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When Headline Risk Hits Municipal Bonds, It’s Usually a Buying Opportunity

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Over the years, the municipal bond market has proven itself to be sensitive to “headline risk,” or in other words, the risk that broader news developments will lead to periods of volatility and short-term underperformance. Since municipal bond investors tend to be a fairly conservative group by nature, these events can be very unsettling when they occur. However, history has also shown that they tend to be good buying opportunities for long-term investors.

The Lessons of the Past

In July 2013, the muni market made headlines following the decision by the city of Detroit, Michigan filed for bankruptcy. Municipal bonds had already been hit hard in the previous two months by a broader bond market sell-off, and the news about Detroit further pressured the market and sparked a massive outflow of cash from municipal bond funds and ETFs. While selling amid negative headlines may seem like a natural reaction, a brief look at history shows that news-related downturns have actually been an excellent opportunity for contrarian investors to step up and buy. Here are a few examples:

Orange County Bankruptcy, 1994: When Orange County filed for bankruptcy in 1994, the municipal market froze up. Munis suffered losses for the year, and many experts saw a dire precedent in the county’s decision. One analyst interviewed in a Wall Street Journal article on the day the news broke said, “The bankruptcy filing by Orange County will have a far greater and far longer impact than just missing a payment on their debt,” while another opined, “More losses will come out. The municipalities will blame Wall Street and the tight financial situation they are in.” It didn’t work out that way, however: munis recovered to deliver returns north of 16% in the year after the bankruptcy occurred.

The 2008 panic: The financial crisis of 2008 led to major downturns in virtually all asset classes, including municipal bonds. From August 31 through October 15, the iShares S&P National AMT-Free Municipal Bond ETF (MUB) collapsed 11.6%, sending investors fleeing for the exits. But from October 15 through year-end, the fund recovered 13.3%. One year later, it had returned nearly 20% from the October low. Naturally, very few investors were able to buy near the exact low, However, someone who had used the headline-driven sell-off to buy, rather than sell, would have profited handsomely.

Meredith Whitney predicts disaster, 2010: In late 2010, the financial analyst famously went on 60 Minutes and declared, “There is not a doubt in my mind that you will see a spate of municipal bond defaults…You could see 50 to 100 sizable defaults, maybe more… This will amount to hundreds of billions of dollars’ worth of defaults.” This prediction set off a firestorm in the muni market, contributing to a decline of approximately 10% over the next two months. But again, an investor who took advantage of this headline-driven sell-off would have come out ahead: Whitney’s prediction never materialized, and munis returned over 18% in the year following their February, 2011 low.

In this sense, Detroit is only the latest in a long series of headline-grabbing events to hit the municipal bond market. The market weakened on the news of the bankruptcy, and many analysts – including Whitney – weighed in with the opinion that Detroit was a sign of larger problems to come. As of this writing, it’s too early to tell how long it will take for the market to recover – but so far, history has shown that these headline-related sell-offs have been opportunities to buy, not to sell.

The Case for Municipals

One reason for this is that the municipal bond market tends to be populated by high-quality issuers. The incidence of defaults has been very low over time: from 1970 to 2011, only 0.13% of all rated municipal issues defaulted. Over time, this has prevented specific news events from having a “contagion” effect in the market. Further, issuers typically do whatever is necessary to avoid defaults, since it brings a major stigma to the region, fuels political pressure from local constituents (who may also be bond-holders), and raises future borrowing costs.

In terms of current market conditions, the asset manager Blackrock pointed out a number of supportive factors in its August 2013 piece titled, “Municipal Market Myths and Realities”:

  • “With an average rating of AA, the municipal market as a whole remains of high quality, particularly relative to the corporate bond market.”
  • “Furthermore, a large portion — roughly two-thirds — of the municipal marketplace has assigned revenues that are an identifiable source of debt repayment.”
  • “Truth be told, distressed cities are far and away the minority. According to Moody’s, of the more than 7,500 municipal entities it rates, only 34 are assigned a rating of below investment-grade. Quantified another way, over 99% of Moody’s rated local government universe is rated investment grade. This tells us that the great majority of the country has been able to manage its debt.”
  • “The market’s underlying fundamentals are very strong: state revenue collections have risen for 13 consecutive quarters while spending is declining; housing markets are improving throughout the US; and state budgets are being passed on time…”

The Bottom Line

Municipal bonds certainly have their share of risks, particularly as it relates to the possibility of rising rates in the years ahead. However, sell-offs related to headline risk – while typically accompanied by mass selling of muni funds by individuals – have generally represented longer-term buying opportunities for longer-term investors. Look for chances to use news events to your advantage, rather than allowing short-term news developments to prompt you to sell due to fear.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.

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