The tax-exempt municipal market exhibited very strong performance over the third quarter. Exceptionally strong seasonal demand was the primary catalyst, as reinvestment of proceeds from coupons/calls/maturities averaged $44 billion in July and August. Tax-exempt new-issue supply over this period came in at only $18.5 billion. This significant supply/demand imbalance resulted in yields in 10-yrs falling by 41 basis points for the quarter, which was in line with the 42 basis points move lower in yield for the 10-year Treasury.
However, performance for September into the first week of October (6th) was drastically weaker. The combination of expected heavy new issuance patterns, a dramatic drop in reinvestment flows, and a very low absolute yield environment contributed to a dramatic sell-off that culminated with municipal yields in 10-yrs rising by 31 basis points. The 10-year Treasury bond was unchanged over the same period.
The resulting underperformance left tax-exempt nominal yields exceeding that of Treasury yields across the curve, and grossed-up tax-exempt yield spread levels versus Treasuries reaching 1-year highs of 116 basis points in 10-yrs. These attractive relative valuations triggered crossover/sector-rotation buying interest, resulting in spreads moving tighter by 29 basis points to a spread of 87 basis points by October 15th. We now believe that most of the attractive buying opportunities have been captured, with tax-adjusted spread relationships between municipals and Treasuries now closer to historical relationships.
The technical profile going forward for the tax-exempt sector could remain challenging if refinancing supply becomes a major issue over the next 1 to 2 months. Prior to the strong performance of municipals over the last week, refunding/refinancing prospects were becoming challenging, as negative arbitrage was becoming an issue. This condition exists when the yields on Treasuries used to fund the defeasance escrow are too low relative to current municipal yield levels, thus making an advanced refunding/refinancing less feasible. With the significant improvement in the relative valuation profile for municipals over the last 1 1/2 weeks, this condition has moved closer to being mitigated and heavier supply conditions could be in the works.
However, new-money financings are expected to remain fairly muted, with issuers more interested in the cost savings associated with issuing in the taxable market via the Build America Program (BAB). So far in 2010, approximately 33% of total municipal supply has been issued as taxable, resulting in tax-exempt supply running 17% below 2009 levels. That trend is expected to continue into year-end.
With the 35% subsidy level of the BAB’s program effectively expiring at the end of the year, there is an expectation that issuers will rush to the market over the last three months to ensure that the significantly lower funding levels from the program are captured. Estimates for taxable issuance over the last three months are between $30 and $40 billion, which would be very constructive for tax-exempt performance going into year-end. The seasonal demand profile for the sector should see measurable improvement from heavier reinvestment flows on December 1st and January 1st.
In regard to BAB issuance beyond 2010, questions related to the extension of the program still exists. There is a measure in both houses of Congress that propose an extension of the program. Both measures call for a declining level of the federal subsidy to 32% in 2011, while the House version also extends the program into 2012 at a further reduced subsidy level of 30%. It appears unlikely that either of these measures will be addressed ahead of the upcoming mid-term elections in November. The more likely scenario is for the Senate version to be passed in the so-called “lame duck” session after the elections. Should the measure fail there, prospects for adoption in early 2011 is possible, but could become a larger question mark, especially if the overall makeup of Congress shifts to the right.
The failure to extend the program or the eventual expiration of the program by 2012, will eventually result in a thinning of the demand profile for the sector, to the point that it resembles the profile that existed prior to the introduction of the BABs program in 2009. Over the period from 2003 to 2008, taxable municipal issuance amounted to an average of just $26 billion per year, which limited investor participation in the sector. A significant drop from the current issuance levels (year-to-date issuance of $93.5 billion as of September 30th) back to pre-BABs levels will inherently result in less investor focus for the sector. Consequently, that should lead to both some increase in overall liquidity risks and pressure spreads for the weakest credits and sectors in the space to widen, especially if negative headlines related to the overall credit profile for the sector continues to be a concern.
To mitigate these risks, our investment approach in the taxable municipal sector will continue to mirror our investment discipline within the tax-exempt sector: We will only invest in the strongest “AA” and “AAA” rated names from the strongest general obligation (GO) and essential service revenue sectors. The state and local governments targeted from the GO sector will not only exhibit the strongest credit metrics, but will also have demonstrated a very constructive political environment to ensure that budget adjustments, either through tax hikes or reductions in expenditures, are made in a very timely manner.
Issuers that display these attributes are more likely to weather any ongoing fiscal challenges and maintain structural balance in a challenging economic environment, thus helping to minimize downgrade risks going forward. Consequently, our high-quality focus should help maintain valuations and mitigate credit risks, and serve our clients well in both the tax-exempt and taxable municipal markets, especially if the economy contracts and moves back into a recessionary environment.
Gregory A. Bell, CFA, CPA
Director of Municipal Products
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