• Muni Nation

    On The Horizon

    Jim Colby, Portfolio Manager
    August 12, 2013

    While some may feel like August's "dog days" may already be descriptive of the next few weeks, I sense an undertone of market uneasiness which seems to me to want to push interest rates even higher (see yield curve graph below). A few observations:

    • According to Lipper, municipal bond fund outflows have continued from the retail sector for 10 consecutive weeks. I believe cash selling from municipal bond funds may have contributed to the higher rates and tested liquidity.

    • The new issue market is challenging participants with more than $11 billion coming to market in the next 30 days.1 

    • This week, Puerto Rico Electric Power Authority (PREPA) tested demand as it brought $600 million BBB rated long maturity bonds to market.

    Yields Pushing Higher Chart

    Source: BofA Merrill Lynch. As of 7/31/13.

    Detroit hovers like a gray mist over the marketplace. I believe market participants have been alerted to an important consequence which, even if it does not come to pass, I think is worthy of attention. As highlighted in his report of August 6, 2013, Michael Zezas of Morgan Stanley warns of how close the municipal bond market is creeping to "extension risk" and its potential impact on portfolios.

    "Our analysis suggests 73% of munis carry calls, and 85% of the callable market is trading at a premium, suggesting the market is pricing in the likelihood that most bonds will be called. As rates rise, many of these bonds will "extend" in duration [interest rate risk], making the market more rates sensitive."

    Mr. Zezas believes we are at, or approaching, a near-term high for rates, but he goes on to note that in his opinion, if rates do push higher by about 60 basis points, some 20% of premium bonds may turn to a discount, pushing duration significantly longer. I believe the challenge now, is to prepare our portfolios and our clients for this type of event.

    1Bond Buyer as of 8/2/2013.

    Extension Risk Explained: For an option-free (i.e., non-callable) fixed-coupon bond, when interest rates rise, the bond’s duration shortens. That is, the price-yield relationship for an option-free bond is said to be convex, which implies prices decline at a decreasing rate as rates rise (i.e., duration shortens). Thus, while the bond will have likely lost market value with an increase in rates, its future sensitivity to interest rate moves is dampened, which is desirable if you fear continued moves higher in rates. However, if the bond is callable, a different dynamic can apply. Specifically, for a bond trading at a premium to its call price, implying an expectation that the bond will be called, duration can extend as interest rates rise. This happens when the bond’s call option falls out of the money as the new, higher rate regime makes calling and refinancing the bond uneconomical. Consequently, the bond, which may have been trading at a yield that implied that its call date was the time when the bondholder would receive full principal, may now trade to its final, longer maturity as the issuer is less likely to redeem the bond early.




    This content is published in the United States for residents of specified countries. Investors are subject to securities and tax regulations within their applicable jurisdictions that are not addressed in this content. Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction.

    VanEck does not provide tax, legal or accounting advice. Investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service.

    Please note that MUNI NATION® represents the opinions of the author and these opinions may change at any time and from time to time. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Current market conditions may not continue. Non-VanEck proprietary information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck. MUNI NATION is a trademark of Van Eck Associates Corporation.

    All indices listed are unmanaged indices and do not reflect the payment of transaction costs, advisory fees or expenses that are associated with an investment in a fund. An index’s performance is not illustrative of a fund’s performance. Indices are not securities in which investments can be made.

    Municipal bonds are subject to risks related to litigation, legislation, political change, conditions in underlying sectors or in local business communities and economies, bankruptcy or other changes in the issuer’s financial condition, and/or the discontinuance of taxes supporting the project or assets or the inability to collect revenues for the project or from the assets. Additional risks include credit, interest rate, call, reinvestment, tax, market and lease obligation risk. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. Municipal bonds may be less liquid than taxable bonds.

    The income generated from some types of municipal bonds may be subject to state and local taxes as well as to federal taxes on capital gains and may also be subject to alternative minimum tax.

    Diversification does not assure a profit or protect against loss.

    Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of a fund carefully before investing. To obtain a prospectus and summary prospectus which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.

    Van Eck Securities Corporation, Distributor
    666 Third Avenue
    New York, NY 10017