The municipal bond market had a terrific January, on both a nominal as well as a relative basis, as the market continued its trek out of the wilderness that dominated the first part of 2011.
Using the AAA Municipal Market Advisors Scale, bonds due in 2022 were marked at 2.53% at year-end and at 2.17% on January 27th. Certainly some of this 36 basis point drop is due to the “roll”. Thirty-year AAA bonds tumbled from 4.22% to 4.06%. And many new issues are now seeing longer bonds well through 4%.
This is more remarkable when one factors in US Treasury yields rising slightly for the month with ten-year governments rising 3 basis points to 1.91% and thirty-year yields rising 18 basis points to 3.08.
In our opinion, there were four parts of the kindling which was lit by the year-end supply/demand imbalance:
1) Credit. The muni market spent most of last year recovering from the hammering it received a year ago when yields spiked due to the Whitney 60 Minutes piece. Quarter by quarter, municipal receipts continued to improve and, more importantly, the public perception of municipal credit improved as well. Defaults - even with the “one-off” events of Harrisburg, PA and Jefferson County, AL - were lower in 2011 than the year before.
2) Overall Supply. Overall tax-exempt supply ended the year at approximately $300 billion. This is a far cry from recent years’ supply of $400 billion and would have been even lower except that low interest rates spurred issuance in the fourth quarter. Certainly, supply was down early in 2011, as many issuers did not want to issue debt into a dysfunctional market. But greater austerity among issuers certainly contributed to the downswing in overall supply.
3) Bond Fund Flows. Bond fund outflows following the Whitney piece were responsible for most of last winter’s meltdown. It took until late spring for the outflows to level off and finally, in the fall, bond fund net inflows resumed. This was a large addition to incremental demand as year-end approached.
4) Crazy Muni/Treasury Ratios. The ratio between thirty-year AAA Muni Bonds and long US Treasuries reached greater than 150% this past fall. These were easily the cheapest ratios the municipal market has seen since the aftermath of the post-Lehman meltdown. This absurdity was a result over the rush into Treasuries following the downgrade of the United States by Standard and Poor’s and the concern over continued problems in Europe. Meanwhile, the muni market was still in recovery mode and yields remained stickily high. Many new issues were over 160% ratios. Crossover buyers (traditional taxable bond buyers who will buy tax-free bonds at high ratios) woke up and entered the market.
The spark that set this rally off was the usual year-end supply distortion, with an estimated $35 billion of coupon payments, called bonds, and maturing bonds in the combined months of December 2011 and January 2012. And, of course, the normal slowdown in issuance that occurs at year-end. The last few years have not always been “normal”. But with the above-mentioned factors in place there were extremely favorable conditions for a muni rally to start the new year.
With fairly low NOMINAL yield levels Cumberland is starting to ratchet down some our durations and maturities. We are starting to add more short-term bonds, cushion bonds (bonds with larger coupons yielding to fairly short call dates) and municipal inflation indexed bonds (MIPS). These low yields should spur on issuance later in the year and we feel that continued economic growth, while slow, should result in overall higher yield levels later in 2012.