Tax-exempt performance for the second quarter of 2011 remained at strong levels on the heels of another quarter of muted new issuance flows. New issue supply year-to-date has been consistently running below 2010’s levels by approximately 50%. This significant below-trend issuance, combined with a drop in perceived headline risk for the sector and a rebound in demand patterns after the April 15 tax filing deadline, contributed to 10-year tax-exempt yields falling by 44 basis points (bps). Tax-exempts also outperformed Treasuries, with 10-year municipal tax-adjusted yield spreads to Treasuries contracting by 34 bps during the quarter.
Even with the strong overall performance, municipals did run into some underperformance over the last six weeks of the quarter. After 10-year tax-exempt yields reached a 6-month low of 2.59% on May 19, new issuance began to spike to approximately $6 billion per week through the end of June. Total new issuance for June was $31.5 billion, which was an increase of 89% relative to the year-to-date average of $16.5 billion per month through May. Although the municipal market seemingly had the benefit of solid technicals from approximately $46 billion in reinvestment dollars from June 1 coupon/call/maturity flows, the low absolute yield environment and supply overhang concerns led to an increase in 10-year yields by 16 bps. These factors also resulted in the steepening of the slope of the yield curve by 18 bps from 2 to 10-years and 10 year municipal tax-adjusted yield spreads to Treasuries to widen by 25 bps.
Supply for the remainder of the year should continue to drive relative performance. Now that practically all of the states have balanced budgets in place, financing of budgeted spending initiatives that were held up with protracted austerity-induced budget battles should now be working their way into the new issue calendar. The consensus estimates are for supply to reach approximately $25 billion per month during the second half of the year. With July and August historically seeing modest new issue calendars, the expectation should be for a heavier new issue cycle to develop for the latter portion of the third quarter and into the fourth quarter.
While supply is expected to remain modest over the next two to three months, the market should see strong positive demand flows from the continued reinvestment of heavy July 1 and August 1 coupons, calls and maturities. Demand has also improved as investors have become less fearful of putting money to work in the sector, with year-to-date municipal defaults failing to come anywhere close to the most extreme predictions of defaults in the “hundreds of billions” range. The perceived reduction in headline risk has resulted in a dramatic improvement in the curtailment of weekly mutual fund outflows, which are now at a 4-week moving average of -$35.6 million. That’s a significant improvement relative to the 4-week average of -$2.1 billion of weekly outflows as of January 5, 2011.
Additionally, there are signs that the fiscal profiles for the states are experiencing improving trends, which should continue to help assuage fears about future default prospects. U.S. states and localities have been reporting consistent revenue growth, with tax collections in the first quarter reporting an increase of 4.7% over the first quarter of 2010, resulting in the sixth straight quarter of growth. As this slow growth trend continues, combined with the austerity and reform measures that have already been adopted, the fiscal outlook for the states should continue to see slow improvement.
Our outlook for the third quarter is for the tax-exempt market to perform well, given the favorable technical backdrop of expected modest supply conditions and for demand to remain firm as heavy reinvestment flows come into the sector. We also expect that the market should experience a much weaker tone in October and November on a dramatic shift in technicals. If we see substantial outperformance during the next two months on any supply/demand imbalances, ahead of the expected weaker technicals expected for the fourth quarter, we will monitor opportunities to execute the cross-over strategy and target for investment those sectors that provide a better total return profile relative to the tax-exempt sector.
Gregory A. Bell, CFA, CPA
Director of Municipal Products
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