The municipal bond market, as measured by the Barclays Municipal Bond Index, eked out a small gain for the month of July, and in my view, this is significant. The forces of what has been a strong U.S. stock market so far this year, and continued evidence of some economic improvements, have interrupted what had been a strong first six months of the year for municipal bonds, generally turning investors toward taxable bonds. Still, the volatility of some equity markets, which appeared to be brought about by elements of the conflicts in Gaza, Ukraine, and Iraq, combined with the default (again) by Argentina, could potentially leave investors favoring municipal bonds.
The saga of Puerto Rico has dominated both the headlines and secondary market trading in recent months, but in general has not dampened interest in the broad market overall. What has remained in place is the equation of demand consuming limited supply. Also the ratio of municipal yields to treasury yields — an important indication of potential value — seems to be pointing to possible opportunity in investment-grade muni bonds, from intermediate maturities to the long end of the curve. It’s here that the ratios have again reached 100% as of July 30.
After redemptions in early June fostered a round of selling, tobacco bonds have posted stronger returns than investment-grade bonds in July, with limited new issue supply supporting price action throughout all sectors. The spreads of high-yield municipals to investment grade continue to signal a potential value opportunity. As of July 29, the Barclays High Yield Municipal Bond Index spread was 454 basis points to the Barclays Municipal Bond (investment-grade) Index, still 170 basis points above the long-term average beginning in 2004.
In addition, the Barclays High Yield Municipal Bond Index is yielding 127% of the Barclays U.S. Corporate High Yield Index as of July 30. From these two comparisons alone, it is hard to ignore the potential for opportunity in municipal bonds. The argument for a crossover trade from high-yield corporates to high-yield municipals can be made, when considered on a taxable-equivalent basis.
Index Yield and Duration Profile as of 7/31/14
Source: FactSet as of 7/31/14. Index performance is not illustrative of Market Vectors ETF performance. Fund performance is available at www.marketvectorsetfs.com.
High-Yield Corps Index: The Barclays U.S. Corporate High Yield Index covers 50 of the most liquid and tradable U.S. dollar-denominated, non-investment grade corporate bonds for sale in the U.S. High Yield Muni Index: The Barclays Municipal Custom High Yield Composite Index covers high yield rated (75%) and BBB rated (25%) municipal bonds with a nominal maturity of 1+ years. The Barclays Municipal Bond Index covers investment-grade municipal bonds with a nominal maturity of one or more years. The Barclays High Yield Municipal Bond Index covers below investment-grade municipal bonds with a nominal maturity of one or more years.
Taxable-equivalent yield represents the yield a taxable bond would have to earn in order to match, after federal taxes, the yield available on a tax-exempt municipal bond (excluding AMT). Municipal bonds may be subject to state and local taxes, as well as to federal taxes on gains, and may be subject to alternative minimum tax. The chart displays the yields of municipal bond indices on a tax-equivalent and duration basis and compares such yields to other asset classes as represented by the indices defined above. Municipal bonds are exempt from federal taxes and often state and local taxes. Corporate bonds are subject to federal, state, and local taxes. Prices of bonds change in response to factors such as interest rates and issuer’s credit worthiness, among others. Duration is represented by duration to worst. Historical information is not indicative of future results; current data may differ from data quoted.