The municipal market experienced the impacts of the “January effect” a month earlier than anticipated. Very strong roll-over investment of heavy January 1, 2012 coupon/call/maturity proceeds has historically led to very strong municipal relative performance during January and February. However, falling supply conditions in December of 2011, combined with very strong demand across a number of buying segments, resulted in municipal yields falling by 39 basis points (bps) in 10-years during the month. That performance helped cap off an exceptional fourth quarter run that resulted in municipal tax-adjusted yield spreads versus Treasuries to tighten by 53 bps for the quarter.
Strong supply and demand technicals have largely been the driver of relative performance all year for the municipal market. Supply during 2011 totaled only $294.5 billion, which was the lowest level since 2001. Compared to 2010 levels, overall supply dropped 32%, while tax-exempt only supply saw a drop of 7% to a total of $262 billion. The large drop in overall issuance was a direct result of the expiration of the Build America Bond program and the massive austerity measures that municipalities undertook to close budget gaps. The spending-cut theme is likely to continue during 2012, which should keep municipal issuance at muted levels relative to issuance patterns over the last six years that saw average annual volume of $408 billion.
On the demand side, sponsorship for the sector during 2011 has largely been grounded in relative-value investors. These investors have been enamored with the generous nominal yields available in the municipal market that have been well north of comparable Treasuries across the yield curve. After 10-year municipal nominal spreads reached a peak of 56 bps on October 7, 2011, the buying momentum from relative-value investors, combined with retail demand from heavy December 1, 2011 reinvestment flows of coupon/calls/maturities, resulted in 10-year nominal yields tightening to -5 bps as of year-end. Demand has also benefited from the increase in inflows to tax-exempt mutual funds. Over the last five weeks through the period ending January 4, 2012, inflows have totaled $5.8 billion.
The increase in buying momentum across the retail and mutual fund segments can be attributed to the lack of credit events in the sector during the year. Entering 2011, a number of investors were worried about the wild predictions that defaults could reach $100 to $200 billion. However, defaults have largely been well contained. Through the end of the third quarter of 2011, defaults involving missed payments totaled about $2.6 billion. Additionally, budget-deficit related issues at the state level have also been addressed with spending cuts and tax increases. As a result of the revenue raising measures and economic growth, state revenues have seen increases over the last eight quarters and currently, only four states (WA, CA, NY, and MO) need to address new mid-year budget deficits. Overall, the credit profile for the sector is expected to continue to see slow progress as the economy improves, which should help maintain the buying momentum that the sector has experienced during 2011.
The near term outlook for the municipal sector is to expect relative valuations to remain at current levels through February. New issue supply should remain fairly quiet through January and February, while demand should remain in place as reinvestment flows from January 1, 2012 and February 1, 2012 coupons/calls/maturities enter the market. However, we anticipate that the recent spread-tightening trend has limited potential for further tightening over the next month. Consequently, we will be looking at opportunities to reduce our exposure to the tax-exempt market over the next several weeks. The strong technicals that are in place today are expected to reverse in March and April, when supply typically rises dramatically and reinvestment demand of coupon/calls/maturities falls substantially. The resulting drop in relative valuations and widening of tax-adjusted spreads should provide a compelling re-entry point for investment in the sector.
Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products
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. 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. 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.