Municipal Bond Market Update - Feb 9, 2010

MARKET UPDATE

Demand is very strong but low yields make rally difficult.

RECOMMENDATION

The yield curve is showing positive momentum from end to end, in particular at intermediate maturities where retail investors and money fund alternative accounts are feeling more comfortable to extend. This area shows the best near term prospects for value preservation, relative value, and total return, although all maturities may struggle to provide absolute return this year if generic taxable rates begin to rise. The front of the curve remains solidly supported, while longer maturities may struggle to erase the effects of the late January correction as the focus has been on safer purchases lately.

INVESTING STRATEGY

The President’s proposal to extend and expand the BAB program could help keep tax-exempt floating rates (and thus the front of the yield curve) pinned at very low levels for an extended period of time.

SUMMARY

Municipal bonds have performed well this year as buyers pursue the credit protection and income in both taxable and tax-exempt markets. Last week, munis rallied despite some flight to safety flows into Treasuries that in past weeks of the current crisis might have precipitated broader weakness. This year, investors appear to be more confident that the scarcity of high grade tax exempts will persist while the Federal government increases the income and capital gains tax rates and dilutes the value of competing tax shelters like the mortgage interest and charitable giving deductions. So long as generic credit quality holds, this should be a very good year for relative outperformance by tax-exempts and BABs. This is not an outlandish assumption; while particular issuers have disclosed a range of credit impairments (noting Harrisburg PA’s recent headlines), widespread forecasting of a muni market collapse appear ill founded in a misunderstanding of how state and local bondholders are actually paid. This week, the new issue calendar is likely to remain slow as the market heads into another holiday, giving institutional accounts more opportunity to realize gains while supplying buyer– and thus rally-friendly supply into the secondary market.