The Tax-exempt sector was generally weaker across the yield curve relative to Treasuries during the first quarter of 2013. The sector started the quarter with very strong demand from reinvestment flows due to heavy January 1st coupons/calls/maturities, resulting in 10-year tax-adjusted municipal yield spreads to Treasuries tightening by 20 basis points (bps) into mid-January. However, technicals turned weaker during March as reinvestment flows declined and as investors began raising cash ahead of the April 15th tax-filing deadline. Overall, 10-year tax-adjusted municipal spreads ended the quarter at 93 bps, an increase of 18 bps over spread levels at the start of the quarter.
Supply has not had a significant effect on relative valuations. Supply during the quarter remained in line with volume from 2012. Total new issuance year-to-date stands at $81 billion, which is a modest increase of 2.4% relative to 2012’s supply through the first quarter. Refinancings/refundings, which had a substantial impact on total issuance in 2012, continues to make up the lion’s share of new issuance in 2013. Year-to-date, refinancings totaled $49.2 billion and made up 61% of total issuance. Although these totals are a modest 6% lower relative to the levels exhibited in 2012, refinancings have declined by an average of 31.2% over the past two months. The current low interest rate environment remains conducive for more refinancing supply to price, but if the recent declining trends in this category continue to play out during the balance of the year, it would be a market positive for tax-exempt performance.
In terms of our near-term outlook for the sector, we expect to see a challenging technical environment to develop, resulting in increased volatility in spread levels relative to Treasuries. Demand should improve as we move beyond the weak technicals tied to the tax-filing deadline. Additionally, municipals-to-Treasury yield ratios above 100% have historically enticed relative value investors to rotate into the tax-exempt sector and, as of April 1st, yields in 10-year municipals stood at 103% of Treasuries. Consequently, relative valuations appear to be attractive. However, supply expectations are ominous. Although new issue supply during April is expected to be a modest $30 to $35 billion, May and June should see a substantial pickup in issuance in the range of $40 to $45 billion per month. This amount of supply has typically overwhelmed the market and we should see spread levels move wider as this issuance clears the market. We would view the latter portion of the quarter as an attractive entry point to put more money to work in the sector, before market technicals strengthen dramatically heading into the summer months.
Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products
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