Top rated tax-free municipal bond yields did not quite match the decline in Treasury yields in August, but performance was impressive nonetheless and followed a strong month of July.
The favorable supply/demand balance that has aided municipal bonds all year became acute in August. Investor demand intensified while supply decreased further. Investor flows into municipal bond mutual funds continued at a frenetic pace. Through August 26, municipal inflows totaled $46 billion according to AMG data services, more than the full year record of $44 billion recorded in 1993. The supply/demand balance helped push year to-date performance of the Barclays Municipal Bond Index just over 10%.
At the same time, Municipal supply decreased further in August with new issuance 27% behind last year’s pace according to Bloomberg. In August the low supply situation was exacerbated by taxable Build America Bonds (BABs) representing one-third of monthly issuance, the highest percentage of monthly issuance since the BABs program was launched in April of this year and higher than an average of 10% to 20% per month. This left traditional tax-exempt bond investors fewer bonds to pick from at a time when demand remained robust. This powerful one-two combination translated into strong municipal performance.
Investor demand for yield…..
caused long-term bonds and lower rated bonds to outperform in August. Long-term bonds benefited from a municipal yield curve that remains at historically steep levels. The yield curve slope, as measured by the yield difference between 2-year and 30-year AAA-rated municipal bonds, remains very near a record wide level. In contrast, the 2-year to 30-year Treasury yield gap of 3.3%, while also wide, is below its 3.6% peak. In other words, municipal investors get compensated more for extending maturity compared to taxable investors.
Record low short-term yields have also pushed investors out further onto the yield curve. The SIFMA 7-day Yield, an average yield on municipal variable rate demand notes, the primary security type in money market funds, has dropped to a new record low and brought money market yields to mere basis points. In response investors have extended maturity to short-term bonds. With one to five-year municipal bonds now expensive and the Federal Reserve stressing an “on hold” message, investors have extended further.
The reach for yield benefited high yield bonds which returned over 3% according to the Barclays High Yield Municipal Index. Within the high yield market, the riskier Tobacco Bond sector outperformed with the average yield declining a staggering 2% in just one month. The grab for yield is also reflected in long-term California St. GO bonds where average yields are 1% lower just two months after being punished on bankruptcy fears. Despite the improvement, yield differentials between top quality municipals and lower rated issues remain relatively wide.
Supply is light to start September which bodes well for the municipal market to hold recent gains. However, recent strength has exceeded our expectations and an expected pick up in new issuance in late September/early October could lead to modest weakness. The state of California is expected to issue $10 billion in short-term notes late in the month and while sentiment has become more positive on California, that is a significant amount of debt for the municipal market to digest.
Lower absolute yield levels…..
may also cause investors to balk or hesitate on new purchases. We view this as simply leading to a more gradual pace of improvement going forward. Although short-term municipal valuations have become expensive in our view, intermediate to long-term municipals are still attractive relative to Treasuries. Thanks to the greater decline in Treasury yields, municipal valuations actually cheapened in August.
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We would use weakness to add to municipal positions as we remain positive on municipals over the longer-term. Several factors support our long-term positive view. Supply should remain light as BAB issuance will continue to take away supply originally intended for the traditional tax-exempt market. President Obama has even proposed extending the BAB program beyond its current year end 2010 sunset date. If extended, the supply dynamic could be positive for longer.
Most importantly, higher future tax rates continue to bode well for municipal valuations. Municipal investors are becoming increasingly aware of this and this factor likely played a role in recent demand. According to Bloomberg,13 states have or are in the process of increasing local taxes. In late August, the Governor of Connecticut was the latest to make headlines and proposed increasing taxes on individuals earning over $500,000 and couples earning more than $1 million. Keep in mind the Bush tax cuts expire at the end of 2010. While some tax rates will be maintained a return to an effective top bracket of 39.6% (or higher) from 35% is highly likely in our view.
Municipal bond performance has been impressive over the summer. While low supply bodes well as we start September, we would not be surprised to see some weakness on a pick up in supply or investors slowing purchases based on now lower yields. However, key factors that have driven year-to-date performance remain in place. We would view any municipal weakness as an opportunity to buy as we still find the sector attractive over the longer-term.
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