Price volatility has returned with a vengeance to many sectors of the financial markets. Most negatively affected have been global equities, high yield debt and commodities. Plunging commodity prices, led by cheapening oil, have caused a precipitous drop in global stock valuations this year. Many equity indices are now in official “correction” territory, defined as a price decline of at least 10% from a previous high. Investment grade bonds such as U.S. Treasuries and municipals have benefitted from the adverse price movement of riskier assets (stocks). The Barclays U.S. Treasury Index has gained 3.40% year-to-date (through February 25), while the Barclays Municipal Index has posted a 1.47% (2.00% on a taxable-equivalent basis) return.
Evidence points to a significant pick-up in investor appetite for the municipal asset class. For substantiation we cite the sustained weekly fund flows registered by municipal bond mutual funds and the outflow of money from stock mutual funds. Tax-exempt fund flows have remained positive for the past twenty weeks. According to Lipper Analytics, over $17 billion has poured into all types of municipal bond funds since October 2015. Strong demand for safe haven assets pushed the U.S. Treasury 10-year yield to a three-year low of 1.55% earlier this month. Likewise, municipal interest rates have responded with an impulsive drop.
A pick-up in new-issue supply has been the result of reduced issuance costs available to municipal debt issuers supported by strong investor buying interest. We anticipate this trend to continue through the second quarter of the year which traditionally is the heaviest seasonal period for municipal sales.
Considering that municipal yields have dropped to multi-decade lows, many professional investment managers and investors are opting to remain on the sidelines anticipating a yield reversal. There are a number of factors that should be considered before concluding that interest rate lows have been reached. For a variety of technical factors the forward supply of new tax-exempt issuance should not increase appreciably. Net new issuance (the difference between total new bond issuance and refinancing of maturing or outstanding debt) has been on the decline for a number of years. Simply stated, state and local governments are not looking to increase their debt loads; instead, they are reducing net outstanding liabilities. For example, bond borrowing for needed infrastructure projects has been on the decline for many years. In our view, investor appetites will remain sufficient to absorb new supply coming into the market. Meanwhile, a significant amount of outstanding bonds are maturing, providing investors with investible monies to redeploy back into the municipal market.
Stock market losses are likely to continue to be bond market gains, particularly if the level of market volatility remains high. SMC expects moderate economic growth, employment gains and benign inflation in 2016. This forecast is more benign than the consensus and argues for staying on plan by investing in suitable municipal bond structures that should optimize performance this year. (See Municipal Market Commentary: Why Bonds Now, January 27, 2016.)
Over time, bonds will produce most of their total return (coupon income + price change) from the receipt and compounding of the semi-annual coupon interest payments. 2015’s market performance was a good example: the 3.30% Barclays Municipal Bond Index total return was generated from the coupon component (-0.99% price + 4.29% coupon). SMC expects 2016 will likely produce similar results.
While past performance results should never be construed as a prologue for future returns, historical municipal market results make a very compelling case to remain invested no matter the level of interest rates. Since its advent, the Barclays Municipal Bond Index has produced 28 years of positive performance and only four years of negative performance. What we find even more compelling about this achievement is the performance rebound attained the year following a downturn. Market performance in the following year more than compensated for the prior year’s loss. An investment made on January 1, 1984 in the Index would have produced an annualized return of 7.06% over 32 years, making a compelling case to “stay the course.”
The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management ("SMC FIM"), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.
This commentary is neither an offer to sell nor a solicitation of an offer to purchase securities, any other investments or any other product sponsored or advised by SMC FIM, nor does it constitute an offer or a solicitation to otherwise provide investment advisory services. Such an offer or solicitation may be made only by the relevant documents for the relevant investment vehicle and/or investment program. This commentary is not, and may not be used as, a recommendation of any security, investment program or vehicle. There is no assurance that any securities discussed herein will remain in a client's account at the time you receive this commentary or that securities sold have not been repurchased. The securities discussed do not represent the client's entire portfolio and in the aggregate may represent only a small percentage of the client's portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed was or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.
Statements contained in this commentary that are not historic facts are based on current expectations, estimates, projections, opinions and beliefs of SMC FIM. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. Unless specified, any views reflected herein are those of SMC FIM and are subject to change without notice. SMC FIM is not under any obligation to update or keep current the information contained herein.
This commentary does not take into account any particular investor's investment objectives or tolerance for risk. The information contained in this commentary is presented solely with respect to the date of its preparation, or as of such earlier date specified in it, and may be changed or updated at any time without notice to any of the recipients of it (whether or not some other recipients receive changes or updates to the information in it).
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