Changing Fortunes in the Muni Market
Correlations between municipal bonds and Treasuries are back on the rise after a bifurcation during the financial crisis.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Municipal-bond fund investors have been on a wild ride during the past several years. Joining me to discuss the municipal market's changing fortunes is Eric Jacobson. He is director of fixed-income research for Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Hi, Christine. Good to be with you.
Benz: Eric, you recently wrote a piece in which you talked about pre-financial-crisis muni correlations. Munis were fairly well-correlated with the Treasury market. Why was that?
Jacobson: Well, in some ways, investors viewed the municipal market as being a lot like the Treasury market, and the underpinning of that was that for many years prior to the crisis, you had somewhere between 50% and 70% of all the new issuance coming wrapped with insurance from third-party companies. Essentially what that said to investors was not only do you have the underlying quality of the issuer, whatever municipality is, but you've got the protection of this insurance agency, most of which were AAA rated and were around for years. Essentially the bonds got treated like AAA bonds in the marketplace, and because of that, logically if you think about it, something that has a AAA rating tends to trade a lot like other AAA bonds, which is where the U.S. government was, as well. So, they were very highly correlated.
Benz: So, the wheels came off that assumption, though, during the financial crisis. Let's talk about what happened there and what led to munis becoming decoupled from the Treasury market.
Jacobson: At least in the short term, one of the big things that happened is that a lot of highly rated municipal bonds had been held in what we call leveraged structures. They were held by hedge funds and other investors, and when a lot of these leveraged investors needed to "unwind" their leverage by reducing their borrowing and so forth, they had to sell out all the underlying collateral. In many cases, where there were munis involved that meant that there was indiscriminate selling of very high-quality munis. So, at the same time during the crisis that high-quality Treasuries were being purchased en masse, investors were selling municipals, and that was a major rift right then and there between them.
The other thing that happened is that the insurance companies about which we just spoke had been badly damaged by the crisis. Several of them had gone out and written insurance on mortgage pools that had nothing to do with their municipals businesses. But because they were so put in such peril by the mortgage crisis, many of them hit the skids. They were either downgraded, or went out of business, or what have you, and suddenly you had this huge portion of the market that had been wrapped with insurance that no longer had insurance. The market was sort of sputtering around, looking to figure out where the bonds should trade, and ultimately not like Treasures is what happened. You had a lot of cases where the underlying credits weren't even that bad, maybe they were only AA instead of AAA, but suddenly investors treated them all very differently. You had this big rift between them, and it really created a strange and different market where correlations went down to nearly zero.
Benz: Treasury investors had a very good experience during the crisis, really it was one of the only assets, the only asset, that did particularly well during the period. Munis didn't perform nearly so well, and in fact, muni funds in some cases had losses, maybe even sizable losses.
Jacobson: That's exactly right. In fact, it was an even bigger problem, just as a side note, for funds that were hedging, and when I say hedging, what I mean is many of them had bought a lot of long-maturity municipals and then sought to hedge their interest-rate risk back with Treasury futures or other items. Because those are essentially negative bets on Treasuries, both sides of the portfolio went bad at the same time. Their municipals were getting sold off at the same time that these Treasury futures and interest-rate swaps were going down because Treasuries were going up. Those were some of the worst cases of all, where people hoped that they had some protection with the hedging that was going on, but it wasn’t to be.
Benz: We saw this bifurcation during the financial crisis. More recently, though, you note that correlations have been going back up, so muni performance and muni yields have been more closely correlated with Treasuries. What's going on there, and what’s driving that trend?
Jacobson: That's a matter of opinion, I have to say, because I have talked to different managers, and it's very hard to get anybody to point at one single thing that they think is sort of completely underpinning this. One clear area, however, that you can point to is the fact that there's been a lot more interest in municipals in the last six to eight months. Toward the late end of the last year, flows started to reverse. We've had at least about $19 billion of inflows into municipals this year. The numbers may come out higher when we finally see the latest numbers from May, though I’m not sure what the trend has been.
That kind of demand and focus on municipals as an alternative has really upped the market action that we've seen, and managers that I've spoken with seem to think that that extra demand and a little bit more liquidity has caused them to start acting, as you said, a little bit more like Treasuries.
Benz: Eric, you noted in a recent commentary that these rising correlations between munis and Treasuries actually could spell some sort of risk for investors. What specifically should investors be attuned to?
Jacobson: This is not a case where I want to necessarily get on the roof and start swinging my arms around about the scare tactic here because the fact of the matter is we don't know what's going to happen with interest rates. There is a possibility that rates could remain quite low for some time.
However, as you know, a lot of people have been worried about it, and it's going to remain a worry as long as interest rates are as low as they are. The risks that I’m talking about is that as long as municipals are more highly correlated to Treasuries, and assuming that that correlation continues to rise and perhaps even approaches where it once was, then you are going to have to want to look at your municipals in very much the same way you would look at your Treasury holdings. In other words, if those Treasury yields rise, there is a sell-off, and prices go down, it’s more likely to happen the same way with your municipals than it would've been a couple of years ago.
Benz: If you are concerned about such a scenario, you want to be careful about having very long-duration munis in your portfolio?
Jacobson: Exactly, and anyone who doesn't quite know what they own, ought to dig in and see because a lot of municipal portfolios are relatively long, and they continue to be relatively long today, if for no other reason than that's where you get the extra income. And that's what they're all competing against each other on.
Benz: More recently, Eric, we've seen very strong performance from Treasuries. The longer Treasuries have been terrific performers. How have munis performed during this recent period of stock market weakness and concern about economic growth? How are you seeing them hold up?
Jacobson: Well, it's really interesting because we just had a period in March during which Treasuries sold off and munis sold off as well about, let's say, 65% as much as Treasuries did when you just look at the Barclays municipal and Treasury indexes. And you've had sort of the opposite effect during this more positive time for Treasuries, where munis haven't gone up quite as much, but they've moved directionally in the same way that Treasuries have.
Benz: Eric, thank you for sharing your insights on the changing fortunes of this marketplace. I know that a lot of Morningstar.com readers are really tuned into what’s going on in munis, so we really appreciate you sharing your insights.
Jacobson: My pleasure. Glad to be with you, Christine.
Benz: Thanks for watching. I’m Christine Benz for Morningstar.com.