Municipal Fixed Income: Disappointing Performance for the Quarter
Delaware Investments Market Veiws by our Municipal Fixed Income group
Economic Summary A big story for the second quarter was the job environment. The strong economic numbers we experienced over the last six to nine months finally began to be reflected in an improved employment situation, as witnessed by the last three job reports. However, a roaring economy that creates jobs - over one million for the first half of 2004 - can also add inflationary pressures to the economy that may be offset with higher interest rates, and the bond markets are rarely favorable of rising rates.
Interest rates rose sharply during the first half of the quarter, with evidence of rising inflation ranging from a review of the consumer price index (CPI) to a trip to the gas pump. Fortunately, rates stabilized somewhat over the balance of the period. Also of concern to interest rate watchers was the Federal Reserve's prolonged period of monetary accommodation, which clearly appeared to be in jeopardy. Fed comments last summer denoted its worries about a "substantial fall in inflation." By fall, the Fed hinted that its accommodative monetary policy would likely be maintained for "a considerable period. With the new year's first quarter came a "patient" Fed. By the second quarter of 2003, the Fed appeared ready to tighten monetary policy in "measured" fashion. In a widely anticipated action, the Fed raised the fed funds target by 25 basis points (bp) to 1.25% at its June 30 meeting.
Market Performance The second quarter was not kind to the fixed-income markets. As measured by the Lehman Brothers indexes, total returns for the quarter were among the worst experienced in over 20 years. Long-term Treasury bond yields* increased by over 50 bp during the period, from 4.77% on March 31 to 5.29% at quarter-end, June 30. Shorter-term maturities experienced even greater increases, which resulted in some flattening of the yield curve. In the two-year range, for example, the yield on the actively traded Treasury increased 110 bp for the quarter, from 1.58% to 2.68%.
Municipal bond returns¹ fared no better. For maturities between five and 20 years, the difference in total returns were quite narrow, ranging from -2.15% for the Lehman Brothers five-year bond index to -2.38% for 10-year bond index. While not setting any records, the equity markets were more sanguine for the second quarter, as demonstrated by the S&P 500 Index's +1.72% return.
Municipal Market Commentary Municipal market investors seemed to be sailing against the wind during the second quarter as yields rose across the entire curve, with shorter maturities experiencing greater increases. In a period of Federal Reserve tightening, or in anticipation thereof, a flattening curve is not uncommon. Yields on two-year, high-grade tax-exempts** rose 70 bp, from 1.40% at March-end to 2.10% on June 30. Note that this increase in municipal yields represents roughly 65% of the change in the Treasury yield curve, which is consistent with the yield ratios for shorter-term municipals versus Treasuries. With longer-term maturities, yields rose 52 bp in the 10-year range to yield 3.95% at quarter-end and 49 bp among 30-year high-grades, to yield just over 5.00% as of June 30. Most of the curve's 20 bp flattening from two years to 30 years occurred during May, just when the markets began anticipating a June Fed tightening (see Chart A).
While we would have expected added flattening of the yield curve in the two- to five-year range based upon heightened volatility with short-term maturities, nearly all of the curve flattening occurred within the range of five to 10 years,** which can largely be attributed to strength in crossover buying in the 10-year range. Crossover buyers are non-traditional investors in the tax-exempt markets, such as pension funds taking advantage of relative values and arbitrage accounts. One concern for us looking forward is how the 10-year segment of the yield curve will respond when the crossover buyers become sellers.
Relative to the Treasury market, tax-exempts performed well for the second quarter, in contrast to the previous three months. For Chart B, which spans the first half of 2004, all three maturity ranges - the short-, intermediate- and long-term portions of the yield curve - underperformed their Treasury counterparts during the first quarter but rebounded in the second quarter, with the two-year bond displaying the greatest relative volatility. Based upon comparative yield data between Treasuries and tax-exempts for the last 12 months,** the two-year bond is somewhat richly valued at 78.3% comparable-term Treasuries, the 10-year is right at fair value - 85.9% - and the 30-year is slightly cheap at 94.7% of Treasuries.
The negative trend in tax-exempt mutual fund cash flows² accelerated during the second quarter. As the June 2004 results are not yet finalized, the estimated year-to-date outflow from open-ended municipal funds is roughly $6.5 billion. Toward quarter-end, even tax-exempt money-market funds were experiencing outflows, with negative flows for each week in June. These flow patterns among municipal funds are similar to those experienced in 1999, which was also the most recent occasion when the Fed shifted to a tighter monetary stance.
With mutual funds failing to generate net purchases of municipals, retail buying, which had been spotty during the first quarter, has recently accelerated. The concept of owning bonds directly, which at some point will be redeemed at face value, increases in appeal to retail investors when rates are rising and fund net asset values (NAVs) are in decline. Also, the seasonal impact of coupon activity and maturity flows is in full swing, which can lend the market further support. Ironically, recent retail buying appears at odds with the activities of non-traditional crossover buyers in the 10-year range of the yield curve and to a lesser degree, the property and casualty insurers (whose purchases have turned spotty this quarter) in the 20-year range.
Municipal supply for 2004 has been light relative to last year,³ with the mid-year results down 8.8% and the second quarter off nearly -15%. With the increase in rates, refunding issues are off nearly -25% this year. If rates continue their ascent, as is widely anticipated, or at least stabilize at levels above those for 2003, we do not expect any pick up in the pace of new issues. Also, with improvement among state budgets (more tax revenues courtesy of a strong economy), it is unlikely that municipalities will continue to look to the markets for "cash flow" funding, as has been effected with economic recovery and tobacco securitization bonds over the last few years.
California was by far the quarter's largest issuer of bonds³, owing to the state's issuance of $15 billion worth of economic recovery bonds throughout the first half of 2004. Texas also experienced a +22.7%
year-over-year increase in new issues, owing to several Houston-related issues that included the city's school district and utility system and which generated over $2 billion in new bonds during the period. New issuance volume fell by more than 20% during the first half of 2004 for New York as last year represented the time during which all of the state's Metropolitan Transportation Authority obligations were refinanced, providing nearly $12 billion in new issuance.
A further narrowing of the credit spread in tax-exempts can be attributed to the improving revenue position of the states, along with the more important influence of "yield reach," which causes a willingness among investors to sacrifice credit quality for the higher yields of lower-grade bonds given a backdrop of muted interest rates. This added demand for weaker credits tends to narrow the difference between high-, mid-, and low-grade bonds.
As shown in Chart C, the BBB to AAA spreads were somewhat flat in the first quarter, narrowing by only 20 and to 25 bp for intermediate- and long-term bonds. This narrowing led to good relative performance during the quarter for mid-grade sectors, particularly hospital and leasing revenues. Going against this trend was the industrial development revenue (IDR) sector, which was negatively impacted by airline securities, as well as stand-alone tobacco settlement bonds (TSB) that experienced yet another negative legal decision. The resultant sell-off highlighted the specific legal risks of TSBs and harkened back to a similar scenario during the first quarter of 2003. Airline bonds had a rocky quarter based upon ongoing union negotiations, increasing fuel costs, and stepped-up competition from low cost carriers.
With the market exiting one its worst quarters in many years, and with the Fed embarking on a tightening cycle, it may seem hard to find good news for the bond markets moving forward. However, we believe there are a few signs that may indicate that not all is doom and gloom.
First, there are currently many more bears than bulls in the bond markets. From a contrarian viewpoint, when an overwhelming degree of market participants are on side of the buy/sell equation, it usually pays to be on the other side (this position applies to the equity and commodity markets as well). Some studies have shown a correlation between broad expectations of higher rates and a peak in rates.
With the heightened volatility in interest rates, particularly as reported by the press, some investors may be tempted to exit bonds, then return when the overall interest rate environment improves. We have consistently discouraged such "market timing" strategies for several reasons. More often than not, it's emotions that drive the decision-making process, when more meaningful rationale, such as a change in one's financial objectives or investment time horizon, should prevail. Also, attempts at timing the market often result in diminished long-term portfolio returns.
For example, from mid-June to late-July 2003, rates rose over 100 bp. Frustrated with declining portfolio values, some investors sold their mid- and long-term bonds in August and reinvested in either short-term fixed income or cash, both of which offered reduced volatility, but also less yield. As it turned out, there couldn't have been a worse time to turn defensive, as the market reversed course. With its 60 bp rate decline, September 2003 became one of the best months for bond market investors in a decade.
Data sources: * Treasury yields - Bloomberg ** Municipal yields - Municipal Market Data ¹ Index returns -- Lipper ² Fund flows - AMG ³ Municipal supply - The Bond Buyer
Past performance is not a guarantee of future results. You can not invest directly in an index. Consumer Price Index - The U.S. Consumer Price Index is calculated by the U.S. Department of Labor and represents the change in the price of goods and services for all urban consumers. Lehman Brothers 5 Year Bond Index is a composite measure of total return performance for bonds with maturities of 5 years. Lehman Brothers 10 Year Bond Index is a composite measure of total return performance for bonds with maturities of 10 years.
The views expressed on this web site were current as of June 30, 2004 (unless otherwise stated), are subject to change, and do not constitute investment advice.