In the wake of dire warnings predicting the imminent collapse of the municipal bond market, it appears the market, through its own dynamics, has begun the process of curing the ills associated with the financial crisis and fiscal mismanagement.

As state and local governments wrestle with their budgets, new bond issuance has slowed to a crawl. The muni market had its lowest quarterly issuance volume since 2000, and the drought is likely to continue. Many analysts expect 2011 new-issue volume to be less than half of last year’s record $430 billion.

With a newfound emphasis on austerity, local and state governments are cutting back on capital projects that are difficult to justify and laying off municipal employees.

In the tax-free bond market, where supply and demand factors are a dominant force in determining price levels, this decline in the volume of new issues is helping to bolster prices and trim yields across the board.

Not a credit-quality problem

Amid the much ballyhooed prognostications of market bear Meredith Whitney, it was widely reported that individual investors, the backbone of the municipal bond market, were fleeing the market in droves, resulting in plummeting prices and climbing yields.

Our take has always been that it wasn’t a credit-quality problem. Rather, the sell-off was caused by the liquidation of muni mutual fund shares, which had been accumulated by non-traditional buyers in record numbers over the years preceding Whitney’s ill-advised pronouncements on “60 Minutes.” These share liquidations forced fund managers to sell holdings they would have preferred to keep in order to raise cash for the redemption of shares.

Based on the flow of our business, we knew that traditional individual bond buyers had stayed the course and were taking advantage of the higher yields by adding quality bonds to their portfolios at bargain-basement prices, a view confirmed recently in a report published by BondDesk Group, LLC.

According to the report, March was the third month in a row that retail investors were net buyers of individual bonds, and the fifth consecutive month that investors sold more shares of muni mutual funds than they purchased.

These figures illustrate that although the market has been unsettled due to the spate of adverse publicity and liquidations of mutual fund shares in recent months, traditional bond investors made 2.6 times more purchases than sales.

Now, with mutual fund redemptions declining, “massive default” fears fading, individual investors consistently buying and new issuance remaining low, all the necessary ingredients are in place to stabilize the tax-free bond market.

And wouldn’t you know, just as the negative sensationalism and hyperbole seemed to be gaining some momentum in the financial press, facts started to get in the way.

Defaults drop

Municipal bond defaults declined dramatically in the first quarter of 2011 compared with last year. Only nine issues totaling $245 million failed, compared with $1 billion at the same point last year, according to Reuters News Service. Tellingly, none of the nine issues carried a rating by S&P.

So why has the outlook for the municipal bond market become so much more optimistic?

  • With the improvement in the national economy, state tax revenue is on the rise.
  • New issuance (supply) is projected to decline by more than 50% in 2011.
  • Empowered by their constituents, state and municipal officials are embracing the need to put their respective fiscal houses in order.
  • Regardless of which political party wins the budget battle, it is clear that federal tax brackets will be rising, pulling the demand for tax-free bonds along with them.
  • As muni mutual funds continue to leave “weaker hands,” redemptions will end and new sales will bring these large institutional buyers back into the market.

Based on any historical evaluation, municipal bonds continue to offer outstanding values.  A 5.25% to 5.50% yield on a top quality bond is equivalent to 8.00% or more on a comparable taxable security for investors in the highest tax bracket (35%). And as fixed income investors know, 8.00% on a top quality taxable bond is just not available today. When you factor in state taxes, the comparison is even more dramatic.

Once again, we are sure investors taking advantage of quality bonds at today’s yields will be very pleased that they did.

James A. Klotz is the President of FMSbonds, Inc. Email the Author04/19/2011