A Nationwide Financial® White Paper
EXECUTIVE SUMMARY
• Municipal bonds have several attractive characteristics, including
tax advantages, low volatility and strong credit quality.
• Challenges have faced the market in recent years, with weak state
and local budgets and lack of availability of bond insurance.
• Dire predictions have not materialized, and municipal bonds offer
an attractive risk/reward dynamic for investors seeking yield,
stability and tax benefits.
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PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
MUNICIPAL MARKET OVERVIEW
Municipal bonds (munis) are issued by governments and government institutions to fund general operations and specific projects. Investing in munis is appealing because of tax benefits, modest volatility and low default risk. Munis are generally exempt from federal taxes, and in some cases exempt from state and local taxes.* The market, according to Federal Reserve data as of June 30, 2013 is $3.7 trillion, up 36% from 2003 but lower than the $3.9 trillion peak in 2010. As Figure 1 shows, this is smaller than the treasury, corporate and mortgage-related segments, but larger than agency, money market and asset-backed. Munis are largely held by individuals, through direct ownership and through mutual funds (Figure 2). Because of the tax treatment, they are generally not held in tax-advantaged accounts (e.g. retirement accounts, trusts and foundations). Munis have traditionally been bought and held, rather than actively traded. According to the Securities Industry & Financial Markets Association, through October of this year, municipal bonds accounted for just over 1% of bond market trading volumes, versus treasury at 67% and agency mortgage-backed at 28%.
Figure 1. Total Bonds Outstanding
Figure 2. Holders of Municipal Securities
As of 6/30/2013. Source: Securities Industry & Financial Markets Assoc.
As of 6/30/2013. Sources: SIFMA, Federal Reserve * Investing in fixed income securities involves risks such as interest rate, call, liquidity,
MUNICIPAL MARKET OVERVIEW
Muni issuance was relatively stable from 2004 through 2010, but has declined in the past three years as
economic pressures and state budget constraints limited legislators’ willingness to approve new projects (Figure 3). An increasing amount of issuance is being used to refinance current bonds outstanding, accounting for 34% of 2013 issuance through October, versus an average of 24% from 2004 through 2010, according to Bond Buyer. Another trend is for an increasing percentage of issuance being used for specific projects rather than general purpose. As Figure 4 illustrates through October 2013, bonds focused on education accounted for 29% and transportation for 15% of year-to-date issuance, compared with 24% for general purpose. In 2004, general purpose made up 32% of issuance while education was 27% and transportation 9%.
Figure 3. Total Municipal Bond Issuance 2004 through October 2013
Figure 4. 2013 Issuance by Segment through October 2013
Source: Federal Reserve
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PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Source: Bond Buyer
Figure 6. Percent of Issuance That Carries Bond Insurance January 2004–October 2013
Source: Moody’s
Figure 5. Cumulative Default Rates over Rolling 10-year periods Average (1970–2012) by rating
The municipal bond market has experienced significant challenges over the last several years. State and local government budgets have been stretched due to economic weakness and declining housing values. Additionally, unfunded pension and retiree health care costs will present an increasingly difficult challenge. Despite press attention focused on a few high-profile credit issues in the municipal market (e.g. Detroit, Puerto Rico), default rates remain extremely low. Figure 5 compares the average default rates of munis versus corporate securities by rating category since 1970. It shows that in each rating category, the frequency of default is much lower for municipals than for corporate. Credit losses have been extremely rare for munis over time, and despite the increased attention on state and local budgets, there has not been a material increase in the incidence of default.
According to a Harvard Business School1 study, during
the height of the financial stress of 2009, 178 issues
defaulted on $3.5 billion, but declined to 75 issuers and $1.7 billion by 2010. There were dire predictions by analysts during this period, the most referenced being Meredith Whitney’s quote on a 2010 CBS 60 Minutes predicting 50 to 100 sizable defaults, amounting to hundreds of billions of dollars. It appears that these fears were exaggerated, as state and local revenues in 2014 are expected to approach the peak level of 2008, according to the National Conference of State Legislatures.
Perhaps the most disruptive factor impacting the market has been the decline in availability of bond insurance. As Figure 6 shows, 57% of issuance in 2005 carried bond insurance, resulting in a AAA rating. Following the financial panic, bond insurers’ credit ratings were downgraded, negating the practicality of using bond insurance. Since that point, the usage of bond insurance has nearly disappeared. While this could eventually lead to greater volatility and credit defaults in the future, there is little evidence of near-term impact.
CHALLENGES AND RECENT DEVELOPMENTS
ATTRACTIVE RISK/RETURN DYNAMICS
Municipal bond investments have delivered returns comparable to treasury bonds with lower volatility. Figure 7 shows that over the past 10 years, the average monthly return for both are 0.4%, but the muni return is higher when adjusting for taxes. The muni index has experienced 37% lower monthly volatility of returns than the treasury index.
The primary benefit for investors owning municipal securities is the tax-advantaged nature of the bonds. The degree of this benefit depends on the marginal tax bracket of the investor. Figure 8 shows the current yield for indexes tracking treasuries, credit, mortgage-backed securities, high yield and munis. The muni rates are adjusted for taxes, with marginal rates of 28% (couples with income over $148,851 in 2014), 33% (over $226,851), 35% (over $405,101) and 39.6% (over $457,601). As the chart shows, regardless of the tax bracket, munis currently carry a higher yield than all categories, other than high yield. Given the low volatility and the low historic credit risk, municipals offer an attractive relative risk/reward.
Figure 7. Return vs. Risk December 2003 – November 2013
Figure 8. Yield on Fixed Income Indexes, Tax Equivalent
Source: Factset Research Systems, Inc.
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Important Disclosures
This report is for informational purposes only, does not constitute advice, and is not intended and should not be relied upon as an offer or recommendation with respect to the purchase or sale of any security. In addition, this report does not consider the specific investment objectives, financial situation and particular needs of any person.
Except where otherwise indicated, the views and opinions expressed are those of Nationwide as of the date noted, and are subject to change at any time, and may not come to pass.
Nationwide does not provide tax, legal, or accounting advice. Investors should seek a professional regarding their specific situation.
Principal Risks
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© 2013 Nationwide Funds Group. All rights reserved. MFM-1255AO (12/13)
The municipal bond market provides opportunities for a stable income-producing investment with low volatility and strong credit performance. Events over the past five years, including deteriorating state and local budgets and the shrinking of the bond insurance market, have raised investor fears about munis. The most dire fears have been proven inaccurate, as state and local budgets have slowly improved, and credit losses have remained limited. The municipal bond environment should continue to provide an attractive dynamic for investors seeking stable income and tax relief.
