A Powerful First Quarter Rally – Will It Continue?
The tax-exempt market exhibited a powerful rally during the first quarter of 2014. Technicals were exceptionally strong during January and February, as heavy reinvestment flows of coupons/calls/maturities coincided with a very anemic new issuance cycle. Municipal 10-year yields during these months collapsed by 37 basis points (bps), which was almost in line with the 38 bps drop in 10-year treasuries. However, performance in March was mixed. The fixed income markets began accounting for an anticipation of earlier-than-expected tightening in monetary policy. This pricing was driven by recent comments from Federal Reserve Chairman Janet Yellen. The results were a flattening of the municipal yield curve, with 5-year yields rising by 31 bps, while 30-year yields fell by 7 bps.
Supply technicals should continue to be generally favorable for municipals. Year-to-date supply of $62.5 billion is running well below 2013’s issuance by 26%. The primary catalyst for the downward trend remains muted refinancing opportunities for municipalities. After the second half of 2013 experienced refinancing declines of 48% versus the same period in 2012, the downtrend has continued in 2014 with declines of 52% versus the first three months of 2013. With interest rates expected to gradually move higher over the course of the year, this trend is expected to remain in place.
In looking forward over the next quarter, demand should continue to improve. After the market moves past potential cash-flow needs leading into the April 15 tax-filing deadline, demand flows should see gradual improvement as we move into the stronger technicals that develop around the summer months. Net supply is expected to decline to a total of -$25 billion during July and August. Additionally, net supply during April, May and June is expected to reach a total of only +$6 billion, which is expected to be very manageable for the quarter. As of this writing, municipal 10-year tax-adjusted yield spread levels to Treasuries stand at 91 bps, which still remains modestly attractive, especially when compared to current 10-year taxable municipal spreads of 67 bps. With a manageable new issuance cycle ahead for the market, we expect municipals to remain in a tight trading range around current levels, before a tightening bias develops as the market moves into stronger technicals starting in late June.
Gregory A. Bell, CFA, CPA
Director of Municipal Bonds
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