Prices of Municipal bonds have rallied steadily for the last 4-5 months. Indeed since last December (2008) when the market was in absolute shambles municipal bonds have proven to be an excellent investment in 2009. At the moment the market feels "toppy". This is an expression traders use to describe a market that has seen a lot of supply at high prices and the street is still long the issues in their inventory. The street keeps the issues while they are waiting for the ultimate buyers (either individuals or institutions) to invest. The question for the investor is why does the market feel this way? Is it a signal for a big reversal (drop in prices) or temporary indigestion of too much supply in a short time?
There are two conflicting trends in the municipal bond market at the moment. The Federal Reserve has lowered interest rates and has indicated that rates will remain low in the near future. This is good for bond prices because when rates fall bond prices go up. This has been the case for all of 2009. The second and counter trend is that municipal credit quality is deteriorating due to lower revenues and increased spending. Even to the casual observer the fiscal problems of the states, cities, towns and local school districts are apparent. The money coming in through taxes and fees is dropping sharply at the same time as promised benefits are increasing at a pre-determined amount, i.e. 3% pay raises.
The market is in a tug-of-war as to which trend will emerge victorious. For most of 2009 investors have ignored the credit considerations while they have reached for additional yield. This has caused lesser grade bonds to rally more than high grade credits. Recently we have seen this struggle manifest itself in the sale of California bonds. While California has not made much progress in solving the budget deficit, their bonds have rallied (increased in price and declined in yield) because of the investor demand. The financing needs of California are enormous due to infrastructure needs, voter approved projects and the growing budget deficit. Last week the underwriters had to raise the yield (increase the interest rate the state had to pay to borrow) and decrease the size of the deal (due to tepid demand). This is a sign that credit considerations are beginning to become more of a concern to the investors.
All municipalities face these problems to various degrees. The investor must realize that after the financial market meltdown of 2008 everything has been changed. You cannot assume that all municipal bonds are an automatic conservative safe investment. Just like car companies, banks, and Wall Street brokerage firms, states and cities and towns can get over-extended. Is there any difference between GM with unsustainable retiree benefits and the State of New Jersey with comparable promises to its retirees? It is a finite world and at some point, unless action is taken, the promise of future benefits will overwhelm the state's ability to pay.
Sophisticated investors have been using the current market to upgrade their portfolios. They do this by selling the lesser grade bonds which have rallied the most and buying higher grade bonds and giving up a little income. If credit considerations play a stronger role in bond pricing going forward (and I believe they will), this strategy will yield dividends in the near future.
Now is the time to rethink your municipal portfolio and see if you can improve the quality of your holdings at a very reasonable price.