Turning "Aggressively" Neutral

May 2016

Investors should stay the course

  • Municipal market records five consecutive monthly gains
  • Further interest rate declines in May
  • $100 billion of bonds mature this summer
  • More money chasing fewer tax-exempt securities
  • Investors should stay the course

Long-term municipal bond yields are still dropping. Despite the fact that market interest rates are at generational lows, investors are still allocating more of their investment dollars to the municipal asset class. U.S. investors are not the only ones buying; foreign investors from Europe and Asia have also been active purchasers of state and local government debt. While municipal yields remain historically low, they are very attractive versus global bond alternatives that carry lower or even negative yields.

The chart above illustrates the dramatic drop in municipal yields over the past year. 10-year municipal yields have fallen from a peak of 2.40% last June to 1.60% currently. Decreasing interest rates have enabled the municipal market to register performance gains every month so far in 2016, the first time this has happened since 1989, according to Merrill Lynch. The Barclays Municipal Bond Index added another 21 basis points (.21%) through May 27, bringing its year-to-date total return (income + price appreciation) to 2.63%, and one-year return to a surprising 6.07%. According to Barclays, the Municipal Bond Index performance has ranked near the top of all global bond indices over the past twelve months.

The municipal market’s ability to register gains during the past two months, typically a period of seasonal weakness, underscores the magnitude of resiliency. With the traditional tough stretch of the calendar behind it, the market can now look forward to a period of perhaps even stronger demand. Municipal investors will collect a wave of investible cash as many municipal securities mature over the summer months: $100 billion of bonds come due from June through August. Generally, the principal proceeds received are used to purchase new securities. Further supporting the municipal market from a technical perspective is the expectation that new debt issuance is likely to slow in the third quarter.

Owners of maturing tax-exempt securities might have fewer reinvestment options to choose from when their bonds come due. The relatively high yields and stability of the municipal asset class has left bond investors with few better yielding alternatives. For 33 consecutive weeks tax-exempt mutual funds have experienced net positive money inflows.

The combination of significant bond maturities occuring over the next few months and a steady inflow of money needing to be deployed in tax-exempt bonds should be sufficient to buoy the market. Lower borrowing costs are often an inducement for issuers to either refinance outstanding bonds or market new securities. For a variety of reasons, the municipal market should not be too concerned about a supply glut. Analysts are forecasting only a moderate amount of new bond deals in the weeks ahead.

Through the release of the minutes from its most recent interest rate meeting and member statements to the press, the Federal Reserve Open Market Committee (FOMC) has provided notice to the financial markets that investors should not remain too complacent by assuming further rate increases are not likely anytime soon. In fact, the FOMC would like investors to assume there is a good possibility of at least one short-term rate hike in the near future, maybe as soon as at its June meeting.

The fixed income markets have taken these words of warning to heart, as short-term rates have drifted a bit higher recently. SMC still maintains its more dovish view of the Fed’s future actions and rate hikes. At most, we can foresee only one 25 basis point rise in the overnight inter-bank lending rate this year. Interest rates in the United States are already significantly higher than elsewhere in other developed markets. Pushing rates higher would likely add to the strength of the U.S. dollar, which would be a further impediment to domestic trade and manufacturing. As was the case when the Fed instituted its intitial rate hike last December, stocks and commodities would probably suffer more than bonds. Economic growth and corporate earnings do not appear to be strong enough to weather much higher borrowing costs.

Given the confluence of events affecting the financial markets so far in 2016, we describe our municipal market posture as “aggressively” neutral. Annualizing municipal market perfomance based on the first five months’ returns would result in a 6% gain for the year. We think this is unlikely to occur, and we believe the second half of the year’s return will not match the first six months. We are not significantly altering our market view. However, in some instancces, we are adjusting duration to a slightly more defensive posture relative to the stratgey benchmark. The municipal asset class still offers a compelling investment opportunity when compared to most other global fixed income alternatives. Without strong evidence of significant global economic improvement, interest rates are unlikely to move appreciably higher. We think yields will remain near current levels.

Many market commentators have been discussing the shape of the municipal yield curve (difference in yield between the shortest and longest maturities) and future performance implications. Recent curve “flattening” is due to the greater decline in long-term yields rather than short-term yield movements. This happened for two reasons: first, is the significant amount of money flowing into long-maturity mutual funds. Secondly, the possibility of a short-term rate hike in the near future has caused short-term yields to drift higher recently.

As yield curve steepness is reduced, the additional yield compensation for extending maturity becomes less attractive. Furthermore, the relatively steep gradient of the curve in the intermediate maturity range (approximately 5-15 years) still holds; the best “rolldown” opportunity for future price appreciation lies within this optimal range.

Our strategy emphasizes maximizing current income by selecting bonds bearing higher coupons that are priced at a premium to face value. Income generation, rather than price appreciation, should be the main performance determinant through the balance of 2016. It is also important to control duration (interest rate risk) in the current environment just in case the declining yield trend reverses. Global economic growth and inflation fundamentals still suggest the continuation of a low interest rate environment going forward. In our view, the absence of a compelling economic growth story will limit interest rate movements. Given the strong technical posture of the market, municipals are likely to outperform taxable alternatives.


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