Municipal Bond Market Update - March 22

MARKET UPDATE

Tax-exempt resilience continues.

RECOMMENDATION

Momentum in the belly of the curve (5-15yrs) came under fire last week, but this is an area of likely stout support just behind current levels—a reasonable sector for asset preservation and liquidity, not to mention bets on spread tightening. The longer end has held up well but could be better suited for income and relative performance, not total return. Moody’s rating plan may also unlock some floating rate supply, subtly loosening the pins holding down the very front end of the yield curve. But this has been a poor area for total return in general.

INVESTING STRATEGY

Rising ratings imply more credit spread tightening across the curve as buyers stretch for yield. It may also weaken trading value in insured paper, although the risk here may be easily overstated—the existing companies are already on their way to a sustainable business model outside of safe-sector underwriting and will now likely face less new competition in the long term.

SUMMARY

The municipal market continues to defy mean reversion, although last week modest spread widening did occur as the Treasury market unspooled some pricing strength up front and as opportunistic institutional holders took a chance to realize some gains. Still, the net effect was very limited and tax-exempts outperformed a flattening Treasury curve. There are still more things at work in our sector’s favor. First, Moody’s has finally unveiled its plan to recalibrate municipal ratings to the global scale, meaning systemically higher ratings for general obligation and other governmental type issuers. This is a sweeping rebuke to the growing media chorus of doom for our sector; financial and economic pressures are undeniable, but the immediate threat to bondholders is manageable. In our opinion, the net effect is a curve flattener, with diluted high grade scarcity allowing yields to rise slightly up front, but greater BAB penetration exacerbating supply pressures at the long end. Regarding funds, ETFs may be the winners versus traditional mutual funds that more heavily depend on the apparent virtues of credit diversification. Of course, credit risk will continue to build for both public and corporate sector issuers in the long term. Second, the new health care bill establishes a 3.8% tax on investment earnings but excludes municipal bonds—one more reason why investors will be reluctant to sell their munis right now.