Municipal markets in review: Risk sentiment versus technical conditions
December 31, 2012
Municipal markets: Snapshot summary
Notes: Market activity cited throughout this commentary is supported by data published by sources that include Barclays, Bloomberg, Municipal Bond Buyer, and Thomson Municipal Market Data (MMD).
As the fourth quarter drew to a close, substantial tax policy issues remained unresolved in Washington, D.C. We remind readers that legislative changes can happen quickly, often with ramifications for financial markets. The material in this commentary reflects legislative information available as of Dec. 31, 2012.
- As measured by the Barclays Municipal Bond Index, broad municipal bond markets declined by 1.24% in the month of December. It was the first monthly decline since March 2012, and only the second monthly decline for the full calendar year.
- Municipal bond yields were essentially unchanged across the yield curve, except for the 3–7 year maturity range (where yields rose between 5 and 19 basis points).
- The municipal yield curve, as measure by the spread between 2- and 30-year MMD AAA yields, flattened 3 basis points to 252 basis points.
- A-rated securities provided the strongest return during the fourth quarter of 2012.
- Municipal bond supply for the fourth quarter of 2012 was $92.6 billion, representing a 2% decrease versus the same period last year.
Broad market overview
With the exception of the 3–7 year maturity range (where yields rose between 5 and 19 basis points), municipal bond yields in most spots along the yield curve were virtually unchanged during the fourth quarter of 2012. Yields on most other maturities were either up or down 1–2 basis points. After strong returns marked the first two months of the fourth quarter, the market, as measured by the Barclays Municipal Bond Index, declined by 1.25% in December, marking the first negative monthly return since March 2012 and only the second monthly negative return for all of 2012.
While yields declined steadily for almost the entire year, this trend came to an abrupt halt during the week of Dec. 10 as a confluence of factors overwhelmed strong technical conditions. We believe the major catalyst for the turnaround was investors' realization that a potential cap on exclusions would limit the tax benefit associated with municipal interest to 28%. On Dec. 12, for instance, The Wall Street Journal ran an article titled "Tax Breaks on Muni Bonds Draw Scrutiny." The article highlighted President Barack Obama's budget proposal, including the cap on municipal interest. There were certainly other factors that played into the market selloff; and there were also certain aspects that we believe can potentially support the market going forward.
Other factors that influenced market performance included the following: municipal bond prices may have appeared too elevated, especially when compared to other fixed income alternatives; municipal bond yields were at or near historic lows; new-issue supply increased sharply; there was a high-profile downgrade of Puerto Rico-related credits; and risk sentiment in the United States was improving (with equities rallying at the expense of bonds), as negotiations around the fiscal-cliff resolution took on a more positive tone.
The municipal market stabilized after seven trading sessions, appearing to be oversold. The market also received favorable news about another high-profile sector when tobacco companies announced a settlement with 17 states, releasing previously disputed payments. At the same time, fiscal-cliff negotiations deteriorated, shifting market sentiment once again to a risk-off trade. An unresolved fiscal cliff would have led to tax rates going higher, providing municipal markets with additional support ahead of what is historically often considered a seasonally strong technical period in January.
Over the course of the quarter, macroeconomic indicators became slightly better, with improving housing data and a strengthening job market, as evidenced by a higher-than-forecast third-quarter gross domestic product figure in the United States (+3.1%). Other macro-level updates at the time of this writing include: (1) While Europe's core debt problems remain unresolved, its markets have generally stabilized, especially after Mario Draghi, president of the European Central Bank, promised to maintain market liquidity back in July; (2) China's economy is likewise stabilizing, as it appears that its trend of declining growth has bottomed; (3) in the U.S., the Federal Reserve has provided more accommodation in the form of a third and fourth round of quantitative easing (often referred to as QE3 and QE4 programs); and (4) although the uncertainty of the U.S. elections is behind us and the fiscal cliff has been avoided (at least partially), political discord in Washington remains.
For the sake of comparison, listed below are the returns posted by major fixed income and equity indices for the fourth quarter of 2012:
|Barclays Municipal Bond Index
|Barclays U.S. Treasury Index
|Barclays U.S. Aggregate Index
|Barclays U.S. Government/Credit Index
|Barclays U.S. Corporate High-Yield Index
|Dow Jones Industrial Average
|S&P 500® Index
(Data: Barclays; Bloomberg. Accessed on or about Jan. 2, 2013. Index performance reflects past performance and does not guarantee future results).
Municipal markets: Statistics
Treasury yields on 5- and 30-year bonds increased 10 basis points during the fourth quarter. Yields on 10-year bonds increased 11 basis points. Municipal yields on 5- and 10-year maturity bonds increased 19 and 2 basis points, respectively, and 30-year maturity bonds decreased 2 basis points during the quarter. This resulted in outperformance of municipal securities versus U.S. Treasurys for the 10- and 30-year periods, as demonstrated by the table below:
|AAA MMD / U.S. Treasury ratios
(Data: Thomson Municipal Market Data, accessed on or about Jan. 2, 2013. Index performance reflects page performnace and does not guarantee future results.)
Other developments during the quarter included:
- The municipal yield curive, as measured by the spread between 2- and 30-year MMD AAA yields, flattened 3 basis points to 252 basis points. Two-year high-grade tax-exempt bond yields increased 1 basis point while 30-year high-grade tax-exempt yields decreased 2 basis points. (Data: Thomson Reuters.)
- The Barclays Municipal Bond Index returned 0.67% for the quarter. The strongest-performing maturity segment was the long bond segemnt (representing bonds with maturities of 22+ years), which genearted a 1.15% return; the weakest-performing maturity segemnt was the 5-year segment (4-6 years), which returned -0.21%. (Data: Barclays).
- A-rated securities provided the best return during the fourth quarter of 2012. Credit spreads, as measured by MMD yields on 30-year BBB general obligation (GO) securities minus 30-year AAA GO securities, tightened. At the end of the fourth quarter, the spread was 131 basis points. (Data: Thomson Reuters).
For the fourth quarter of 2012, the total return within the Barclays Municipal Bond Index by rating, as well as the Barclays High-Yield Municipal Bond Index (representing noninvestment grade bonds) was as follows:
| Barclays High-Yield Municipal Bond Index
(Data: Barclays. Accessed on or about Jan. 2, 2013. Index performance reflects past performance and does not guarantee future results.)
Leading the investment grade sector were IDR/PCR1 bonds, which returned 2.02% for the period. They were followed by hospitals (+1.22%) and transportation (+0.92%). High yield tobacco was the strongest overall performing sector for the period, returning 8.85%.
Supply for the fourth quarterof 2012 was $92.6 billion, representing a 2% decrease as compared to the same period last year. Supply for the calendar year 2012 was approximately $373.1 billion versus $287.7 billion in 2011, a roughly 29.7% year-over-year increase. (Data: Municipal Bond Buyer).
The congressional resolution on income tax rates has resulted in higher taxed for joint filers with incomes above $450,000 ($400,000 for single filiers). The top income bracket will increase from 35.0% to 39.6%. This, combined with the new 3.8% Medicare tax on unearned income (interest, dividends, capital gains), will put top income earners at a 43.4% marginal tax rate. Currently, municipal bond interest is exempt from this 3.8% tax in addition to being exempt from the 39.6% income tax. In a market starved for yield, this alone may have the potential to provide support to municipal bonds in the form of more attractive taxable-equivalent yields. The market is also expected to be aided in early 2013 by continued low levels of new issuance.
As mentioned in the market review section above, there are still substantial issues to be resolved in Washington. The combination of reaching the fast-approaching debt ceiling and the two-month deadline to resolve the sequestration spending cuts should result in another round of tough negotiations by political leaders, wtih an ultimate goal of deficit reduction and tax reform. There will be negotiations for spending cuts in exchange for a debt ceiling increase as well as negotiations for additional revenue. The risk to teh municipal bond market is that the 28% cap on exclusions can potentially be on the table as a revenue enhancer. This would negate many of the positive effects of higher marginal tax rates.
We believe there are many risks to the bond market as we enter into the new year. There is the risk of a further downgrade of U.S. Debt, there is the risk of a volatile interest rate market, and there is the risk that the municiapl exemption may be capped. Due to the volatile nature of these negotiations, and their potential to affect financial markets, we are taking a cautious approach to the market in the near term. We will continue to monitor these events, macroeconomic conditions, and municipal credit metrics while continuing to employ our fundamental, bottom-up (bond by bond) approach to security selection.
Additional reading: Developments within selected states, briefly noted
(State-specific developments noted below are based on information published by each state's respective budget authorities and supplemented by sources that include Standard & Poor's, the National Conference of State Legislatures, the U.S. Labor Department, and the National Association of State Budget Officers.)
1The abbreviation IDR refers to industrial development revenue bonds, while PCR refers to pollution control revenue bonds.
- In Idaho, the unemployment rate totaled 6.8%. The governor signed a $2.7 billion 2013 budget into law on April 2012. For the first five months of fiscal 2013, general fund revenues totaled $1.1 billion. This was 4.4% above the prior year but 0.7% below budget projections. Individual income and sales taxes were 1.5 % and 1.3% below budget, respectively. Corporate taxes, which are more volatile, were 5.3% below estimates.
- Arizona has seen improvement in its unemployment rate, which has declined to 7.8% in November. The fiscal 2013 $8.6 billion budget represents a 0.6% increase from fiscal 2012. For the first five months of fiscal 2013, general fund revenues totaled $3.6 billion. This is 0.4% below the prior year but 0.6% above forecast. If we were to exclude adjustments, general fund base reveneus are coming in 4% higher than fiscal 2012. The state had $45.8 million in reserves in its official stabilization fund.
- The unemployment rate in Minnesota registered 5.7% in November. According to the state’s November forecast, general fund revenues for the 2012-2013 biennium are estimated to exceed end-of-session estimates by $1.1 billion, or 3.2%. General fund spending is projected to be $262 million below earlier estimates. This improvement reflects gains from fiscal 2012 and spending savings in K-12 education, debt service, and property tax aid. These forecast changes produce a $1.3 billion balance. This will be allocated to buy back some of the outstanding school aid payment shifts amounting to $2.4 billion. After this buyback, $1.1 billion of school aid shifts will remain. The state forecasts a $1.1 billion deficit for the 2014-2015 biennium.
- Colorado's unemployment rate has improved in recent months, to 7.7% in November. The governor signed a $7.4 billion 2013 general fund budget into law on May 7, 2012. According to the December economic update, general fund revenue for the current fiscal year is expected to be 2% higher than forecasted in September. Overall, general fund revenue is expected to grow 4.9% in fiscal 2013. After accounting for a 1% increase in the reserve level, the state is forecast to have excess reserves of $789.6 million. All excess reserves will be transferred to the state's education fund.
- In New York, the unemployment rate totaled 8.3% in November, higher than the national rate but improved over prior months. Lawmakers signed off on a $132.6 billion budget that cuts spending by $135 million and includes no new taxes. Through the first eight months of fiscal 2013, general fund revenues were 1.4% higher than fiscal 2012 but 0.9% below the latest November estimates. The November midyear update projected 2.9% growth in taxes, but taxes are currently running 0.4% higher than the prior year. Additionally, the midyear update did not reflect the effects of Hurricane Sandy. The governor's proposed budget, expected on Jan. 22, 2013, is anticipated to include projections based on the storm as well as conditions of the economy.
- California's unemployment rate totaled 9.8% in November, continuing to improve over prior months. The governor signed a $91.3 billion 2013 budget into law, closing a $15.7 billion budget gap through revenue increases and expenditure cuts. Revenues for the first five months of fiscal 2103 are currently running 2.5% above the prior year figures but 2.6% below budget, with shortfalls among all the big three tax sources. Additionally, spending is actually exceeding projections by 4.9%. The shortfall of revenues, together with excess spending, equates to an overall deficit of $2.7 billion. The state has sufficient cash liquidity, resulting in a stronger position than originally anticipated for this point in the current fiscal year.
- In Pennsylvania, the unemployment rate totaled 7.8% in November, on par with national levels. On June 30, the governor signed a $27.7 billion budget for fiscal 2013. Through the first six months of fiscal 2013, general fund revenues are 1.4% above estimates due to strong corporate and individual income taxes. Sales tax collections remain weak, coming in 2.7% less than anticipated.
- The unemployment rate in Puerto Rico has improved slightly to 13.8%, but is still well above the U.S. national rate. Moody's recently downgraded its rating of the commonwealth from Baa1 to Baa3 based on factors that included its weak economy, high debt levels, weak retirement system, and history of general fund deficits. The commonwealth certainly has its weaknesses but it has taken steps toward correcting them in the form of tax and fiscal reform. While the general fund deficit has diminished over the past few years, general fund revenues for the first four months of fiscal 2013 are coming in 3.4% below projections, indicating that structural balance may still be out of reach. Puerto Rico needs to implement additional pension reform and strive toward structural balance for fiscal 2014 in order to prevent any further downgrades.
1The abbreviation IDR refers to industrial development revenue bonds, while PCR refers to pollution control revenue bonds.
Important disclosures and definitions
Investing in mutual funds involves risk including the possible loss of principal. Past performance does not guarantee future results.
Unless otherwise noted, the sources of statistical information in this document are Bloomberg, Municipal Bond Buyer, Barclays, and Thomson Municipal Market Data. Data were originally accessed on or about Jan. 2, 2013.
The information is provided with the understanding that Delaware Investments is not engaged in rendering accounting, legal, or other professional services. Seek the services of a competent professional if legal advice or other expert assistance is needed.
Advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.
Joseph R. Baxter and Stephen J. Czepiel are officers of Delaware Management Company, a series of Delaware Management Business Trust and a registered investment advisor.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer's ability to make interest and principal payments on its debt. These funds may also be subject to prepayment risk (the risk that the principal of a fxied income security may be prepaid prior to maturity), potentially forcing a fund to reinvest that money at a lower interest rate.
High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.
Funds that invest primarily in one state may be more susceptible to economic, regulatory, and other factors of that state than funds that invest more broadly.
Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.
Bond ratings mentioned in this document are published by Standard & Poor's, a nationally recognized statistical rating organization. Bonds rated AAA are rated as having the highest quality and are generally considered to have the lowest degree of investment risk. Bonds rated AA are considered to be of high quality, but with a slightly higher degree of risk than bonds rated AAA. Bonds rated A are considered to have many favorable investment qualities, though they are somewhat more susceptible to adverse economic conditions. Bonds rated BBB are believed to be of medium-grade quality and generally riskier over the long term.
The Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.
The Barclays High-Yield Municipal Bond Index measures the total return performance of the long-term, noninvestment grade tax-exempt bond market.
The Barclays U.S. Corporate High-Yield Index is composed of U.S. dollar-denominated, noninvestment grade corporate bonds for which the middle rating among Moody's Investors Service, Inc., Fitch, Inc., and Standard & Poor's is Ba1/BB+/BB+ or below.
The Barclays U.S. Treasury Index measures the performance of U.S. Treasury bonds and nottes that have at least one year to maturity.
The Barclays U.S. Aggregate Index measures the performance of publicly issued investment grade (Baa3/BBB- or better) corporate, U.S. government, mortgage- and asset-backed securities with at least one year to maturity and at least $250 million par amount outstanding.
The Barclays U.S. Government/Credit Index is a market value–weighted index of government fixed-rate debt securities and investment grade fixed-rate debt securities.
The Dow Jones Industrial Average is an often-quoted market indicator that comprises 30 widely held blue-chip stocks.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market.
Index performance returns do not reflect any management fees, transaction costs, or expenses. indices are unmanaged and one cannot invest directly in an index.
The views expressed represent the Manager's assessment of the market environment as of Dec. 31, 2012, are subject to change, and may not reflect the manager's current views. Views should not be considered as recommendations to buy, hold, or sell any security, and should not be relied on as research or investment advice. Please see important disclosures and definitions at the end of the document.
Carefully consider a mutual fund’s investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the fund’s prospectus and, if available, its summary prospectus, which may be obtained by visiting delawareinvestments.com or calling 800 523-1918. Investors should read the prospectus and, if available, the summary prospectus carefully before investing.
For the national sales desk, please contact 877 693-3546.
Individual investors, please contact 800 523-1918.
All third-party marks cited are the property of their respective owners.