The municipal market took off like a rocket ship from late-August through early October. The tax-free bond market closed higher or unchanged for 28
consecutive trading days from late August through October 5. An impressive run to say the least, but soon thereafter the municipal market sent out a distress call, “Houston we have a problem.” The municipal market finished the first half of October down nearly 2% according to Barclays index data.
A combination of increased supply, investors balking at record low yields, and large institutional investors taking profits conspired to knock the municipal market down over the first two weeks of October. Controlled supply has been one of the primary drivers of excellent municipal performance year-to-date. However, during the first full week of October, new issuance totaled $11 billion, one of the biggest supply weeks all year, as municipal issuers sought to take advantage of low yields (i.e., low funding costs).
Not only was new issuance volume high but also bond dealers were relatively full on municipal bond inventory. Weekly new issuance was also heavy over the latter half of September with two weeks totaling nearly $10 billion. At the same time demand was firm but diminishing leaving a greater amount of bonds finding a home on bond dealer balance sheets. Although financial firms (bond dealers) have strengthened over the past year they remain sensitive to balance sheet constraints especially holding bonds near peak prices. Dealers responded by cutting prices on bonds to move inventory. If that wasn’t enough large institutional investors began selling bonds taking profits on substantial year-to-date gains. The Barclays Municipal Index* returned 14% through the end of September, second only to 1995’s record year. The influx of bonds to be sold lowered prices across the municipal market but particularly for longer maturity bonds which had posted the strongest gains in 2009. Bond dealers were unwilling to bid aggressively given their already significant inventory.
Record low yields compounded the problem, as investors balked at yield levels. Short-term yields had already been hovering at record lows but this
wasn’t entirely surprising given the low Federal Funds target rate which has kept all short-term bond yields at historically low levels. However, the decline in average 10-year AAA-rated GO yields to a new record low caused price shock for yield sensitive investors. Buying slowed sharply in response and added to market weakness.
The municipal market began to show signs of stabilization late last week and thanks in part to the jump in yields. The average 10-year AAA yield
remains low by historical comparison but the 0.3% jump in yields is helping to lure buyers. The average 30-year AAA yield has jumped back over the key 5% level. The yield charts also reflect that recent weakness looks similar to other bouts witness over the past year. Financial markets have improved a great deal but supply/demand imbalances can still work against markets from time to time.
Focusing on the Positive
On a positive note, the factors that have driven strong municipal performance year-to-date remain in place. First, supply remains favorable with issuance of traditional tax-exempt bonds on pace to decline by 10% in 2009 compared to 2008’s depressed level. Barclays forecasts a smaller
4-5% contraction in 2010. The Build America Bond (BAB) program expires at the end of 2010 and will continue to siphon new issuance away from the
traditional tax-exempt market and into the taxable market.
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In conjunction with diminished supply, municipal demand should remain elevated given the prospect of higher tax rates. The 2003 Bush tax cuts
expire at the end of 2010 and absent new legislation the top tax rate will revert back to 39.6% from 35%. In addition, 13 states have already
increased local taxes. Record year-to-date mutual fund inflows have in part been attributable to expectations of higher tax rates. While these inflows may slow they’re likely to remain elevated. We would not be surprised to see a further increase in the top tax bracket in coming years.
We remain positive on the municipal market given that positive drivers remain in place. Our preference remains on intermediate to longer-term
municipal bonds, which possess more attractive valuations. We find short to short-intermediate municipals expensive and appropriate for the highest bracket investors. A municipal rebound may not come quickly however as supply projections remain elevated for the remainder of October with $8 to $9 billion per week expected to come to market over the coming two weeks. On a longer term basis, valuations, as measured by municipal-to-Treasury yield ratios, could increase back to levels that existed under President Clinton when higher tax rates prevailed. The lower the ratio the more expensive municipals are relative to Treasuries and vice versa. This increase in valuations could offset the impact of higher interest rates. We expect a trading range to persist in the interest rate markets into next year. However, we expect municipals to remain more resilient in a rising rate environment that may unfold in the coming years. We would use weakness to add to positions based on the positive backdrop that bodes well for municipal bonds over the long-term.
- This report was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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