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Market Commentary

Muni Bonds Start to Outperform
September 28, 2012  John Mousseau, CFA, Managing Director and Portfolio Manager

The third quarter of 2012 saw the municipal bond market outperform US Treasuries after a second quarter that saw a precipitous drop in Treasury yields. To give you a flavor, at the start of the third quarter, ten- and thirty-year US Treasury yields were 1.65% and 2.75% respectively.  The corresponding tax-free AAA yields (source: Bloomberg) for ten- and thirty-year maturities were 2.05% and 3.56%.  Thus, the prevailing yield ratios at the start of the third quarter were 124% for ten-year and 129% for thirty-year.  As of September 27th, the US Treasury yields were essentially unchanged in ten-years at 1.64%, while thirty-years had risen to 2.83%.  Meanwhile, tax-free rates fell to 1.98% and 3.34%.  Thus, the corresponding yield ratios had moved somewhat lower in the ten-year range, to 121%, but were decidedly lower in longer bonds at 118%.

What happened?

As the quarter drew to a close, the Federal Reserve announced their latest round of quantitative easing, or QE 3.  This essentially amounts to ongoing monthly buying of $40 billion of mortgage-backed securities, with the idea that it will continue to keep mortgage rates low, or make them lower.  The key to this announcement was that it HAD NO TERMINATION DATE.  Thus, the Fed is telling us that they will keep at it until the unemployment rate comes down and housing markets stabilize.  In advance of, and after, the announcement, Treasury yields spiked – the thirty-year Treasury yield moved from a low 2.45% at the end of July and 2.67% at the end of August to 3.10% two weeks ago before settling lower.  Thus, there is a steeper yield curve from ten to thirty years in Treasuries.  While we believe that the economy is still fragile, it is LESS fragile than before and although inflation is currently not a problem, it COULD become a problem if labor markets firm.  The Treasury bond market, which for most of the year has been concerned, in general, with problems in Europe, is starting to move toward a focus on the future; and that means an accommodative Federal Reserve, as well as an accommodative European Central Bank. So whereas short-term yields seem to be on a path to stay low through 2015, the path of longer-term yields may be somewhat more complicated.

Tax-free demand has continued to increase, even at lower nominal yields.  This is in part due to the continued inflows into municipal bond funds.  But also important is the fact that, even though overall issuance is up over 40% over last year, the amount of NET new issuance is quite small.  This is because of the large amount of CURRENT refunding of older bonds that were issued ten years ago.  Proceeds from new issues are used to call older issues.  In addition, demand from private accounts has continued to be strong.  Fixed income remains a focal point for Baby Boomers who are retiring.  And in the background of this is the looming expiration of the Bush tax cuts, as well as the Obamacare Medicare tax of 3.8% on investment income for married couples earning $250,000 or more.  This will increase the taxable equivalent yield of all municipal bond investments, making them more attractive on a relative basis.

Muni credit has actually improved.  Clearly there has been more headline risk this year, with California municipalities such as Stockton and San Bernardino declaring Chapter 9 insolvency.  However, on an overall basis, the amount of municipal debt falling into bankruptcy is smaller than a year ago.  And the well-publicized prognostications of a celebrity bank analyst of mega-sized municipal defaults have not been realized.

Many municipalities – on a state as well as a county or city basis – are starting to attack their overhanging pension problems.  And though there are plenty of local problems still to be solved, it is worth noting that local governments’ property tax collections increased 6.2% during the second quarter of 2012 from the year before.  This reflects a firming in housing prices nationally, though there are still a number of trouble spots.  And in contrast to the federal government’s large deficits, state and local government spending, when adjusted for inflation, has FALLEN this year.  The point is that most municipalities GET IT when it comes to operating in the leaner, post-financial-crisis world.

So we head into the fourth quarter – a time of usually heavy municipal bond issuance. Issuers will often speed up issuance to have deals priced before year end.  And this is an election year, so this could spur some issuance to beat any perceived tax changes expected due to the new Congressional makeup.  An Obama victory, combined with continued Republican control of the House, would probably lead to continued gridlock. A surprise in either the White House race or the overall results in the House of Representatives could spur even more issuance to beat year end.

But the still-inherent cheapness of tax-free bonds should keep them in the spotlight as a continued good bargain.  And, as we have written about in past pieces, a RISE in Treasury yields could spur on ADVANCED refunding of older higher-coupon bonds if municipal/Treasury ratios head lower, toward 100%.  That would mean more unrealized gains for holders of higher-coupon bonds that are prerefunded by their issuers.

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John Mousseau, CFA, Managing Director and Portfolio Manager 

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