Munis "Spring Ahead"

Market Overview

To coin a phrase, what March takes away, munis look to recoup in April and May. We witnessed the start of this dynamic post-April 15 when the seasonal selling of municipal bonds (to pay tax obligations) abated. The month saw investors broadly embrace fixed income, especially municipals, as economic data softened and the effects of a more onerous tax regime influenced investor sentiment.

As April began, the muni market took cues from the Treasury market, with rates generally moving lower (and prices higher). The momentum gained steam as tax season passed and supply/demand began to find a more favorable balance, propelling tax-exempts to a strong April showing. Municipal bonds generally continue to trade at yields above US Treasuries, indicating the market is not pricing in the tax-exempt nature of the product and resulting in attractive relative value for investors.

March's murky supply/demand picture began to brighten in April, with new issuance well telegraphed and favorable in composition. Monthly issuance totaled $34 billion, which was 1.4% lower than last April and 2.9% higher year-to-date (ytd) versus 2012. Meanwhile, demand remained volatile, with $1.4 billion in outflows for the month. This is an unsurprising continuation of the tax-time selling (modest as it is) and May already shows a rebound that is returning the market to a positive technical backdrop of demand outpacing supply.

Making Headlines

State and local governments continue to wrestle with a slow recovery, but have benefited from a 12th-consecutive quarter of higher state tax collections. Cumulative state budget gaps for fiscal year 2013 are $55 billion, but proposals like the Marketplace Fairness Act (the Internet sales tax) are gaining support. In collecting taxes from online retailers and catalogs ("remote sellers"), states would benefit from an estimated $23 billion in additional annual tax revenues. If passed, the measure would also satisfy brick-and-mortar businesses that are disadvantaged versus their online competitors. The bill, which includes an exemption for smaller sellers (those with revenue under $1 million per year), has solid support (bipartisan at that) in the Senate and from the Obama administration. Most opponents in the Senate represent states that do not rely upon sales tax revenues (NH and MT).

After several months of minimal supply, the high yield sector grabbed headlines recently with the issuance of $1.2 billion in BB-rated Midwest Disaster Area Bonds for the Iowa Fertilizer Co. The bonds, which would be used to fund the construction of a nitrogen fertilizer plant, were well received by the market, despite the recent explosion at a West, TX fertilizer distribution facility. The deal is one of the largest private activity high yield issues in history.

By the Numbers

The S&P Municipal Bond Index returned 1.05% in April, bringing the market's ytd total return to 1.63%. Performance was positive across all but the shortest maturities, with maturities of 20+ years leading the way. Credit spreads widened by 14 basis points (bps), causing high yield to lag the broader market slightly for the month. Among sectors, transportation provided the best performance, beating the main index by 21 bps, while the pre-refunded index lagged by 90 bps. Regionally, volatile Puerto Rico posted the best results after trailing markedly in March; New Mexico was the monthly laggard, underperforming the main index by 41 bps.

Strategy and Outlook

We remain very constructive on the municipal asset class as we enter a strong seasonal period marked by modest supply and resurgent demand post tax time. Our optimism has us more comfortable leaning slightly longer on the yield curve. We believe the primary market remains the place to source incremental yield and should continue to be priced at a concession to the secondary market. June historically tends to be a less favorable month for the municipal market, and we stand ready to adjust our strategy should it herald elevated supply. Overall, munis remain an important allocation for income-hungry, tax-stressed investors.

Current Strategy
Duration	Neutral
Yield Curve	Short and long maturities (i.e., a barbell approach)
Overweight Sectors	State tax-backed and essentialservice bonds, particularly the Southwest (TX), Plains and Southeast (VA) regions Dedicated-tax bonds
Underweight Sectors	Land-secured, senior-living and pre-refunded bonds Bond insurers Student loans Local tax-backed issues, particularly in CA , NV, AZ, MI, IL , RI and PR

Monthly Change in Yields
	AAA Muni Yield (%)		Treasury Yield (%)
Term	3/31/13	4/30/13	3/31/13	4/30/13
2 years	0.31	0.29	0.24	0.21
5 years	0.83	0.74	0.77	0.68
10 years	1.89	1.69	1.85	1.68
30 years	3.09	2.84	3.10	2.89

Municipal Performance Analysis
	April 2013	Mar. 2013
S&P Municipal Bond Index	1.05%	-0.45%
Long maturities (20+ yrs.)	1.51	-0.72
Intermediate maturities (3-14 yrs.)	0.98	-0.31
Short maturities (6 mos.-3 yrs.)	0.10	0.06
High yield	0.99	0.45
Pre-refunded bonds	0.15	-0.07
General obligation (GO) bonds	1.02	-0.55
Regions
California	1.07	-0.41
Florida	1.05	-0.34
New Jersey	1.13	-0.42
New York	0.97	-0.44
Pennsylvania	1.01	-0.33
Puerto Rico	2.40	-2.72

Source: S&P Indices.

 

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Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results.

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