The municipal market saw a substantial selloff during the second quarter of 2013.  Stronger economic growth during the quarter and increased expectations for the “tapering” of the Federal Reserve’s quantitative easing program fed investors’ concerns over the prospects for higher interest rates. These concerns led to a dramatic Technical-driven selloff, led by a massive $10.5 billion liquidation of mutual fund holdings during the month of June.  Aggressive selling by mutual funds to meet the heavy redemption flow overwhelmed the market, forcing yields higher across the yield curve.  For the quarter, 10-year tax-exempt rates rose by 65 basis points (bps), with 47 bps of this rise occurring during June.

Even with the substantial amount of selling during the quarter, the municipal market began to see some stability during the last week in June.  The backup in municipal rates created substantial dislocations in relative valuations versus Treasuries, resulting in municipal-to-Treasury 10-year yield ratios reaching a 2013 high of 110% on June 25.  That ratio level created an attractive entry point for relative value investors to aggressively rotate into the municipal sector, which in turn helped push yield levels lower by 25 bps from June 26 to July 1.

The late-quarter buying surge should continue into the third quarter. July and August reinvestment flows of coupon/calls/maturities are expected to total approximately $90 billion.  With municipal-to-Treasury ratios sitting well above 100% in most maturities across the yield curve and 10-year municipal tax-adjusted yield spreads to Treasuries at 124 bps, investors should continue to find the sector attractive for further investment.

However, higher-than-expected supply conditions during July may temper expectations for any substantial outsized returns relative to Treasuries during the quarter. The higher rate environment during May and June resulted in a number of new deals being pulled from the market.  New issuance during June was expected to be as high as $40 billion, but because of the rise in rates, only $23 billion was priced. That was a drop of 46.5% relative to June 2012.  Additionally, refinancings/refundings, the largest component of new issuance over the last two years, was down 45%% during May and June versus the same time period in 2012.  To the extent that market conditions are conducive, some of the refinancing supply that was pulled in the second quarter is expected to re-enter the market during July, which would soften the expected net negative supply conditions for the quarter.

Our near term outlook for the sector is for the strong Technical backdrop to support the market for the next several months.  Although, we could see a heavier new issuance cycle develop in July relative to historical norms, demand resulting from high reinvestment flows and attractive relative valuations should lead to gradual improvements in relative performance during the quarter.  However, the positive Technicals that should exist during the third quarter should see a reversal as we enter the final weeks of September and into the fourth quarter.  If relative valuations move to unattractive levels, we will look to reducing exposure to the Municipal sector in tax-advantaged accounts.

Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

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Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here. The information presented, including any statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. AAM assumes no duty to provide updates to any analysis contained herein. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.