Increased volume and market volatility combined to provide a torturous first quarter for insured bonds and investment portfolios, While many dealers, strategists, and money managers don't see the turmoil ending any time soon, recent tightening moves by the Federal Reserve may change that.
"What the Fed did will go a long way toward helping the prospects for the market," said Jim Colby, vice president and senior portfolio manager for The Evergreen Funds' $39 million insured tax-exempt fund.
"We need a period of stability, and the Fed has given us a chance to have that," Colby said of the Federal Reserve Board's actions on May 17 to raise two short-term interest rates, the discount rate and the federal funds rate, by 50 basis points each.
However, Colby said, "the real wild card is the individual buyer."
Compared to general market names during the first quarter, "over all, insured names underperformed five to 10 basis points," said Randy Smollick, a senior analyst with Municipal Market Data.
From Feb. 12, when declines in the fixed-income markets began accelerating through May 12, yields on insured municipals throughout the tax-exempt yield curve rose on average about 90 basis points, George D. Friedlander, a managing director in the portfolio strategy and fixed-income high net worth unit of Smith Barney Shearson, said in the May 13 issue of Credit Market Comment.
Moves by fund managers to reposition bond portfolios in light of rising interest rates characterized much of the activity during the quarter, dealers said. To take advantage of rising interest rates, fund managers sold insured and discount bonds to purchase current coupon securities and did some "tax swapping" market participants said.
In a tax swap, an investor typically sells one security and purchases another with the proceeds. Often, there is a loss on the bond sold because rates have risen since the security was purchased. Such swaps are done to generate a tax loss to offset gains elsewhere, but without substantially changing the dollar value, risk level, yield, or maturity of the investment.
The liquidity of insured bonds, as well as their attractiveness to most investors, including retail customers, often in the first quarter caused them to be the first offered for sale from bond portfolios, dealers said.
The Lure of Liquidity
One municipal dealer pointed out the attractiveness of insured bonds in the rising interest rate environment: "If you have to sell something and you need the best bid, you want to sell something that most people can bid on," the dealer said.
"If you're trying to do portfolio restructuring, [an insured bond] is the most liquid," said Chris Dillon, vice president of market strategy and quantitative analysis at J.P. Morgan Securities Inc. "It's a very convenient vehicle for accounts to move in and out of the market in."
Mutual funds' limited cash for bond purchases also caused a backup of insured bonds in the secondary market, which hurt the bonds' overall performance, Dillon said.
While municipal issuance during the first quarter faltered relative to levels a year ago, the percentage of insured bonds compared to overall issuance has been rising. Further, "insured volume in April was more than half of April's volume," Dillon said.
During January, February, and March, insured issuance totaled $18.7 billion, and it accounted for 30% or more of new issuance in each of those months, according to Securities Data Co. In April, insured volume was $4.87 billion, or 52.5%, of the month's $9.28 billion of issuance.
The burgeoning supply of newly issued insured bonds, added to those being dumped by mutual funds, resulted in lower prices and caused spreads on the bonds to tighten, raising yields on the securities closer to those available on uninsured bonds. This made the insured bonds attractive to prospective purchasers who believed they could gain the security of insurance at a low cost.
However, a large supply of deep discount and original issue discount insured bonds in the secondary market made some investors wary of the bonds, which could be subject to tax law changes affecting market discount bonds.
The tax law change was not of much concern to investors when it was enacted last year because at the time there was a bull market and interest rates were falling.
But in a bear market, as interest rates rise, an investor who purchases a discount bond in the secondary market and later resells it at a premium could see some of the gain taxed as ordinary income. Confusion about how to calculate taxable income under a de minimus rule added another stigma, some dealers said.
During the first quarter, insured funds posted the poorest total return of all tax-exempt mutual funds, according to figures from Lipper Analytical Services. The 10 best funds in the category had an average total return for the quarter of -4.28%.
Despite the insured market's overall dismal performance, some insured bonds performed well in the weeks preceding the latest Federal Reserve action.
Florida insured bonds tended to perform better than uninsured Florida bonds, Dillon said. Although issuance of Florida insured bonds can be high, investor demand helps hold up prices, he said.
In addition, recent increased buying interest from speciality state and insured unit investment trusts could help dry up the supply of insured bonds and cause them to perform better, Colby forecast.
