Municipal investors should prepare for the day when non-traditional and international buyers who've been boosting demand pull out of the tax-exempt market, according to a report from Regions Investment Management.
Even though that time isn't near, Regions said it favors intermediate maturities, higher coupons and stronger credits to buffer its exposure to duration risk, as well as other inherent, and recent, challenges within the sector.
"In the current market environment it appears that the municipal market is attracting investors, both domestic and international, with no use for the tax exemption," the report said. "This is on top of continuing strong demand from traditional investors – measured by ongoing net purchases of municipal bond mutual funds."
The Treasury yield curve and the high-grade municipal curve are "unusually close," as munis buck their historical trend of trading below other fixed-income bonds due to their tax exemption, the Birmingham-Ala.-based investment advisor said in a fixed income outlook, published on July 18.
For instance, on June 30, the 10-year high-grade municipal bond was priced to yield 1.36%, or 93% of the 1.47% 10-year Treasury yield, the report said.
The yield curve is unusually flat, as the difference between the high-grade two-year and 30-year municipal yields was only 1.44% -- or less than half of the historical average, Regions said.
On Monday, the 30-year triple-A rated municipal bond was yielding 91.7% of the 30-year Treasury yield at 2.11% and 2.30%, respectively, according to Municipal Market Data.
Although the flat municipal curve means investors get little incremental yield for extending duration, the fact that it is unusually flat against the U.S. Treasury curve is keeping demand for the tax advantaged municipal product strong domestically and overseas, Regions said.
"With interest rates at all-time lows, the tax-exempt market is actually attractively priced on a relative basis compared with the rest of the fixed income market," the report said.
The unusual shifts in bond market valuations stems from "extreme monetary policy measures" as well as demand from non-traditional, international, and cross over buyers seeking either relatively higher yields within the fixed income landscape, or those seeking a flight to quality.
That phenomenon – and consistent flows into municipal bond mutual funds – is having a greater impact on the municipal market than it has historically, and is keeping yields historically low, according to the firm.
"Municipal bonds tend to have less volatility and higher credit quality than corporate bonds and mortgages, but they also have less market liquidity," the report said.
"While we have fewer credit concerns than in recent years, the full valuation of the market, with yields at record lows, presents the biggest challenge to investing in the municipal bond market in 2016," the report continued.
While non-traditional buyers typically flock to the extra yield available at times when domestic or global financial stress impacts municipal credits, that demand can often dry up when market conditions change, Regions said.
"So-called crossover buyers may be attracted by these characteristics as well as the relative yield," the report said. "When market conditions change, these investors may desire to make a speedy exit, potentially upending valuations and reshaping the yield curves.
"This doesn't appear to be imminent," the report said, "but the potential volatility is another reason to practice defensive investing in the municipal market."
