The municipal sector experienced a substantial amount of volatility over the course of the third quarter. During July and August, 10-year yields increased by 48 basis points (bps), culminating in a 2013 high of 3.04% on September 6, 2013. Most of this sell-off was attributed to increased investor anxiety over the higher interest rate environment, and headline risk resulting from both the bankruptcy filing of Detroit and reported deterioration in the fiscal condition of Puerto Rico. The confluence of all of these events led to a continuation of the heavy level of withdrawals out of mutual funds that the market experienced during the second quarter.
However, over the last three weeks of the quarter, tax-exempt municipals experienced a dramatic turnaround. The Federal Reserve’s decision to postpone “tapering” of its quantitative easing program, along with Larry Summers’ decision to drop out of consideration as the next chairman of the Federal Reserve, started the rally. Additionally, a significant drop in new issuance levels, combined with the extremely attractive relative valuations for tax-exempt municipals, produced significant crossover buying interest in the sector. The increase in demand resulted in 10-year yields falling by 50 bps from September 6 through the end of the quarter. Tax-adjusted yield spreads to Treasuries during this period tightened by 34 bps and stood at 109 bps as of October 1.
At current spread levels, we remain constructive on the market over the next quarter due primarily to an expectation that market technicals should continue to improve through the balance of the year. Although the market has continued to deal with mutual fund outflows that have totaled $41billion year-to-date, these flows have begun to moderate. Weekly-only reporting funds averaged outflows of $1.7 billion from June 5 through September 18; however, over the last two reporting sessions, these outflows have averaged only $424 million.
Supply should also continue to contract and provide support for the market going forward. Even with the recent rally, 10-year yield levels, now at 2.54%, are 74 bps higher than the average yield levels over the first five months of 2013. This higher rate environment should continue to make refinancings look unattractive. Elevated yield levels have already resulted in the June to September monthly average of straight-refinancings to decline by 58% versus the monthly averages during the January to May period. Unless we see a substantial decrease in rates, we expect that the supply cycle should continue to moderate to levels that are well below historical norms. With these positive supply developments, combined with strong seasonal reinvestment flows of coupons/call/maturities expected on December 1 and January 1, we expect to see a continued gradual improvement in relative valuations into 2014.
Written by 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.