Fourth Quarter 2012 Municipal Commentary and Outlook for 2013
First 3 Quarters Summary
The municipal sector exhibited a considerable amount of volatility during the final quarter of 2012, with most of the volatility being attributed to news events out of Washington DC. The presidential election results, which ushered in the prospects for higher marginal tax rates, were a huge boost to municipal performance in November. From November 6, 2012 through November 29, 2012, 10-year municipal yields in collapsed by 25 basis points (bps) and tax-adjusted yield spreads to Treasuries tightened by 31 bps. With the highest marginal tax rate expected to return to Clinton-era levels of 39.6% from 35%, the municipal market quickly priced in the increased value of the tax-exemption. At this point, 10-year tax-adjusted yield spreads were at their tightest of the year at 51 bps.
However, from the end of November to December 20, 2012, 10-year yields spiked 35 bps and spreads widened by 34 bps. A large proportion of the selloff was attributed to concerns over tax-reform and the increasing probability that the municipal tax-exemption could be compromised as part of the proposal to cap deductions and exclusions at the 28% marginal tax rate. As the new-year approached and it became clear that the “fiscal cliff” agreement would not include the 28% cap, municipals outperformed taxables as 10-year Treasury yields increased by 14 bps from December 31, 2012 to January 3, 2013, while municipal yields were higher by only 6 bps.
As of this writing, 10-year tax-adjusted municipal spreads stand at 72 bps, which remains substantially wider than the 51 bps spread that existed at the end of November. However, tax-reform concerns continue to be an issue hanging over the market and that’s led to a more muted conviction to develop around current spread levels. Investors remain nervous that there’s some probability that additional revenue-raising measures as a part of tax reform could come out of the sequestration (the mandatory, across-the-board spending cuts) and debt ceiling discussions coming within the next two months. This legislative risk has led to a very quiet tone during the first week of January, and the typical performance boost from the “January effect” on low primary issuance and heavy reinvestment flows of coupons/calls/maturities has been slow to develop.
As for the near term outlook for the sector, positive technicals should provide solid relative performance. Supply/demand imbalances are generally constructive during the first two months of the year and there should be a general bias toward tighter spreads going forward for the next seven to eight weeks. However, legislative risk surrounding the tax-exemption status of municipals remains a concern that won’t be abated until a deal is reached on both the sequester cuts and the debt ceiling. Although the probability is low that Republicans will agree to additional revenue-raising measures beyond what was accepted in the fiscal cliff agreement, investors are likely to remain cautious. Consequently, demand flows into the market should lead to strong relative performance, but the buying conviction for municipals will remain less than optimal until we reach a final resolution to the legislative issues.
The longer-term outlook for the market for 2013 is generally favorable. Underlying credit fundamentals for the sector have been and should continue to gradually improve. Although there remain credit concerns and heightened default concerns on some local issuers, especially in California, defaults overall have continued to exhibit a declining trend. Payment defaults in 2012 declined 31% to $903 million from $2.2 billion in 2011.
A major reason for the improvement in the credit profile for the sector is the steady growth in revenues. State and local government revenues have seen positive growth over the last ten quarters. And, as the economy continues to see growth in employment, states should continue to see steady growth in income tax revenues. Additionally, property taxes have seemed to be on an improving trend over the last two quarters. Most of the improvement can be ascribed to higher assessment rates, and with property taxes being the primary source of funding for general operations of local issuers, this improvement should continue to lessen some of the credit concerns surrounding local credits.
Tightening of credit spreads has been reflective of the improvement in underlying credit fundamentals for the sector. Spreads on 5-year A- and BBB-rated paper have tightened by 45 and 66 bps, respectively, during 2012 and spreads are now back to levels that existed just prior to the 2008 financial crisis. As the municipal market continues to exhibit a generally improving credit profile and fully regains its notoriety as a semi-safe sector, these spread levels should continue to see a tightening bias during the course of 2013.
Technicals should also be supportive for solid municipal performance in 2013. One measure of the demand trends in the municipal market is to examine mutual fund flows. In 2011, tax-exempt funds saw net outflows of $17.9 billion, primarily as a result of heightened credit concerns surrounding predictions of a massive wave of defaults to hit local issuers. As these risks have subsided, and as the prospects for higher marginal tax rates became evident late in the year, 2012 saw a massive turnaround in flows. Municipal mutual funds experienced net inflows of $49.48 billion during 2012, according to Lipper data and, at one point, saw a streak of positive inflows in 65 of the prior 67 weeks as of December 14, 2012. However, in the last two weeks of the year, legislative risks tied to the 28% cap on deductions and exclusions resulted in outflows of $2.7 billion, before moderating in the new year. The risks related to tax-reform and the possible resurrection of the 28% cap discussion may linger over the market and suppress flows until final details have been agreed upon to resolving the debt ceiling and avoiding the sequestration cuts. Outside of these legislative risks, demand should continue to remain solid during 2013.
Supply during 2013 is not expected to put pressure on relative valuations. Consensus estimates for new issuance is $400 billion in 2013, which would be an increase of only 7.2% over 2012’s levels and would be just north of the 10-year average of $385.8 billion. Additionally, with interest rates remaining near all-time lows, refinancings/refundings are expected to remain a major component of new supply. In 2012, total refinancings accounted for a total of 62% of issuance. And, as long as rates remain near historic lows, issuers will continue to target borrowing costs as a source for potential budget savings as part of their overall austerity focus.
The focus on spending restraint should also translate to a continued below-trend in new money issuance for infrastructure spending. The average issuance in this category over the last 2 years has been $148 billion, which is 40% below the average of $248 billion from 2003 through 2010. With local issuers cutting education-related employment by approximately 54,000 during 2012 and with the trend in new money issuance in 2012 down 6% to $143 billion from $153 billion in 2011, it does not appear that there will be a turnaround in project-related financing in 2013. Consequently, refinancing supply should continue to drive the new issuance cycle. Additionally, any substantial move higher in rates could drastically reduce refinancing opportunities. Actual total issuance under this scenario could come in well below consensus estimates, which would be very constructive for municipal relative valuations for 2013.
Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products
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