Municipal bonds -- a year in review

Joseph G. Mowrer III, The Daily Record Newswire

Contrary to nearly every market expert's prediction, 2014 turned out to be a tremendous year for the broad bond market and municipal bonds. As we close out the year, the municipal bond market will have posted a gain of 9 percent (as measured by the Barclays municipal bond index). Along with exceptional returns, let's review some of the other notable developments in municipal bond market in 2014.

The big story of the year is the incredible bond rally of 2014. At the start of the year, nearly every economist and market expert was predicting higher bond yields as the Fed ended its bond buying stimulus. But just the opposite is what happened. Bond yields moved dramatically lower in one of the most powerful bond rallies in history.

Municipal bonds benefitted from this great rally and have posted a gain in every month of 2014 to date (December is still up in the air). This reminds us yet again that no one can predict the direction of interest rates, and that bond investors should maintain a reasonable allocation to the bond market at all times.

Another notable development in the world of municipal bonds is the ongoing improving credit conditions of state and local governments. While underfunded pensions are still a concern, particularly in Illinois and New Jersey, most states have begun to take steps to address this problem by reducing public employee benefits and/or increase employee contributions. This is not an overnight fix and will take time, but we are moving in the right direction and seeing some improvements for the future.

Municipalities are also reducing their expenses (thus improving their credit) by taking advantage of current 50-year lows in municipal bond rates. Their debt service costs have become much cheaper as 6 percent coupon bonds are replaced with 3 percent coupons bonds. Further, they have been refinancing existing debt at a much faster clip than they have been issuing new debt, which results in less debt outstanding.

Municipal bond credit conditions have also been buoyed by generally improving real estate prices which substantially provide local and state general tax revenues. These are positive developments for the ongoing health and stability of the municipal bond market, and provide assurance that default risk will remain miniscule.

The city of Detroit has emerged from the largest bankruptcy filing in US History after 18 months of negotiations. After decades of economic despair and overwhelming debt, bondholders and public employees shared in sacrifice to come to a resolution. The outcome favored pensioners at the expense of bondholders, but at the end, gives hope that Detroit will once again return to economic stability.

Puerto Rico, an issuer of tax-free municipal bonds, also made regular news in 2014 for its deteriorating credit conditions. It has become clear that the island's economy cannot support its public debt load, and at some point in the near future will have to address this growing problem. For now, its problems persist, and bond investors should remain extremely cautious of owning Puerto Rico Bonds.

A diversified portfolio of high quality municipal bonds can virtually negate any credit risk. Defaults are and will continue to be rare and isolated events. The other risk to consider is interest rate risk. While it's true rising interest rates can cause temporary damage to a bond portfolio, the bigger risk may be missing a bond market rally like we had in 2014.

Long-term bond investors know that it is impossible to lose money in the bond market over time (ignoring inflation and assuming no defaults) with a high quality diversified portfolio of bonds in any interest rate environment. In fact, long-term bond investors should welcome higher bond yields as they can finally begin to realize increasing income.

According to Nuveen Investments, over the past 20 years of history if you invested right before the municipal bond market sold off and stayed the course, you would have made all your money back within 10 months. For this reason, municipal bonds remain attractive despite low yields and should remain a part of any well diversified portfolio.


Joseph G. Mowrer III is a senior tax-sensitive fixed income analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.

Published: Fri, Jan 09, 2015