Municipal Debt Discipline
Advisors Asset Management
By Tom Dalpiaz
October 18, 2012
The strong demand for municipal bonds has been a constant throughout 2012. That demand was a major factor forcing municipal bond yields lower by the end of the third quarter in spite of an increase in new issue supply compared to last year.
The September through December period usually sees a healthy increase in new municipal (muni) bond issuance and September of this year confirmed the beginning of that pattern. Given this seasonal increase in supply, it is not unusual, in any given year, to expect some backup in municipal bond yields throughout the fall period. The ongoing robust demand for municipals has confounded that usual expectation. Money flows into muni bond funds have been strong and new municipal bond deals have been generally well received. A number of new deals have been oversubscribed and re-priced at smaller spreads than the comparatively modest spreads contained in original pricing thoughts.
Our commentary last quarter suggested the likelihood of ongoing strong demand for municipal bonds and the reasons behind it. We believe the forces supporting the healthy desire for munis are not fully spent. Nominal muni yields are low but they continue to make sense for income-oriented conservative investors given the alternatives. The desire to invest in an asset class with generally modest volatility expectations compared to others, the possibility of higher taxes down the road, and nervousness about equities are additional forces supporting muni demand.
On the supply side, new issue volume is comfortably above last year’s very low levels but contains mostly refunding issues replacing existing high-cost debt. The small amount of bond issuance designed for new projects is still restrained enough to result in a net reduction of municipal bonds outstanding. Some projections suggest this trend could continue next year as issuers continue improving their fiscal standing by constraining new money debt issuance among other measures.
The upcoming election, the possible fiscal cliff/sequestration issues of year-end, and major tax reform are topics of increasing interest for municipal bond investors. Those complex topics all deal with deeply held convictions and the unpredictable political process. Who wins the presidency is of course important but the makeup of the next Congress (will one party control both houses?) is an equally important factor to consider when imagining future public policy. Bottom line, we suggest it is unwise now to re-arrange an investment grade, intermediate maturity municipal bond portfolio in anticipation of any particular possible outcome in the political arena. Muni issuers will continue to issue bonds to finance important long term projects and investors will still seek an appropriate place to garner attractive income in a comparatively conservative investment.
Regarding tax reform and the municipal bond exemption, we suggest two broad possibilities. Existing municipal bonds could be grandfathered (with no negative impact to existing munis) or changes will affect both existing and future municipal bonds. The size of the adjustment to all municipal bond values if there is no grandfathering will depend on the relationship of municipal bond yields to U.S. Treasury bond yields at the time and the bond maturities in an investor’s portfolio. We believe a short/intermediate bond portfolio is likely to realize a more muted one-time shift in values than a longer portfolio. Our best judgment now tells us that these worst case scenarios are unlikely to materialize within the next year. In the past, the issues of major tax reform or major changes to the muni exemption have been too complex and divisive to count on their arrival in such a short period of time.
We continue to suggest a bond journey that includes a value-oriented, investment grade, short/intermediate approach to the municipal bond market. We believe this approach has weathered the storm of the past five years in reasonable fashion and we remain comfortable with its ability to deal with future challenges in the municipal bond market.
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