Weaker Technicals Lead to Relative Value Volatility

Relative value performance for tax-exempts were volatile during the first quarter of 2016. Tax-adjusted yield spreads to Treasuries for 10-year maturities dropped as low as 40 basis points (bps) during the first week of the year, before widening to a 91 basis points (bps) spread by the first week of March. Most of this volatility in relative performance was a direct result of the rapidly shifting supply/demand imbalances within the sector, combined with a substantial flight-to-quality rally for Treasuries. Although both sectors benefited from the “risk-off” demand, Treasury rates during the quarter fell by 50 basis points (bps), while municipal yields fell by only 22 basis points (bps).

During January, in addition to the flight-to-quality trading that developed, tax-exempt performance also benefited from very strong seasonal technicals that typically occurs during the first two months of the year. A combination of robust reinvestment flows and a dearth of new issuance supply helped push tax-adjusted spread levels to Treasuries to a near ten year low on January 7 of 40 basis points (bps). Spreads remained at these overbought levels for most of January before crossover investors started selling aggressively. In addition to the selling pressure, tax-exempt new issue supply started to see a considerable rebound from levels exhibited over the prior five months. After new issuance averaged only $27 billion per month from September 2015 to January 2016, average supply for February and March increased by 30%.

February issuance came in relatively heavy at $31 billion. That was an increase of 22% relative to the 10 year average for February supply. Supply in March was also heavy at $39.3 billion, with refinancing activity leading the way at $16 billion. During February and March, refinancings averaged $14.45 billion, resulting in an increase of 76% versus the monthly average over the prior 5 month period. During the fourth quarter of 2015, municipalities scaled back their refunding activity in an attempt to avoid any potential market volatility surrounding the timing of the Federal Reserve’s first expected move towards normalizing rates. With that event now past and the market demand for tax-exempts exceptionally strong, issuers have started to take advantage of the low absolute rate environment during the quarter.

Weaker supply Technicals are expected to remain in place for the next 2.5 months. As of April 11, 2016 10 year municipal rates were at 1.59%, which remains at a very compelling level for issuers to continue targeting debt service savings through refinancings. Additionally, infrastructure-related financings have been on the rise this year. On a year-to-date basis, new issuance classified as “new money” is up 27% versus 2015. The combination of these two components are expected to help the market produce a total of $80 billion in issuance in May and June, and potentially provide for very compelling entry points for a sector rotation move into the tax-exempt sector. At the moment, tax-adjusted spread levels for 10 year maturities stands at 50 basis points (bps), which we view as expensive heading into the expected supply surge. We are currently positioning accounts to an underweight exposure to the sector until compelling opportunities present themselves that warrant a move to a neutral or overweight bias.

Written by:


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

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