Over a year has passed since the arrival of the tsunami that rocked the financial markets to their foundation and ushered in the worst recession since the 1930s.
During this horrific period, investors witnessed the demise of Fannie Mae, Freddie Mac, AIG, Bear Stearns, Washington Mutual, Wachovia, Merrill Lynch, to name just a few of the many well-known corporate casualties. It also saw the complete meltdown of the U.S. banking system, which needed to be propped up by massive amounts of government (taxpayer) funds.
Although the stock markets took the brunt of the blow, the municipal bond market experienced its own version of the perfect storm.
The once reliable “AAA” bond insurers found themselves entangled in the subprime mortgage mess, having ventured from the stability of municipal bonds to providing insurance for collateralized debt obligations, which came to be known universally as “toxic assets.”
This caused the once unimpeachable credit ratings of the bond insurers to be downgraded continually, and many formerly top-rated insurers were relegated to the junk heap.
As a result, “tender option funds,” which were required to own “AAA” securities, were forced to liquidate their substantial holdings of municipal bonds. This, in turn, dampened muni bond prices, which are primarily governed by supply and demand considerations.
A similar dynamic was afoot in the auction rate securities market (floaters). Floaters were typically viewed as short-term instruments because investors could redeem their shares through regular weekly or monthly auctions. Unfortunately, they were actually comprised of long-term bonds whose forced liquidation helped glut an already fragile market.
As the major banks, brokerage firms and giant hedge funds which normally supported the market became sellers, the decline in muni bond prices became cataclysmic.
In our September 2008 commentary, “A Tale of Two Investors,” we encouraged clients to view this market action as an opportunity to take advantage of what we believed would prove to be historically high yields and bargain basement prices: “The higher yields in the marketplace today afford the bond investor an opportunity to increase the current yield on his/her portfolio,” we said then. “One thing we know for sure is that these conditions will not last.”
The sky didn’t fall
Well, these conditions did not last. Conversely, over the last six months, municipal bond prices have staged an extraordinary rally, surging well above last year’s levels. Further, the ingredients which fueled this upturn continue to prevail.
More than 25% of state and local borrowing has shifted into Build America Bonds (BABs), the taxable munis that are part of President Obama’s stimulus plan, which substantially lessened the issuance of tax-free debt.
Combine this with the fact that high tax bracket investors are convinced that tax rates will continue to rise, throw in the Fed’s stated intention to keep interest rates low for the foreseeable future, and you end up with a bullish scenario for municipal bond market fundamentals.
Time to revisit your portfolio
Today’s higher prices provide a perfect opportunity for you, the bond investor, to evaluate your current municipal bond holdings. Since the future economic landscape is still uncertain, we recommend reviewing your portfolio in terms of improving quality and diversification. You may determine, because of the higher yields that were available, you over-invested in certain sectors, such as tobacco, energy, etc. The dramatic price appreciation of these securities provides the perfect occasion for you to rebalance your bond portfolio.
Please contact your FMSbonds representative to assist you in this regard.