| Dear Valued Investor,
Like a summer heat wave that will not break, the municipal bond market remains under pressure. Municipal bond prices continued to weaken in July and early August, even if more slowly, despite taxable bond prices stabilizing or in some cases rebounding. The current episode is the most severe since the late 2010 and early 2011 pullback when credit quality fears proved to be grossly misguided. Unique market dynamics, not credit quality fears, are behind current municipal weakness as state and local government revenue has continued to improve. It is important to understand that the municipal bond market has a more limited investor base relative to the taxable bond market. Institutional investors, pensions, endowments, retirement plans, and foreign investors are regular investors in the taxable bond market and can act as a stabilizing force during times of weakness. These investors do not benefit from tax exemption, and therefore, municipal bonds can be more sensitive to the whims of a relatively small number of primarily individual investors. In late May, concerns over the Federal Reserve's intent to slow bond purchases sparked panic and heavy selling pressured the market lower. A seasonal increase in new bond issuance compounded the problem as supply far outstripped demand leading to still lower prices. The city of Detroit did not engender confidence or help the healing process when it made history by filing the largest Chapter 9 bankruptcy on record in July. For most in the municipal bond market, the news was not surprising. Detroit's demise was many years in the making and several factors played a role in the city ultimately filing for bankruptcy. The municipal market impact of the Detroit news has largely been a psychological one with buyers remaining on the sidelines. Nonetheless, we do not see Detroit as the harbinger of a surge in bankruptcies or defaults. Although highly publicized bankruptcies, like Detroit, will continue to garner attention, they remain isolated events and the number of municipal bond defaults is on pace to decline for the fourth consecutive year as fiscal conditions improve for most issuers. On a positive note, municipal bond yields are near their highest levels of the past few years. Average yields on intermediate to long-term top-rated municipal bond yields are 0.25% to 0.65% higher than comparable maturity Treasury yields. Such a condition is not only rare, since municipal bond yields are typically lower than comparable Treasury yields due to their tax-exempt interest, but also led to attractive valuations. Current prices and yields discount the tax benefit of municipal bonds. Ironically, the tax benefit has improved in 2013. The top tax rate is back up to 39.6%, and municipal bonds are the lone investment that is exempt from the 3.8% surcharge on investment income that is in effect this year as a result of the Affordable Care Act. Unfortunately, supply-demand imbalances can often be an overwhelming force despite attractive valuations or good credit quality, and therefore, the timing of improvement is uncertain. Over the past two months, bouts of strength have emerged on a few occasions but upward momentum has not been sustained. So despite the fact that municipal bond prices may have been inordinately punished, or that investors are discounting the inherent credit quality of municipal bonds, improvement may still take some time. Historically, however, improvement eventually prevailed as extreme valuations rarely last for an extended period of time. For patient investors, lower prices, attractive valuations, and higher yields provide a potential opportunity amid an overall arid bond market landscape lacking desirability. As always, if you have questions, I encourage you to contact me.
IMPORTANT INFORMATION
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.
Bonds given an investment grade rating indicate a relatively low risk of default.
Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
This research material has been prepared by LPL Financial.
LPL Financial, Member FINRA/SIPC
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