July 2014 Municipal Market Credit Review- “Time to Clean Up Your SWAN?”

The month of July was a “yawner” for the municipal bond market, and we expect the same for August. However, this does not mean an investor should be tuning out the market. This is beginning to feel like the calm before the storm. The major factors that determine the value of municipal bonds have all been positive over the last twelve months. Combine this trend with the current seasonal effects which show good demand for bonds, we are thinking it may be time to review and clean-up your “SWAN -sleep well at night” portfolio.

This month, we discuss the changing of the municipal yield curve over the last 12 months, and highlight in the credit review a study we did in February 2013. This review was a study of the seasonal supply and demand factors in the municipal market. This analysis helps show relatively good times to sell bonds, and good times to buy bonds. Guess what time it is now?

July 2014 Municipal Market Review:

During the month of July 2014, the municipal market was very quiet. Low new issuance and an unchanged US Treasury market led to the following (yawn) highlights:

  • 5 & 7 year muni yields increased 2 bps over the month.
  • 25 year muni yields decreased 3 bps over the month.

Of more interest is examining what has happened to the municipal yield curve over the last twelve months, and then looking ahead. More specifically, over the last twelve months:

  • 5 year muni yields have decreased 5 bps vs. US Libor rates which increased 32 bps.
    • 5 year muni to libor ratio is at 65% vs. last year’s ratio of 82%, and a long-term average of 73%.
  • 10 year muni yields have decreased 41 bps vs. US Libor rates which decreased 8 bps.
    • 10 year muni to libor ratio is at 84% vs. last year’s ratio of 96% and a long-term average of 80%.
  • 25 year muni yields have decreased 85 bps vs. US Libor rates which decreased 26 bps.
    • 25 year muni to libor ratio is at 99% vs. last year’s ratio of 116%, and a long-term average of 90%.

The municipal market has had all of its major fundamental factors turn bullish over the last twelve months. More specifically:

  1. General level of interest rates lower on international fears.
  2. Higher tax rates and the realization of the 2013 tax increase as individuals paid them in 2014.
  3. Lower than average issuance (15% lower versus 2013), creating less supply for investors.
  4. Credit quality continues to improve for most issuers. Default rate year-to-date is 1.4% of issuance versus 3.8% in 2013 (info From Municipal Market Advisors 7/31/14)

What does this mean today, other than long-term munis were cheap last summer? If any of these three factors change, this quiet market could wake up ugly. The short-end of the municipal market is very vulnerable. The fed fund rate forecast shows an expected 75 bps increase over the next 18 months, and the taxable market has begun factoring this in. The municipal market has not, and is relatively rich to the taxable market. The lack of activity in the market, and the strong seasonal techinicals keeps us defensive, and now looking at ways to reposition portfolios before the market wakes up.

Investment Strategy Review:

We are not big proponents of active trading, but do like to take advantage of relative value plays when we see them. It makes even more sense to us to sell bonds when it helps diversify a portfolio’s market value/reinvestment risk, and/or clean up long-term credit concerns. We are encouraging investors to review their portfolios (and we will too) for imbalanced reinvestment risk profiles, poor coupon structures or issuers with credit profiles that are concerning. More specifically, we would focus on bonds with expected maturities from 4 to 7 years and longer–term bonds with sub 4% coupons. If the market does correct, we feel these bonds will get hurt the most. This may be a good time, given the seasonal strength of the market, (please see this month’s credit review “When to Buy a When to Sell”) to clean things up, and go into one of our defensive strategies until the curve flattens and yield levels rise.

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