Supply and demand imbalances during the first quarter of 2012 resulted in a substantial amount of volatility in tax-exempt yield levels. Demand during January and early February was incredibly strong as a result of very heavy roll-over investment of January 1st and February 1st coupons/calls/maturities. This reinvestment demand pressured yields in 10-years to fall by 16 basis points (bps) to a low of 1.67% on January 19th, which created some concerns that absolute yield levels had become too low on maturities 10 years and shorter. Consequently, investors began to target longer maturities in the 15 to 20 year range, which led to a decline of 48 bps in yield on 20-year bonds to a low of 2.70% on February 1st. Since that time, the technical environment has seen a dramatic shift, with demand cooling substantially ahead of the tax-filing season and new-issue supply increasing dramatically. The net result was an increase in 10-year yields of 43 bps over the last two months of the quarter.
Supply during the first quarter was up sharply from last year, primarily as a result of refinancing/refunding of currently-callable structures. Overall supply increased by 63.5% to a total of $78.2 billion, with 47% of this amount directly related to refinancings. That’s an increase of 159% over first quarter 2011 refinancings and a 74% increase over the average refinancing volume for the period 2006 to 2010. The refinancings have been driven in large part by the near-record low interest rate environment and the need for municipalities to garner budgetary savings wherever they can find them.
However, first quarter new money financing of $26.4 billion remains at anemic levels, with a decrease of 3% relative to 2011. When compared to the 5-year average for the period from 2006 to 2010, the percentage decline is substantial with a decrease of 51%. These numbers suggest that most of the austerity measures at the state and local level are still in force and portends a modest new-money issuance cycle for 2012.
In the near term, technicals should gradually improve. After the tax-filing season has passed in mid-April, the market begins to move closer to another upswing in heavier reinvestment flows in May, June and July. Additionally, with most of the refinancing supply targeting currently-callable structures, a large number of investors will receive the proceeds of these calls and will need to redeploy them in the market.
Based on the positive trend for demand flows, the outlook for the municipal market is for relative performance to be positive over the next quarter. But as in the first quarter, the market should continue to experience significant swings in relative valuation levels. Current 10-year tax-adjusted municipal yield spreads versus Treasuries are at 104 bps, which is substantially higher than the 54 bps spread that existed on January 19th. Current spreads also remain well-below the 173 bps spread that existed on October 7, 2011. Consequently, tax-exempt spread levels look to be fairly valued today. However, with approximately 50% of the market’s new-issue supply made up of rate-sensitive refinancings, the market could experience very volatile performance on either a sharp increase in supply or any substantial spike in yields. In the latter case, significant yield increases could reduce the potential savings of refinancings and drastically reduce the pace of supply during 2012, resulting in tax-adjusted spreads tightening dramatically from current levels. In either case, we will continue to closely monitor supply/demand dynamics over the coming quarter and look to trade on imbalance-related opportunities as they occur.
Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products
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