With the end of the first half of 2012 approaching, analysts are predicting what they think the landscape of the financial markets will look like in the remaining half of the year and what advantages or hurdles, if any, investors will be facing.
Jim Swanson, chief investment strategist at MFS Investment Management, shared his views of the markets during the firm's annual mid-year investment outlook teleconference last Monday with members of the financial press, during which he outlined a broad range of topics, from Europe and emerging markets to the U.S. economy and municipal bonds.
Later, he participated in a question-and-answer session with The Bond Buyer in which he offered in more detail his views about the tax-exempt market.
Overall, with the threat of major credit risks having subsided and with manageable interest-rate risk in the near term, the market's strength has paved the way for investment opportunities for individuals in high tax brackets, Swanson said during the teleconference.
"I don't see any hurdles," he said, fielding a question about the municipal market. "This time last year, the municipal market was dealing with credit frustrations from that famous '60 Minutes' broadcast and worries of widespread defaults — and that proved not to be the case."
"In the ensuing year, the expansion of the economy and jobs has brought most of the states back in the black," he added.
Assuming the credit risks are largely off the table and there is the potential of higher taxes ahead, Swanson promoted the tax-exempt market as a good place to invest, especially since the 10-year and 20-year slope of the curve offers a 100 basis-point spread to comparable Treasuries.
"I think munis are a very interesting area for high-taxed investors to look at, since they seem cheap … and since interest rates are not likely to go anywhere for a year or two," he said during the call. "In an environment with a boundary to yields, the muni market ought to be investigated by people in the higher tax brackets."
During the Q&A with The Bond Buyer, Swanson provided his view and the view of his municipal group at MFS on the muni market in the second half of 2012 as it relates to the economies of state and local governments, political or legislative issues affecting the market, overall volume and his prognosis on mutual fund flows and performance.
With credit concerns at a minimum, can you identify any sweet spots in the municipal market that are currently offering good opportunities in terms of yield curve, maturity, sector or coupon?
JS: In our view, the credit concerns that buffeted the asset class in late 2010 and early 2011 were very much overdone. While the fiscal dynamics of many municipal issuers were indeed stretched by the Great Recession, most emerged from the slowdown fundamentally sound.
Nevertheless, there are municipalities where finances haven't fully recovered and where credit is an issue (Stockton and Detroit). As a result, credit concerns shouldn't be dismissed out of hand. Rather, the investor should be very selective on the basis of underlying fundamentals — recognizing that insurance will no longer cover for deficiencies in the buyer's due diligence efforts.
With yield ratios at the 10-year segment of the curve near 120%, we think 10-year muni bonds look attractive versus Treasuries. You may see crossover buyers step in at current levels. With the sectors, we have a bias toward revenue bonds over GOs, and we see attractive valuation in areas, such as charter schools and private higher education, as well as stable and seasoned senior housing projects.
Do you expect to see states and municipalities continue to improve their finances in 2012? If so, how? Do you expect many upgrades to GOs as a result?
JS: While continued moderate economic growth should be broadly supportive of municipal finance, we aren't looking for widespread upgrades in the near future. Many issuers have seen the fiscal climate improve, but local issuers with heavy dependence on property tax revenues are still waiting for the turn; revenues are still declining as they continue to work their way through the assessment cycle.
At the state level, there's a risk that spending could rise even as revenue growth begins to moderate. States have been cautious about spending, but some expenses can be deferred only so long. On the revenue side, tax receipts for many states may have recovered to 2007 levels, but the pace of revenue growth is decelerating.
What is your forecast for issuance/volume in the remainder of 2012? Do you think it will be on par with 2011's second half? If not, what can we expect?
JS: We think we're likely to hit a seasonally slow period of issuance in the months ahead. The new-issue calendar has been relatively heavy, but importantly, lots of the new issuance has been refunding versus new money. This has been driven by historically low rates and by reticence on the part of fiscally cautious officials about seeking funding for new projects. That emphasis on refundings seems likely to continue.
We could end the year with total calendar year issuance in the vicinity of $350 to $400 billion, but without much change in total muni issuance outstanding.
Do you think inflows into tax-exempt mutual bond funds will be slow, steady or strong, and why? What will drive demand-need for bond funds?
JS: We're expecting steady inflows. With yields so low, the risk to that outlook is the potential for investor "sticker shock." Even so, there are few viable alternatives for investors seeking yield with relative stability, and plenty of cash flow from maturities and calls.
In our view, tax-equivalent yields in the muni space look quite attractive versus taxable debt, so that should also support inflows. In addition, uncertainty about impending changes to the tax code could provide a technical bid for munis.
What factors will affect fund performance in the second half? Is there any evidence that performance will be weaker or stronger?
JS: Treasury yields have been a major driver of performance in the first half and will likely remain a driver in the second half. It is hard to imagine rates falling much further, but it's also hard to build a convincing case for rates becoming a serious headwind for munis in the second half, given all the factors in play that should keep rates in check (safe-haven bid for Treasuries due to Euro-zone turmoil, and Federal Reserve policy firmly committed to easing, etc.). We're looking for rates to back up slightly, and for munis to outperform Treasuries as they do.
The supply-demand dynamic will also remain a key driver of performance. There may be times when supply outstrips demand, but on balance we think demand will remain strong and that munis will perform reasonably well in that environment. At the same time, we aren't expecting them to outperform most other fixed-income assets as they did in 2011 — that was the payback for the big sell-off at the end of 2010 and likely won't be repeated.
Besides moderate interest rate risk, should investors have any major concerns into the remainder of the year?
JS: Interest rate risk is one of the concerns we have, but we feel it's a manageable risk over the balance of the year. We're also focused on the potential for headline risk related to a high-profile credit problem. Thus far this year, the market has dismissed most bad news regarding muni issuers as expected and unsurprising — the anticipated outcome of idiosyncratic local circumstances. There's always a risk of a shift in sentiment. If the market begins to perceive news of troubled municipalities as symptomatic of broader systemic stress, it could lead to some selling pressure.
Are there any major hot-button issues (legislative, governmental, political, etc.) that could affect the municipal market in general? What effects could they have?
JS: There are a number of legislative and political issues that introduce a degree of uncertainty to the muni bond market, and uncertainty always demands a yield premium. These include unfunded pension liabilities (a longer-term problem where we are starting to see real progress in the form of negotiations on public employee benefits), legislative challenges to the tax-exempt status of munis (which will recur periodically as Congress seeks to address tax expenditures, i.e., places where the federal government foregoes potential revenue) and the threat of cutbacks in federal funding to states and municipalities. We suspect these risks won't intensify ahead of the election, but they will remain latent worries for which investors will look to be compensated.
Perhaps of more immediate concern is the debate concerning proposed regulatory changes, including changes to money market funds and the Volcker rule's restrictions on trading activity. The former could potentially make tax-exempt money market funds less attractive as cash management tools, while the latter could possibly have a detrimental impact on liquidity in the muni bond market.
In addition, the scheduled year-end sunsetting of Bush-era tax cuts could nearly triple the effective tax rate on dividends. While we suspect Congress will extend the cuts at the 11th hour, the uncertainty as we wait could make munis a more interesting alternative.
Are there any areas of the muni market investors should avoid in terms of credit quality, sector, maturity or structure?
JS: We've been underweight in GOs, which is not to say that investors should avoid them, but rather to suggest that we believe the recovery among municipalities will be uneven at best.
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