The municipal market enjoyed a very strong rally during the summer, with supply and demand imbalances continuing to be the driving force behind municipal performance. Although supply during the third quarter was ahead of third quarter 2011’s pace by 10% to $84.9 billion, new issuance was down sharply by 26% versus second quarter 2012’s levels. The sharp drop, combined with the strongest reinvestment flows of the year for coupons/calls/maturities, led to rates falling by 16 to 41 basis points (bps) in maturities 5 years and longer on the yield curve. Municipal tax-adjusted yield spreads to Treasuries also tightened by 15 to 63 bps in the same maturity range. The strongest performance was exhibited in the 12 to 30 year maturity range, as the near-record low interest rate environment and steep yield curve provided the impetus for investors to extend their investment dollars into longer-term maturities.

As we’ve noted in prior commentaries, dramatic changes in the supply cycle will continue to help create volatility in the relative performance for the municipal market. While supply did drop sharply during the third quarter, supply year to date remains 44% ahead of 2011, driven in large part by refinancing/refunding issuance. So far this year, straight refinancings at $117.6 billion are up 91% versus the same point in 2011 and account for 42% of total issuance versus a 5-year historical average of 24.4%. As austerity measures at the state and local level remain a major theme to counteract stagnating-to-falling property tax revenues, cost savings achieved through refinancing currently-callable debt will continue to drive overall new issuance.

Demand should also remain strong as the refinancing wave continues. Investors will continue to be faced with receiving the proceeds of the currently-callable bond structures that have been refinanced. Reinvestment of these proceeds are expected to continue to target the 7 to 30 year area of the very steep yield curve, as the hunger for yield drives investors into longer maturities. Additionally, the mutual fund sector has also continued to see robust inflows all year. Inflows for 2012 so far have totaled $43.2 billion, and inflows of $1.5 billion during the week of October 10, 2012 marked the 45th consecutive week of inflows.

In terms of the near-term outlook for the sector, the fourth quarter is expected to see some challenges in relative performance. Supply is expected to come in at approximately $103 billion, which would be an increase of 8.4% relative to the issuance in the fourth quarter of 2011 and an increase of 23% versus third quarter 2012 issuance. Additionally, demand is expected to moderate quite a bit during the fall, as reinvestment flows of coupons and maturities are typically very weak during October and November, before rebounding to much stronger levels in December, January and February. Consequently, we view the sector as vulnerable to underperformance over the next two months as the market struggles to confront a much heavier supply cycle.

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.

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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.