Municipal bonds have been the sleeper hit among investment categories in 2015. They're the biggest gainers in the bond market, outperforming corporates and Treasuries, and they're poised to beat the major stock indexes as well.
The Merrill Lynch Muni Master index is up almost 3% year-to-date compared to a 0.81% loss in the Merrill investment corporate master index, a 0.36% loss in the Barclays agg and a less than 1% gain in the S&P 500 as of the market close on Tuesday, December 29.
The outperformance was "probably a big surprise for everyone," says Richard Ciccarone, president and CEO of Merritt Research Services, a municipal credit and research company.
The question now for investors and advisors is what happens to the muni market in 2016 given the expected rise in rates as a result of the Fed's new tightening policy and credit concerns that involve not just Puerto Rico, whose bonds are teetering on default, but also other vulnerable credits like Chicago, Illinois, New Jersey, Pennsylvania.
"January 1 will start the year with a big bang," says Ciccarone. "The biggest event in the market will be whether or not Puerto Rico will pay." About $1 billion in bond interest payments come due January 1 for the commonwealth, which is roughly $70 billion in debt. On Wednesday Governor Alejandro Garcia Padilla announced that Puerto Rico will default on about $37 million in bond payments.
Of course some default expectations have already been discounted in the muni bond market but not all. The "real occurrence still has an impact on most optimistic investors who always believe muni bonds will pay on time," says Ciccarone.
In the case of a Puerto Rican default the most vulnerable assets are high-yield muni bond funds since they currently hold most Puerto Rican debt, says Ciccarone. But even investment grade muni funds with little or no Puerto Rican bonds and the muni market in general could be impacted because of the possibility of contagion.
"It's not the credit risk per se, it's the headline risk," says John Mousseau, director of fixed income at Cumberland Advisors. "Last summer when the Illinois Supreme Court overturned the state's pension reform plan, Chicago bonds also tanked, not because of coverage [for rate payments] but because of the perception that things are going to get worse."
Mousseau recommends that advisors and their clients look closely at their muni fund holdings to see if their funds hold any Puerto Rican bonds. Those with less than 10% of their assets in Puerto Rican bonds and insured funds will hold up better, says Mousseau. And individual bonds with no Puerto Rico debt should be an even safer bet because unlike mutual funds they are not subject to investor redemptions which can impact a fund's net asset value and thus performance.
"It's hard to say if munis will continue to outperform," says Ciccarone. "The greater risk [than Puerto Rico default] is a steady rise in interest rates."
