cost to offset the tax-free benefits of municipal bonds. With talk of dismantling some of the tax-free benefits for high-income Americans, the outflow of individual investors could accelerate.
If this trend begins to dampen demand for municipal bonds, the overall impact on yields is uncertain. Rising interest rates, credit risk, and smaller demand will push yields up, while smaller supply and increasing tax revenues will push them back down. Which one dominates will be unclear unless pressure in one direction accelerates much faster than the other.
In the near-term, however, supply-side effects are winning out, pushing muni yields ever lower – and making them even less attractive to the investors who have traditionally held, directly or indirectly, upwards of 80% of them.
