Weekly Municipal Bond Outlook - A Correction May Be Due

MARKET UPDATE

A correction may be due, with more risk at the long-end.

RECOMMENDATION

While the overall yield curve continues to look at least neutral versus recent averages, the front end is likely better positioned to endure a temporary correction in prices. Longer bonds could see near-term losses but, because 2010’s outlook is for ongoing scarcity in high grades, we expect any reversal will be more limited than in October. Credit spreads are continuing to tighten; levels may be more sustainable and thus better suited to stretching for yield, within 10 years. Longer bond spread contraction has slowed recently; levels here may be at some resistance points, reflecting the availability of incremental yield in the larger calendars of health care paper.

INVESTING STRATEGY

While public pension underfunding represents a long-term drag on economic growth (and in theory, if the rating agencies become interested again, could drive rating downgrades) there is little risk of associated non-payment to bondholders.

SUMMARY

Once again, municipal bonds held on to low nominal yields; however, tax-exempts did lag the Wednesday and Thursday flight to safety rally in Treasuries last week. More muni participants are actively discussing the possibility of a correction in prices this week: a reasonable development noting moderate institutional gains taking on Friday and the potential for a stock market rebound early this week. If yields do rise, long bonds appear most vulnerable. These have shown the weakest price momentum recently as traders grow concerned that BAB issuance will be less than forecast. We believe it is too early to make this assessment. Post Jan 1 issuance has been largely tax-exempt, but that likely reflects the exceptional demand from Jan 1 tax-exempt coupon reinvestment. Still, persistently low tax-exempt yields versus Treasuries may induce more issuers into traditional offerings; this represents a limited downside to expectations of 2010 performance focusing at the long end of the yield curve. As it is, the front end of the curve continues to be exceptionally strongly bid, with tax-exempt money funds and cash alternative investment providers continuing to search for adequate product. This situation will likely persist for some time, bolstering relative performance at the front end and limiting risk there from any imminent correction in prices.