The municipal market continued to see very strong performance during the third quarter of 2011. After 10-year rates fell 41 basis points (bps) during the first half of the year on strong demand flows and low supply conditions, rates in 10-years dropped another 53 bps during the third quarter. Performance for the quarter can largely be attributed to both the continuation of the supply/demand imbalances from the first half of the year and to the substantial rally that occurred in Treasuries. Treasury 10-year rates fell 125 bps on lower-than-expected economic results and concerns over the European Union’s bailout of Greece.
Demand for municipals has generally been strong all year as the sector continues to allay fears of substantial default risk. Although municipalities continue to face ongoing budget challenges, so far they’ve met these challenges head on with austerity measures that have led to over 680,000 cuts in payroll since the third quarter of 2008. In addition, tax revenues have also seen a steady climb. State and local government revenues rose another 6.9% during the second quarter according to the U.S. Census Bureau, which marked the seventh-straight quarter of growth. These positive developments have resulted in the sector reporting defaults of only $1.1 billion during the year, which is about a quarter of the total exhibited in 2010 and well-below the predictions of over $100 billion.
Although demand has seemingly been consistently strong all year, much heavier supply over the last four weeks through October 7, 2011 resulted in a drastic level of underperformance relative to Treasuries. An average of approximately $8 billion per week came to market during this period, with $9 billion pricing during the first week of October. That helped pressure municipal yields higher by 48 bps in 10-years, while Treasury yields in 10-years were higher by only 16 bps. Additionally, the heavier supply conditions also forced many of the new deals to price at substantial concessions to historical spread levels to clear the market. The overall rise in yields resulted in the relative value profile for the sector to reach 2-year highs on October 7th, with tax-adjusted and nominal yield spreads to Treasuries reaching 172 bps and 56 bps, respectively.
The near-term outlook for the tax-exempt sector is positive. The substantial relative-value attractiveness of the municipal sector should continue to attract a number of buyers, including non-traditional cross-over investors who can’t use tax-exempt income. These buyers are primarily looking at the substantial dislocation in relative valuations as measured by the municipal nominal yield advantage to Treasuries and are betting that these dislocations eventually revert to their historical means. This demand trend is expected to help provide the sector with the needed sponsorship to help absorb what’s expected to be heavier supply flows through the last three months of the year.
Through the first three quarters of 2011, new issue supply has been running below 2010’s levels by approximately 35%; however, the current extremely low yield environment has created a new wave of unexpected refinancing/refunding opportunities for issuers. This potential additional supply, in conjunction with the typical increase in supply that occurs during the fall months, will lead to continued spikes in volatility in tax-adjusted and nominal yield spread relationships. It’s expected that crossover investors, traditional and non-traditional alike, will continue to treat these spikes as buying opportunities. As we move into December 1st and January 1st, demand should also increase as heavier reinvestment flows from coupon/calls/maturities enter the market. These positive demand technicals should result in tax-exempts outperforming Treasuries during the fourth quarter, especially if we see a substantial rise in Treasury rates from current levels.
Gregory A. Bell, CFA, CPA
Director of Municipal Products
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