Municipal Market Update
Q1 2009
The municipal bond market experienced its strongest quarterly performance in years and was among the best performing fixed income sectors in the first quarter.
New issue volume was nearly on pace with the first quarter of 2008, but the number of issues declined nearly 10%. This is evidence that only the larger, better known credits have begun to have market access. In addition, it has been the strongest credits that have been the predominant deals in the market. Nearly two-thirds of all new issues, representing 86% of the total new issue volume, came via negotiated deals, illustrating the desire by investment banks to distribute new issues and not retain inventory. Retail order periods for new issue pricing have also been common, demonstrating the increased importance of the demand from individuals in the current marketplace. Volatility remains and has been compounded by the reduced liquidity emanating from the weakened capital position of most broker-dealers and money-center banks. As a result, attractive opportunities can be found, especially in the secondary market.
Credit quality remains a major focus among market participants and has resulted in historically wide yield spreads, especially between upper and lower investment grade credits. Moody's highlighted these concerns in early April by placing the entire tax-backed local government sector under negative outlook. The national recession has dominated the state legislative budget sessions across the country. In an effort to meet its legal requirements to balance their budgets in fiscal year 2010, various institutions have deferred difficult budgetary decisions in the hopes that an improving economy will relieve these financial pressures. While the current recession has touched all regions of the country, there are specific states and entities that are particularly vulnerable due to a combination of sector dominance as well as political issues in balancing their respective budgets. Such examples include the State of New York and the Metropolitan Transportation Authority with its revenue dependence on the financial industry and fractious state government, the State of California with its progressive tax structure and rapidly declining real estate market and the State of Illinois with its industrial dependence and unresolved pension liability issues. While general obligation bonds for states are facing credit deterioration to varying degrees, states have issued bonds secured by dedicated revenue streams, especially sales taxes or personal income taxes. We have favored these issues as they are less susceptible to credit deterioration since the revenues flow first to make debt service payments and then to governments for general operations. Other bonds that we have actively sought are revenue bonds backed by user fees to pay for essential infrastructure.
Municipal bonds have outperformed U S Treasury bonds since mid-March, subsequent to the Federal Reserve announcement that it would purchase $300 billion of U S Treasuries (see attached). Barring a collapse of U S Treasury yields and the expectation of higher income tax rates at both the Federal and State levels, we anticipate that municipals will continue to outperform Treasuries. While the municipal market remains faced with heavy new issue supply, significantly large deals including California General Obligation bonds ($6.5 billion - - the largest municipal deal since 2003), and Wisconsin State Appropriation Revenue ($1.5 billion) have already come and gone, credit spreads have begun to narrow, and the issuance of taxable Build America Bonds will reduce the supply of quality longer term tax exempt bonds. Historically low yields are a psychological obstacle to further declines in rates. Nevertheless, anemic yields available from cash and short maturity instruments combined with the steepness of the municipal curve should continue to attract investors to extend maturities. While longer term we are concerned by the potentially inflationary impact of the Federal budget deficit, we are constructive on the tax exempt market for the near term. We have been balancing our purchases, using a combination of investments in the 10-15 year range with short term issues and callable bonds that provide greater yields.
Disclaimer: Any opinions quoted are for information only and do not constitute investment advice or recommendation to any reader to buy or sell investments.