The municipal bond market bounced back a bit in March from a very unfriendly February, but still posted its worst quarterly performance in over 16 years. On many days, the municipal bond market seems to be more correlated with the stock market than the Treasury bond market. Municipal bond yields have risen to uncharted territory relative to Treasury yields, even for some of the highest quality bonds (see graph below). Overall, volatility is higher than we have seen in many years.
What explains the transformation of this normally quiet market into a sea of volatility? Well, it’s a fairly long story, but I’ll try to condense it as best I can.
First, most of the bond insurers got themselves heavily involved in the business of insuring mortgage backed securities and collateralized debt obligations (CDOs) made up largely of mortgage backed securities. They thought they understood the risks that they were taking, but apparently did not. They are now facing billions in claims that will be paid out over many years to come. No one knows exactly the magnitude of the claims, but estimates range from about $10 billion to over $30 billion. The insurers appear to have enough claims paying resources to continue supporting the bonds they insure, but it is possible that, in some cases, they do not. In any case, it seems that some, if not all, of them (with the exception of FSA and Assured Guaranty) are not worthy of a AAA rating. Luckily, the municipal bond market can still function without the assistance of the troubled bond insurers. According to recent reports by Moody’s and S&P, 10-year cumulative default rates on investment grade municipal bonds have averaged less than 0.1%. So, in the vast majority of cases, the bond insurance is not necessary.
However, tax-exempt money-market funds have grown highly dependent on bond insurance. These funds are restricted by Rule 2(a) 7 of the Investment Company Act of 1940 to buying only short-term securities rated AA- or higher. Many issuers of floating rate municipal bonds favored by money market funds relied upon the bond insurers to secure the ratings they needed. With the bond insurers getting downgraded or being placed on review for downgrade, money market funds started putting their variable rate bonds back to the dealers that marketed the bonds. When the dealers’ balance sheets got too heavy with floating rate bonds, including auction rate bonds, they stopped supporting the market. This led to many auction failures and otherwise high interest rates on nearly all floating rate municipal bonds. When an auction fails, the interest rate on the bond reverts to a maximum rate defined in the bond documents. Since money market funds wouldn’t buy auction rate bonds, other buyers had to be found, but in the meantime, many high quality issuers got stuck paying interest rates as high as 12 or 15% on their auction rate debt. This market has started to calm down of late, but many auctions are still failing and many issuers are starting to refund their auction rate bonds with fixed rate debt, adding to the supply of long-term bonds.
This leads us to the third phase of the cycle. Tender option programs have been among the largest issuers of short-term debt recently. These programs were created several years ago to provide a means of using leverage to amplify returns in the municipal bond market. They have been put together by hedge funds, proprietary trading programs, and some mutual funds (not ours). The basic structure is as follows: an investor acquires a large block of long-term bonds. Those bonds are placed into a trust, which sells floating rate bonds with a tender option (they can be put back) to money market funds and other short-term buyers. The investor holds on to a residual interest in the trust and earns a spread based upon the difference in yield between the variable rate bonds and the fixed rate bonds placed into the trust, magnified by the amount of leverage used. These programs produced double-digit yields for their investors when the yield curve was steep and when money market funds were willing buyers. However, with money market funds avoiding exotic structures and exposure to many bond insurers, the economics of tender option bond programs have been turned upside down. This has forced several large hedge funds and others to unwind the programs by selling billions of bonds into a market already suffering from a lack of liquidity. The enormous selling pressure overwhelmed the demand side of the municipal market, peaking with concentrated underperformance (particularly toward Treasury bonds) in late February. Since that time the market has recovered fairly significantly, although further selling pressure is still a distinct possibility.
While short-term volatility has grabbed most of the headlines, long-term trends could prove to be more important going forward. So far, 28 states have announced projected budget shortfalls of $39 billion in fiscal 2009 according to the Center on Budget and Policy Priorities. The budget shortfalls are concentrated in states that were accustomed to very high growth rates in the housing led boom that prevailed recently, but there are very few areas that are escaping weakness altogether. Budgetary reserve balances are generally healthy and many states are implementing hiring freezes and other means of achieving balanced operations, but we expect the credit environment to be challenging for at least the next couple of years. Some of the weakness will also affect local credits such as school districts and housing authorities, but so far the damage has been relatively contained and upgrades are still outnumbering downgrades. As always, we will continue to monitor Thornburg bond portfolios carefully and maintain broad diversification.
The other trend worth noting is the rapid steepening of the yield curve (see graph above). As you know, the Federal Reserve has some control over short-term interest rates, but market expectations generally control long-term interest rates. The Fed has aggressively eased monetary policy recently while the U.S. and the global economy are facing rising inflationary pressures. This turn of events seems to be feeding market expectations of higher inflation down the road, which is leading to a greater risk premium on long-term bonds relative to short-term bonds – thus the steeper yield curve. Given that the Fed seems to be predisposed toward extending its easy money policy while the weak dollar and other factors continue to fuel inflation, we think that the steep yield curve may stick around for a while.
A steep yield curve is ideal for Thornburg laddered bond portfolios, which generally make new purchases toward the top of the steepest part of the yield curve. The buy-and-hold approach of our portfolios helps them to garner the higher yield available at the top of the ladder, while often capturing price appreciation as bonds move closer to maturity. The laddered structure, coupled with generally high-quality positions, also helped shelter Thornburg portfolios from the worst of the first quarter slide, while the severe dislocations in the market and forced selling by others proved to be a tremendous opportunity for Thornburg accounts to buy new high-quality bonds at bargain bin prices. We expect market volatility to stay high for the time being, but we will continue to manage the portfolios using the same time-tested methods that have served them well for the last 23 years.
Investments in the Fund carry risks including possible loss of principal. As with direct bond ownership, Funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. The principal value of bond funds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. Unlike bonds, bond funds have ongoing fees and expenses. Shares in the fund are not deposits or obligations of, or guaranteed or endorsed by, any bank, the Federal Deposit Insurance Corporation, the Federal Reserve Board or any government agency.
The laddering strategy does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Carefully consider the Fund’s investment objectives, risks, sales charges, and expenses; these are found in the prospectus, which is available from your financial advisor or from our download library. Read it carefully before you invest or send money.
The views expressed by the author reflects his professional opinions and should not be considered buy or sell recommendations. These views are subject to change.
U.S. Treasury bonds are used to finance borrowing by the U.S. government. In return purchasing the bond, the government pays the owner of the bond interest, called the coupon rate. The note can be sold prior to its maturity in the secondary market. Since the prevailing interest rate when a bond is re-sold will usually be different than the coupon rate, the price of the bond must adjust so that the financial return (called "yield-to-maturity") is consistent with prevailing interest rates.
This material is for financial advisors and institutional clients only.
