- The municipal market posted its first positive October since 2007, supported by a continued favorable supply/demand backdrop.
- Issuance was concentrated in lower-rated investment-grade credits, delivering exactly what yield-hungry investors desired and helping to keep volatility muted.
- A focus on income and capital preservation is prudent now, as the market has likely realized the majority of its capital appreciation potential this year.
The seasonal trends that tend to produce municipal market weakness in October were absent this year. Demand continued to outpace supply throughout the month, defying expectations and supporting market performance. While supply most often drives market technicals, this year demand has dominated the equation. In fact, it is difficult to imagine a scenario where supply increases enough to satisfy the robust demand, at least not over the next couple of months.
October issuance totaled $33.8 billion, up 31% versus September and 3% higher than October 2011. Meanwhile, continued strong demand was evident in the $5.3 billion in assets committed to municipal bond mutual funds in October, bringing year-to-date fund flows to $48 billion, according to ICI data. Issuance was concentrated in lower-rated investment-grade credits. This was consistent with investor appetite and, as such, helped keep volatility muted throughout the month. ultimately, munis modestly outpaced comparable Treasuries.
Notably, this month’s positive return broke a negative October streak dating back to 2008. This indicates to us that there remains a tremendous investor appetite for income-oriented asset classes, perhaps even more so as we head into a period of heightened uncertainty within the broader economy and financial markets. With Election Day behind us, one of the biggest drivers of sentiment will be how Congress and the administration address the looming year-end fiscal cliff.
After anticipating the elections throughout October, the market received some clarity on November 6. In total, there were 174 ballot initiatives across 37 states. California saw a major win with the passage of Prop 30, which proposed higher sales tax and marginal income tax rates to fund education and plug deficits. Failure would have meant a $2.5 billion budget shortfall and considerable school district downgrades. Initiatives in Michigan met with less success. Voters rejected Prop 1, which would have allowed the governor to appoint an emergency manager for local governments in fiscal distress. Despite a decisive result at the national level, with President Obama winning a clear majority of electoral votes, there is no clarity on whether Congress might pass legislation that could reduce or eliminate the tax exemption of municipal bonds.
October’s final week brought devastation to the Northeast in Superstorm Sandy. At this point, predicting recovery times and a “return to normalcy” is nearly impossible. However, past natural disasters have not been a precursor to defaults and we expect the same to be true in this instance. In the past, FEMA has typically covered 75% of clean-up costs. New Jersey and New York locals also tend to benefit from strong state oversight.
Finally, three months into fiscal year 2013, tax collections are already expected to rise in 75% of states for the third consecutive year. The trend is positive, albeit below the pace of previous recoveries.
By the Numbers
The S&P Municipal Bond Index returned 0.31% in October and 7.03% year-to-date. Credit spreads (high yield vs. GOs) tightened 5 basis points (bps) and high yield outperformed the main index by 85 bps for the month and 851 bps year-to-date. As for sectors, the land-secured index led, beating the main index by 35 bps, while the pre-refunded index underperformed by 33 bps. Regionally, the top performer was the Virgin Islands, besting the main index by 87 bps, while Nevada lagged by 103 bps.
Strategy and Outlook
We maintain a neutral duration posture ahead of what we expect will be a more volatile period. Supply traditionally increases toward year-end, and although it will not likely overwhelm demand, it may match it in the near-term. Despite our less-aggressive duration stance, we intend to take full advantage of the increased supply to purchase new issues at a concession to the secondary market in an effort to enhance the structure and call features of our portfolios. Overall, we are focusing on income and capital preservation, as the majority of the market’s capital appreciation potential has likely been realized this year.