- Despite a modestly negative return overall, tax-exempt municipals were largely cushioned from macro fears and outperformed a volatile Treasury market.
- Muni-to-Treasury yield ratios narrowed, but remain attractive and above 100% across all maturities.
- We believe new issuance presents opportunities to enter the market at attractive levels, particularly relative to the secondary market.
June is typically a negative performance month for munis, and this year was no different. Municipal rates moved higher (and prices low) early in the month and were unable to fully recoup as supply picked up. Still, supply/demand was much more balanced than in prior months, and that helped to mute the market’s losses. June issuance totaled roughly $40.7 billion, with the majority of the new supply taking the form of refunding issues. In fact, the market is in a period of net negative supply where more bonds are being called and maturing than being issued, a trend that should continue in July as bond calls reach record levels. The market’s technical backdrop is also supported by continued strong demand as investors are increasingly drawn to the asset class for income and capital preservation, as well as its relatively low volatility. Municipal bond funds recorded inflows throughout June. Year-to-date inflows, according to ICI, amounted to $26.8 billion at the mid-year point.
Muni-to-Treasury yield ratios remain attractive, despite declining marginally as munis outperformed the volatile Treasury market. Munis have been better positioned to weather recent weakness in US economic data and persistent eurozone uncertainty.
All 46 states with fiscal years (FYs) ending in June have enacted FY 2013 budgets. According to the Center on Budget and Policy Priorities, 31 states closed $55 billion in budget gaps for FY 2013. Gap closure is large by historical comparisons, but has shrunk since reaching $191 billion in FY 2010. While governors proposed nearly $7 billion in new net taxes and fees for FY 2013, spending reductions and other measures were primarily used to close the gaps. Other notable developments in June include:
- The Governmental Accounting Standards Board (GASB) revised pension reporting guidelines such that governments must now report pension promises as a liability on their financial statements. Although GASB’s new method of calculation will have pensions appear less funded, it increases transparency and may provide impetus for the most troubled systems to reform.
- The city council in Stockton (CA) approved a plan to file for Chapter 9 bankruptcy protection after nearly four months of unsuccessful efforts to negotiate with creditors.
- In the bankruptcy proceedings of Jefferson County (AL), the judge upheld a contract between the county and the bond trustee, which prioritizes debt payments before non-operating expenses. This establishes an important precedent.
- The Supreme Court ruling on the Affordable Care Act should be positive for not-for-profit healthcare bonds, as the number of uninsured patients should decrease. Munis should also benefit from their exemption from the 3.8% surtax on net investment income for certain higher-income taxpayers.
- Moody’s downgrade of the global banks impacted bonds issued by 1,675 local and state governments totaling $45 billion. The agency’s action was well telegraphed and widely expected, thus having little to no market impact.
By the Numbers
The S&P Municipal Bond Index returned -0.02% in May and 4.14% year to date. Returns were positive for short and long maturities, with the greatest weakness among maturities of 7-8 years. High yield outperformed the broad market by 78 basis points (bps) in June and 580 bps year to date. Among sectors, land-backed led, outpacing the main index by 51 bps, while GOs lagged by 13 bps.
Strategy and Outlook
We assumed a long duration stance, fully cognizant of the low-rate environment and tight spreads. New issues present opportunity to enter the market at attractive levels, particularly relative to the secondary market. We expect munis to continue taking cues from the Treasury market, but with less volatility. Performance is likely to be driven by yield curve positioning, trading the maturity ranges, capitalizing on supply/demand imbalances and security selection.