Municipal market performance during the 1st quarter of 2011 exhibited a nice rebound from the disastrous performance of the 4th quarter of 2010. After tax-exempt 10-year yield levels reached a two-year high of 3.46% on January 17th, rates fell 56 basis points (bps) to 2.90% on March 17th. Municipals also performed very well relative to the taxable sector during this timeframe, with tax-adjusted yield spreads to Treasuries contracting by 68 bps. The catalyst for this performance was a combination of strong demand flows from crossover investors who were taking advantage of very attractive relative valuations, and a dearth of new issue supply that’s on pace to achieve 11-year lows in total new issuance for the year.

However, since March 17th, 10-year rates have moved higher by 24 bps as a result of the typical demand weakness that’s prevalent at this time of year. Reinvestment flows of coupons/calls/maturities are at their lowest point of the year between March 1st and May 1st, and selling of municipals typically gains momentum ahead of the tax-filing deadline of mid-April. Investors have also been very apprehensive about investing in the market ahead of what’s expected to be a pickup in new issue supply during the latter portion of the 2nd quarter.

Thus far in 2011, new issue supply has come in at a total of $46.9 billion, which is 55% below the same period in 2010 and 44% below the 5-year average. Record issuance in the 4th quarter of 2010 that was pushed into the market ahead of the expiration of the Build America Bond program is seen as one of the major causes for the drop. Additionally, with 10-year rates reaching a two-year high in mid-January, much higher funding levels is also considered to be a key contributor to the slowdown.

One additional explanation for the supply drought, which could also portend higher supply later this quarter, is related to the current delays exhibited in the budgetary process of the states. There is typically an inherent “black-out” period for new issuance  during the first two months of the year as states grapple with planning and passing their budgets. Delays this year have been exacerbated by the election of 27 new governors, who have initiated significant austerity measures to close budget gaps. Some of these austerity measures have included fights with unions over collective bargaining rights, along with the adoption of significant reforms to pensions. These battles, along with the extensive debates surrounding the right mix of spending cuts and/or tax hikes to close an estimated $112 billion in budget deficits, have resulted in delays of any bonding initiatives that are tied to the adoption of a balanced budget.

As the budgeting process comes closer to an end, and with most states starting their fiscal years on July 1st, the expectation for a heavier supply cycle is expected for May and June. If this supply increase is significant, we expect to see relative valuations for municipals move to more attractive levels and provide an entry point for additional investment into the sector. A more favorable technical profile should develop after June 30th, as demand should increase substantially from a significant increase in reinvestment flows from coupons/calls/maturities. Consequently,  we expect to see a tightening-bias in tax-adjusted yield levels relative to Treasuries during the summer months. Once that occurs, we will look toward opportunities in reducing our tax-exempt exposure and redeploying the proceeds into sectors with better total return prospects.

Gregory A. Bell, CFA, CPA
Principal and 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.

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.

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.