What to expect from muni bonds this fall

The tax-exempt municipal bond market enjoyed favorable technical factors for much of the summer, which allowed it to outperform U.S. Treasuries.
OCT 10, 2012
The following is excerpted from the September investment overview from Morgan Stanley Smith Barney's Global Investment Committee. The tax-exempt municipal bond market enjoyed favorable technical factors for much of the summer, which allowed it to outperform U.S. Treasuries. These technical included a high level of cash from bond redemptions and coupon payments, robust inflows to municipal bond mutual funds, a seasonal slowdown in the new issue market and an elevated relative value ratio, which is simply the ratio of yields on municipals relative to those on comparable-maturity U.S. Treasuries. TREND REVERSAL Looking toward the fall, we anticipate a reversal of those supporting trends. Historically, bond redemptions are weaker in the fall, largely due to issuers' fiscal calendars. Furthermore, the supply of new issues is typically more robust; the monthly new-issue supply was approximately $30 billion in July and August. New issuance in the October-through-December period has historically averaged around $33 billion per month. Evidencing the changing trend was an $8.5 billion calendar for the week of Sept. 17. Meanwhile, the previously elevated relative-value ratio —which reached 120% for 10-year bonds in June — has since retreated. Although the ratio, at 103%, is still well north of the long-term average, the lower level reduces the buffer should Treasury prices fall. Mitigating the weaker technicals is the continued presence of municipal bond mutual fund inflows, which have been running at approximately $4.8 billion per month this year and continue to surprise to the upside. While there little doubt that primary market supply will rise in the coming months, the pent-up demand from summer redemptions and fund inflows may offset the initial impact of a heavier new-issue calendar. This would suggest that it may be a bit longer before municipal market pricing begins to weaken. ENTRY POINTS In considering favorable entry points for prospective municipal bond purchases, both absolute yields and relative value matter. The Federal Reserve's recent announcement of additional monetary stimulus — a third round of Quantitative Ease, the extension of Operation Twist and guidance that keeps policy rates at today's rock-bottom levels until at least mid-2015 — has driven U.S. Treasury yields notably higher. Even though heavier municipal supply is only now arriving, tax-exempt bonds are already playing catch-up, with yields rising substantially. One scenario that may prove favorable for muni investors is one that combines higher U.S. Treasury yields with underperformance from tax exempts due to an elevated supply. Such a combination could provide a compelling entry point from both an absolute-yield and relative-value perspective. Our current “cautiously neutral” stance speaks to this delicate balance. TIME TO TARGET For individual investors, now may be an opportune time to identify the types of bonds — by sector, maturity, coupon structure and/or call features — worth targeting for purchase if the price weakness that we anticipate occurs. We continue to advocate A-rated-and-higher general-obligation bonds and essential-service revenue bonds with above-market coupons and final maturities of six to 14 years, as well as state-level general-obligation bonds and state-level appropriated pap

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