What is the outlook for the municipal bond market through the first half of the 1990s, and what investment strategy should be followed in light of that outlook? David C. Clapp, partner in charge of municipals at Goldman Sachs, in a recent speech in New York identified three trends that hold significance for holders of tax-exempt bonds over the next several years.
The first is the continued steady growth in the new issue volume of municipal bonds that has occurred since 1987, particularly "new-money" bond issues, as opposed to debt sold to refinance or refund issues already outstanding. So far in 1990, the average new-money volume is nearly 30 percent ahead of last year's figure.
Oddly enough, with the new-money issuance expected to increase, Clapp believes that the second trend will be to a lower volume of outstanding municipal bonds. During the early 1980s, a large amount of new issues were marketed with unusually large coupons -- 9 percent and higher. When interest rates declined, these high-couponed issues were "advanced refunded," or simply refinanced. Goldman Sachs estimates that at a minimum, $200 billion of these pre-refunded issues, out of a current outstanding total volume of $800 billion, will be retired during 1994 and by the end of 1995. That's one-quarter of the current outstanding volume.
With that many bonds leaving the marketplace, it is reasonable to assume that the outstanding volume of municipals will decline over the next few years.
The third trend is the increase in the demand for tax exempts. The buying is in open-end bond funds, unit investment trusts and trust departments, as well as outright purchases by individuals, and it is attributed to an increase in savings and more disposable income. It is also anticipated that another major buyer of municipal bonds -- insurance companies -- will be returning to the market in the next few years.
Regardless of which way interest rates go during the next few years, the demand for municipal bonds will outstrip the supply, Clapp believes, and that has ramifications for the municipal bond industry as a whole and for the individual investor in particular.
With the supply-demand imbalance, the relative spread between tax-exempt and taxable yields will increase. Whereas the yield on a 30-year AAA-rated general obligation bond is presently 82 percent of the 30-year Treasury, it could easily move back to the 72 percent level that it reached in May 1984. Because of the high quality of municipal bonds, Clapp believes that the relative yield on municipal bonds could sell through the taxable yield on corporate bonds.
The supply-demand situation also means that issuers of municipal bonds will be king and that the steady increase in new money bonds will benefit beleaguered underwriters. The people who will benefit least will be individual investors, who will quite possibly face the unenviable problem of reinvesting their proceeds from the retired pre-refunded bonds just when fewer bonds are available and interest rates are much lower.
Clapp's solution to the problem is to "move tax-exempt bond maturities out beyond 1997 to the extent possible." In other words, if you can extend maturities without going beyond your risk-tolerance maturity level, it would be wise to do so now.
Here is what you could accomplish: AAA-rated pre-refunded bonds with coupons of 9 percent or higher and due to be retired in 1994 or 1995 can probably be sold at 6.20 percent. This would give the seller a price of about 112.5 ($1,125 per bond). The proceeds could be used to purchase an AA-rated general obligation bond due in 2000 at 6.50 percent, in 2005 at 6.85 percent, and in 2010 at 7 percent. The premium from the sale ($125) could be used to purchase extra bonds.
You do give up quality and income, but most of the pre-refunded bonds will be retired at a price of 101 to 102 ($1,010 to $1,020 per bond), which means that you would lose the larger premium of $125 (which helps offset the loss of income) in the example. It also means that you can control your reinvestment destiny now and that the market will not control you in 1994-95 when you run the risk of having to reinvest the proceeds from your retired bonds at much lower interest rates.
The Treasury will offer a two-year note in $5,000 minimums on Tuesday and a five-year note in $1,000 minimums on Wednesday. They should return 7.53 percent and 7.96 percent, respectively.