Tax-Exempts Performed Well in the Midst of Market Volatility

The municipal market remained resilient as it navigated through a number of issues during the quarter, including anticipation of potential Federal Reserve action on interest rates and volatility in global financial markets.  Additionally, the municipal sector continued to avoid any contagion risks due to the negative credit developments in Puerto Rico.  During the quarter, as expected, the Commonwealth did indeed default on its appropriation-backed debt payments due for the Puerto Rico Public Finance Corp. Further defaults are expected as the Commonwealth faces a liquidity crisis as its cash balances continues to dwindle during the fourth quarter.

In the face of these developments, municipals performed well, with 10-year yields during the quarter collapsing by 25 basis points (bps).  The sector was largely supported by very strong seasonal technicals.  On the demand side, the market was buoyed by heavy reinvestment flows of coupons/calls/maturities, which are at their highest levels of the year during the summer months. Supply technicals during the quarter were also beneficial to market performance.  Although new issuance in July and August increased by 26% versus the same period in 2014 to a total of $66.1 billion, September issuance plunged to $18.3 billion, a drop of 27.3% relative to the same period in 2014.  That was the lowest monthly total reported over the last 19 months.  The dramatic drop off in issuance was likely driven by a reluctance of issuers to come to market during expectations for both a lift-off in short term rates by the FOMC (Federal Open Market Committee) and a thinning of market participation due to vacations and holidays during the month.

Underlying credit fundamentals also provided support for the sector.  As reported by the U.S. Census Bureau, state and local government revenues exhibited a strong showing in the second quarter with a growth rate of 6.9% versus second quarter 2014 levels.  That compares favorably to revenue growth over the prior three quarters that averaged 4.2%.  Additionally, outside of the ongoing fiscal struggles of Puerto Rico, Illinois and New Jersey, and a budget stalemate in Pennsylvania, headline risk has remained muted and the sector has continued to exhibit slow, but steady improvement in fundamentals.  The improving credit profile, combined with the FOMC’s postponement in raising rates, has already resulted in solid improvement in mutual fund flows over the last month.  After funds reporting on a weekly basis reported average outflows of $359 million per week from August 26 through September 16, fund flows have turned positive, with a weekly average of $300 million in inflows over the last four weeks.  Additionally, these flows have largely targeted longer duration assets.  Funds that were classified as “long-term” recorded a four-week average of $459 million of inflows.

Looking forward, with the rally in rates during the quarter, the current level of yields could provide headwinds for relative market performance during the fourth quarter.  As of this writing, 10-year yields are at 2.03%, which has historically been very conducive to a heavy refinancing/refunding cycle.  During the first four months of this year, “AAA” 10-year rates averaged 1.96% and during that period, deals that were classified as straight refinancings/refundings, averaged approximately $17 billion per month.  Since that time, as rates moved higher during the year, the average over the last five months plunged by 41% to $10 billion per month.  If rates remain near current levels or move lower from here, we could see some upside surprise in new issuance levels.

However, we remain constructive on the sector.  As of the end of the third quarter, total refinancings are up over 56% versus the same time period in 2014 and have made up over 64% of total new issuance for the year.  We believe that the called bond proceeds generated from this spike in year-to-date refinancings will provide solid sponsorship for the expected overall increase in issuance during the fourth quarter, and make supply technicals appear manageable.  Additionally, although we could experience some near-term volatility in relative valuation levels on heightened supply concerns, strong seasonal technicals return in December, as supply begins to wane into the new year and heavy reinvestment flows enter the market starting on December 1.  If the sector experiences any deterioration in relative valuation levels, we would view this as an opportunity to further increase our overweight position to the sector.

Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

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Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here. The information presented, including any statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. AAM assumes no duty to provide updates to any analysis contained herein. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.