Thanks to the recent market dislocations, the complex municipal market offers attractive opportunities for strong returns, notes Guggenheim.

B. Scott Minerd and the team at Guggenheim point out volatility induced by headline events has created attractive investment opportunities in the municipal market.

Interestingly, the recently announced Volcker Rule too creates big opportunities in munis. As reported earlier, the Volcker Rule is not going to limit proprietary trading in municipal obligations.

Investors withdraw $50 billion from munis

Guggenheim analysts point out without conducting the requisite analysis to identify the truly at-risk issuers, it appears many investors have chosen to flee the municipal market. They point out that $50 billion in capital has been withdrawn from municipal bond funds this year, with investors clearly operating under ‘sell first, ask questions later’ mentality. The analysts relate the investors’ mentality to what occurred following Meredith Whitney’s now famous prediction of financial Armageddon in the municipal market in late 2010.

The following graph highlights recent trends reminiscent of the Whitney effect:

Whitney effect Municipal Market

Guggenheim analysts observe that the financial media’s fixation on troubled issuers has created the perception that fiscal conditions are deteriorating across the U.S. However, in reality, the overall fiscal picture is improving as U.S. state and local tax revenues in the second quarter of 2013 rose 8.9%, the 14th consecutive quarter of growth.

The analysts also point out that regulatory changes and public policy decisions have contributed to waning demand for municipal bonds from commercial banks. They note over the past 30 years, banks’ market share has fallen to 11% from 40%, as individual investors have become the biggest holders of municipal debt.

Also see: Are Municipal Bonds Cheap Relative To Taxable Counterparts?

Opportunities for sophisticated investors in municipal market

According to B. Scott Minerd and team at Guggenheim, the market’s disproportionate fixation on select credit issues creates opportunities for sophisticated investors with the ability and resources to evaluate credits throughout the highly diverse $3.7 trillion municipal market. The analysts note devising an investment strategy to take advantage of current market dislocations relies both on optimal positioning on the yield curve as well as identifying credits offering strong structural protection.

The analysts point out that over the years, it has become easier to evaluate the fiscal health of U.S. states, though the analysis remains increasingly more difficult at the city and county level given the localized nature of issues. The analysts consider this as a potential opportunity as local bonds typically trade cheap to comparable state issued bonds.

The analysts also prefer bonds secured by revenue streams over local appropriation-backed debt. The analysts point out that bonds backed by water and sewer utility systems are preferable as they have proven to be well-insulated from impairment, even in situations of local government bankruptcies, such as Detroit or Stockton. As utilities provide an essential service, the analysts believe delinquencies tend to be mutued even in economically strained areas.

The following table depicts Municipal Market Heatmap prepared by Guggenheim detailing the areas where the analysts find attractive:

Municipal market heatmap