Munis Untouched by European Fears - Municipal Bond Update - May 17, 2010

MARKET UPDATE

If another credit meltdown is in the offing, municipals are much better prepared this time around than they were in 2008.

RECOMMENDATION

The front of the yield curve remains solidly positioned to, at worst, maintain absolute and relative value although the lack of income is dissuading to investors with calculators. The belly of the curve may also rally on extensions for yield, but the potential for underperformance versus Treasuries makes bonds difficult to hedge and not-so-attractive to most relative value accounts. Same for the long end. We believe issuers should be in the market, even though instantaneous disruptions this week could drive cuts or drag out selling periods.

INVESTING STRATEGY

Consider the traditional credit barbell: staying focused on safe-sector paper for performance and liquidity while tapping high yield mutual funds for income. Relative returns on high yield flagged last week and may continue to do so; however, this sector benefits from an attractive confluence of investor cash and distressed situations.

SUMMARY

The municipal market continues to bob along at the top of the dishpan, regardless of what’s going on below. There, Treasuries and gold have surged, unwound, and surged again on flight to safety fears while the Euro-drama has unnerved equities and credit. The fear is that this week’s large, BAB-heavy calendar could get caught offsides if risk-appetites melt at the long end where Treasuries (and, lately, LIBOR swaps) are expected to rally. In general, the markets have enough issues to contend with this week that a heavy spate of new issue supply could struggle. Notably, regulatory reform is scheduled to come to a head with an expected vote in the Senate—developments here have been increasingly unpredictable, with dealer derivative and prop trading operations now hanging in the balance. Also there is some hope that muni BAB extension could come for a vote this week, although the pressure here is ever downward for future subsidy rates as cost control is more in vogue.