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Main Website >>Investment Management / Alternative Investment >>Blog >> A Growing Attraction to Municipal Bonds
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Kevin Mahn, President & Chief Investment Officer, HENNION & WALSH ASSET MANAGEMENT

A Growing Attraction to Municipal Bonds
Monday, May 14 2012 | 12:46 PM
Kevin D. Mahn
President & Chief Investment Officer, HENNION & WALSH ASSET MANAGEMENT

Author: Kevin Mahn

We, at Hennion & Walsh, have long maintained that, for income oriented investors, bonds can provide for a dependable and consistent stream of income, and principal protection when held to maturity. Bonds, whether they are Municipal, Government or Corporate bonds, can also provide for compounded growth opportunities when the income received from the bonds is reinvested.

Additionally, for growth-oriented investors, fixed income securities can provide investors with downside protection and diversification within a growth portfolio especially in a highly volatile market where additional, measured, short-term flights to quality are likely.

While allocations to bonds may vary based upon market conditions and investor objectives and risk appetites, bonds (or other fixed income-oriented strategies) can typically find a home in most investment portfolios throughout most market cycles.

With respect to the current market outlook for the third quarter, it would appear as though there is a growing appetite and attraction to municipal bonds. I believe that this growing appetite is being fueled by the following factors:
1.Lack of Supply – new issuance of municipal bonds has slowed dramatically of late. While headline statistics will show that the total amount of municipal bonds issued through April 2012 is nearly twice what it was at this point in time last year, it should be noted that close to 70% of new deals were refinancing as opposed to brand new issuances. To this end, RBC Capital Markets, in an Investment News article on May 6, 2012 entitled, “Stage set for rally in municipal bonds” projects that municipalities will return approximately $140 billion to muni bond holders through distributions/returns of principal over the next 4 months while issuing only $140 billion in new muni bonds.
2.Potential for Higher Taxes Following Fall U.S. Presidential Election – if individual investors feel that the likelihood that their personal tax rates will go higher in the near future, their appetite for tax-advantaged products, including municipal bonds, will increase seeing that roughly 75% of the municipal bond market is owned by individual (i.e. retail) investors.
3.Aftermath of Muni Bond Fund Outflows following Meredith Whitney’s Default Predictions– It wasn’t that long ago that Meredith Whitney made her bold predictions on 60 minutes that there would be “hundreds of billions of dollars of municipal defaults” in 2011. The panic and concern that ensued drove retail investors out of municipal bond funds in record numbers. As it turned out, the forecasted onslaught of municipal defaults never occurred and municipal bonds still maintain a low cumulative default rate history when compared to other debt instruments as evidenced by the comparison to corporate bonds below.
Average Cumulative Default Rates
(1970 – 2011)

Rating
Municipal Bonds 10 Year Cumulative Default Rate
Corporate Bonds 10 Year Cumulative Default Rate

Aaa
0.00% Municipal Bonds 10 Year Cumulative Default Rate

0.48%Corporate Bonds 10 Year Cumulative Default Rate


Aa
0.01% Municipal Bonds 10 Year Cumulative Default Rate

0.86%Corporate Bonds 10 Year Cumulative Default Rate


A
0.04% Municipal Bonds 10 Year Cumulative Default Rate

2.22%Corporate Bonds 10 Year Cumulative Default Rate


Baa
0.37% Municipal Bonds 10 Year Cumulative Default Rate

4.71%Corporate Bonds 10 Year Cumulative Default Rate


Ba
3.92% Municipal Bonds 10 Year Cumulative Default Rate

19.54%Corporate Bonds 10 Year Cumulative Default Rate


B
21.85%Municipal Bonds 10 Year Cumulative Default Rate

43.00%Corporate Bonds 10 Year Cumulative Default Rate


Caa-C
23.68%Municipal Bonds 10 Year Cumulative Default Rate

70.24%Corporate Bonds 10 Year Cumulative Default Rate





Please Note: Data source is Wells Farg0 Advisors, Moody’s, Average Cumulative Default Rates, 1970 – 2011.

Once the default concerns waned in 2011, retail investors started to put money back into municipal bond funds which helped municipal bonds (along with the volatility that returned to the stock market following the downturn in equities during the 3rd quarter of 2011) turn in one the best annual performance results across all asset classes for 2011 as evidenced by the total return of 10.70% that the Barclays Capital Muni Bond Index posted for the calendar year – adding to an already impressive 10 year total return performance history for this index.

Barclays Capital Municipal Bond Index Historical Performance
(2000 – 2011)

Calendar Year
Calendar Year Total Return %

2000
11.68%

2001
5.13%

2002
9.60%

2003
5.31%

2004
4.48%

2005
3.51%

2006
4.84%

2007
3.36%

2008
-2.47%

2009
12.91%

2010
2.38%

2011
10.70%




Please Note: Data source is Wells Fargo Advisors, May 7, 2012. The Barclays Capital Municipal Bond Index is a broad measure of the municipal bond market with maturities of at least one year. Past performance is not indicative of future results. Investing in fixed income securities involves certain risks if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity. Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the Alternative Minimum Tax (AMT).

Another rally in municipal bonds could thus take place if more of the previously redeemed municipal bond fund money moves back into municipal bond funds or if new money is deposited in municipal bonds given the volatility that we are now starting to see again in the equity markets.

Hence, it would appear as though there is credence behind the growing attraction to municipal bonds on the part of investors given the lack of supply and increasing demand for tax-free bonds and this attraction is anticipated to last at least through the end of third quarter based upon current market information. However, with this said individual investors would be wise to educate themselves about the intricacies of municipal bonds, interest rates and the fixed income markets in general and consult with a professional who has expertise in this area. Part of this consultation should include a detailed review of financial goals and objectives (i.e. growth, income or a combination of both), investment timeframes, tax sensitivity and risk tolerance so that an appropriate, overall investment strategy, often incorporating a customized asset allocation framework, can be developed and implemented.

In this regard, and to provide for full disclosure, at Hennion & Walsh, we started out as specialists in tax-free municipal bonds and built our reputation by selling bank investment grade municipal bonds to conservative investors looking for safe, predictable income that's tax-free.
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