Given our outlook and the currently attractive relative valuation levels, we are moving to an overweight bias for the municipal sector.

Supply technicals were expected to drive volatility in relative valuations this year, and so far, that’s played out in the second half of the year. With 10-yr Treasury rates plunging at the beginning of the 3rd quarter to 1.36% following Britain’s decision to leave the European Union, munis followed suit, with rates moving to a record low of 1.29%. These low nominal yields have induced state and local governments to execute refinancings to levels that are running in tandem with 2015’s record level of issuance. The surge in refinancings during the quarter helped produce record levels of issuance in August and September, resulting in yields rising across the yield curve. Tax-exempt yields in 10-yrs moved higher by 16 basis points (bps) versus a 12 bps move in Treasuries. The long-end of the municipal curve exhibited the worst performance, with yields in 20 and 30-yrs increasing by 27 and 29 bps, respectively. Treasury rates in 30-yrs were higher by only 3 bps.

The front end of the muni yield curve also faced poor performance as the market adjusted to the new regulations surrounding money market reform. New standards that went into effect on October 14th now require that money market funds sold to institutions move to a floating valuation and adopt restrictions that limit investor withdrawal access if the fund’s liquidity falls below certain levels. These reform measures have resulted in year-to-date municipal money market fund outflows of $126 billion as of October 19th.

Consequently, relative valuations of bonds with maturities from 1 to 3-yrs have moved to some of the most attractive levels the market has experienced in over three years. Since August 29th, tax-adjusted spreads for these maturities moved wider by 39, 49 and 44 bps in 1, 2, and 3-yrs, respectively. These adjustments in spread levels have moved our relative valuation bias to a neutral position for this area of the curve from a negative bias that was in place during the first 9 months of the year.

Similarly, the balance of the yield curve is also facing significantly weaker relative valuation levels resulting from weaker technicals. Mutual fund flows, which were experiencing very strong weekly inflows through September with an average of ~$700 million per week, have now moved to outflows of $136 million as of October 19th.

Additionally, seasonal reinvestment flows for coupons/calls/maturities are also near lows for the year during October and November. The drop in demand flows, combined with the recent surge in new issuance, has produced substantial curve steepening pressure. The slope of the yield curve from 5 to 20-yrs has steepened by 13 bps since August 29th and tax-adjusted spreads in 15 and 20-yrs have widened by 43 and 41 bps, respectively, providing that area of the curve with a very compelling entry point for investment.

In looking at the supply outlook for the year, the market is expecting the sector to produce a new record of $445 billion. Both August and September have already reached record levels for their months, with issuance of $45 billion and $35.6 billion, respectively. The market also expects that October and November could approach record levels of over $50 billion per month. Consequently, key relative valuation metrics of municipal/Treasury ratios and tax-adjusted yield spreads to Treasuries have adjusted to near 6-month highs as of this writing.

Looking forward, we expect to see a dramatic slowdown in issuance going into December. In a comparable fashion to the issuance cycle that developed during the latter portion of 2015, it’s expected that state and local governments will curtail issuance, especially rate-sensitive refinancings, to avoid any potential market volatility surrounding the Federal Reserve’s next rate increase. Going into potential Federal Reserve rate hikes in September and December last year, new issuance supply plunged 24% during the last 6 months of the year. Similarly, with the market consensus of at least one rate hike for the balance of this year, the market projects issuance in December this year to decline by 33% relative to the average expected monthly issuance of $41 billion from August to November. This dramatic drop in issuance, combined with the anticipated improvement in demand technicals from robust reinvestment flows of coupon/calls/maturities in December and January, should produce solid muni relative performance going into the new year. Given our outlook and the currently attractive relative valuation levels, we are moving to an overweight bias for the municipal sector. Our objective will be to gradually build up our sector exposure level into the projected supply surge and to further extend our overweight exposure if further dislocations in relative valuations develop.

Written by:
GregoryABell
Greg Bell, CFA
Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

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Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here. The information presented, including any statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. AAM assumes no duty to provide updates to any analysis contained herein. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.