The bond market had a spectacular year in 1993. Prices peaked on the 30-year Treasury bond, with a yield of 5.79%. Municipal market volume hit $290 billion, shattering the $235 billion record set just the year before.
A year ago we thought that interest rates would generally rise in 1994, and that supply in the municipal market would decline substantially, to about $150 billion to $160 billion. We also argued that, because of record volume, municipals underperformed fixed-income alternatives in 1993 and were well positioned to outperform in 1994.
Well, we were partially right.
Yes, the municipal market experienced a 45% decline in supply, to $160 billion. That was the good news.
The bad news was the Fed increased short-term rates an unprecedented six times in 1994, from 3% to 5.5%, and long-term rates as represented by 30- year Treasury bonds increased from 6.35% on Dec. 31, 1993, to 7.88% a year later. Long-term municipal bond yields, as measured by the Bond Buyer 40 index, increased from 5. 52% at the end of 1993 to 6.92% a year later.
For most of 1994, municipals did outperform the Treasury market. In the last quarter a number of events reversed the trend.
First, investors sold municipal bond mutual fund shares to capture tax losses.
Second, the economy refused to slow, forcing the Fed to increase short- term rates 75 basis points at its Nov. 15 meeting. Finally, the market was forced to digest the largest municipal bankruptcy filing in history, by Orange County.
As a result, municipals gave back most of their relative gains as the yield ratio of the Bond Buyer 40 index to 30-year Treasury bonds widened from 83% in September to 92% in December, which was as cheap as municipals were at any time during the year.
As a result, some investors in individual long-term municipal bonds could have experienced losses of 15% or more, while those invested in diversified, open-end national long-term funds experienced losses of about 7%.
On a positive note, credit trends in 1994 were generally good, with most states benefiting from the stronger economy in the form of higher tax revenues. Even California is showing a number of signs of a strengthening economy, such as stronger job growth, population migration back in to the state, strong exports to Canada, Mexico, and the Pacific Rim countries, a stronger housing market, and a more favorable budget outlook through December.
With the Republicans taking control at the federal and state level, proposed tax cuts will create budget struggles, especially in states such as New Jersey in which elected officials have promised aggressive tax cuts of as much as 30%.
Health care investing will continue to be a challenge, especially with the increasing consolidation activity, as well as pricing and reimbursement pressures.
The utility sector, containing credits with high-cost structures and pressures from deregulation, will likely create winners and losers.
We feel the Orange County and Orange County investment pool bankruptcies are most likely isolated problems resulting from an ill-conceived investment strategy incorporating the extreme use of leverage and a heavy concentration of volatile and illiquid derivative securities.
The resulting loss currently estimated to be in the range of $2 billion, could be resolved not only by budget cuts and asset sales, but also through a long-term solution, which may involve accessing the credit markets.
Because of the complex structure of the investment pool and its participants, a tremendous amount of litigation will probably add to the length of time required to resolve this problem fully.
In our opinion the Orange County crises and the resulting decline in prices of certain individual bond issues, highlight how a diversified municipal bond portfolio can help protect investors from credit risk.
We see potential for a more favorable bond market in 1995, with the Fed likely to increase short-term rates until the economy slows to a growth rate of about 2.5%, and to stay ahead of the curve in controlling inflation.
The result should be a continued flattening of the yield curve. The municipal market should remain very attractive for a number of reasons, including relatively high after-tax yields for long-term bonds (depending on an investor's tax situation).
In addition, demand should increase as a record number of bonds mature or are called and are removed from the market and the resulting cash proceeds are reinvested in the municipal market. At the same time, municipal supply should remain low, and we expect volume to be about $140 million to $150 billion, versus $235 billion, $291 billion, and $164 billion in 1992, 1993, and 1994, respectively.
In fact, 1994 was the first year ever where the amount of outstanding municipal bonds actually declined ($25 billion more were redeemed than were issued), and we expect a recurrence in 1995, by about $40 billion.
We believe municipal bonds are well positioned to perform well in 1995.
One of the best comments about 1994 is that it is over! We look forward to a potentially more favorable 1995, especially in the municipal market.
Mr. Kenny is director of the municipal bond department at Franklin Templeton Group in San Diego. Orange County's bankruptcy is most likely an isolated problem.