Municipals

The Tax-exempt sector was generally weaker across the yield curve relative to Treasuries during the first quarter of 2013. The sector started the quarter with very strong demand from reinvestment flows due to heavy January 1st coupons/calls/maturities, resulting in 10-year tax-adjusted municipal yield spreads to Treasuries tightening by 20 basis points (bps) into mid-January. However, technicals turned weaker during March as reinvestment flows declined and as investors began raising cash ahead of the April 15th tax-filing deadline. Overall, 10-year tax-adjusted municipal spreads ended the quarter at 93 bps, an increase of 18 bps over spread levels at the start of the quarter.

Supply has not had a significant effect on relative valuations. Supply during the quarter remained in line with volume from 2012. Total new issuance year-to-date stands at $81 billion, which is a modest increase of 2.4% relative to 2012’s supply through the first quarter. Refinancings/refundings, which had a substantial impact on total issuance in 2012, continues to make up the lion’s share of new issuance in 2013. Year-to-date, refinancings totaled $49.2 billion and made up 61% of total issuance. Although these totals are a modest 6% lower relative to the levels exhibited in 2012, refinancings have declined by an average of 31.2% over the past two months. The current low interest rate environment remains conducive for more refinancing supply to price, but if the recent declining trends in this category continue to play out during the balance of the year, it would be a market positive for tax-exempt performance.

In terms of our near-term outlook for the sector, we expect to see a challenging technical environment to develop, resulting in increased volatility in spread levels relative to Treasuries. Demand should improve as we move beyond the weak technicals tied to the tax-filing deadline. Additionally, municipals-to-Treasury yield ratios above 100% have historically enticed relative value investors to rotate into the tax-exempt sector and, as of April 1st, yields in 10-year municipals stood at 103% of Treasuries. Consequently, relative valuations appear to be attractive. However, supply expectations are ominous. Although new issue supply during April is expected to be a modest $30 to $35 billion, May and June should see a substantial pickup in issuance in the range of $40 to $45 billion per month. This amount of supply has typically overwhelmed the market and we should see spread levels move wider as this issuance clears the market. We would view the latter portion of the quarter as an attractive entry point to put more money to work in the sector, before market technicals strengthen dramatically heading into the summer months.

Written by:

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.

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.

 

Fourth Quarter 2012 Municipal Commentary and Outlook for 2013

First 3 Quarters Summary

The municipal sector exhibited a considerable amount of volatility during the final quarter of 2012, with most of the volatility being attributed to news events out of Washington DC. The presidential election results, which ushered in the prospects for higher marginal tax rates, were a huge boost to municipal performance in November. From November 6, 2012 through November 29, 2012, 10-year municipal yields in collapsed by 25 basis points (bps) and tax-adjusted yield spreads to Treasuries tightened by 31 bps. With the highest marginal tax rate expected to return to Clinton-era levels of 39.6% from 35%, the municipal market quickly priced in the increased value of the tax-exemption. At this point, 10-year tax-adjusted yield spreads were at their tightest of the year at 51 bps.

However, from the end of November to December 20, 2012, 10-year yields spiked 35 bps and spreads widened by 34 bps. A large proportion of the selloff was attributed to concerns over tax-reform and the increasing probability that the municipal tax-exemption could be compromised as part of the  proposal to cap deductions and exclusions at the 28% marginal tax rate. As the new-year approached and it became clear that the “fiscal cliff” agreement would not include the 28% cap, municipals outperformed taxables as 10-year Treasury yields increased by 14 bps from December 31, 2012 to January 3, 2013, while municipal yields were higher by only 6 bps.

As of this writing, 10-year tax-adjusted municipal spreads stand at 72 bps, which remains substantially wider than the 51 bps spread that existed at the end of November. However, tax-reform concerns continue to be an issue hanging over the market and that’s led to a more muted conviction to develop around current spread levels. Investors remain nervous that there’s some probability that additional revenue-raising measures as a part of tax reform could come out of the sequestration (the mandatory, across-the-board spending cuts) and debt ceiling discussions coming within the next two months. This legislative risk has led to a very quiet tone during the first week of January, and the typical performance boost from the “January effect” on low primary issuance and heavy reinvestment flows of coupons/calls/maturities has been slow to develop.

As for the near term outlook for the sector, positive technicals should provide solid relative performance. Supply/demand imbalances are generally constructive during the first two months of the year and there should be a general bias toward tighter spreads going forward for the next seven to eight weeks. However, legislative risk surrounding the tax-exemption status of municipals remains a concern that won’t be abated until a deal is reached on both the sequester cuts and the debt ceiling. Although the probability is low that Republicans will agree to additional revenue-raising measures beyond what was accepted in the fiscal cliff agreement, investors are likely to remain cautious. Consequently, demand flows into the market should lead to strong relative performance, but the buying conviction for municipals will remain less than optimal until we reach a final resolution to the legislative issues.

The longer-term outlook for the market for 2013 is generally favorable. Underlying credit fundamentals for the sector have been and should continue to gradually improve. Although there remain credit concerns and heightened default concerns on some local issuers, especially in California, defaults overall have continued to exhibit a declining trend. Payment defaults in 2012 declined 31% to $903 million from $2.2 billion in 2011.

A major reason for the improvement in the credit profile for the sector is the steady growth in revenues. State and local government revenues have seen positive growth over the last ten quarters.  And, as the economy continues to see growth in employment, states should continue to see steady growth in income tax revenues.  Additionally, property taxes have seemed to be on an improving trend over the last two quarters. Most of the improvement can be ascribed to higher assessment rates, and with property taxes being the primary source of funding for general operations of local issuers, this improvement should continue to lessen some of the credit concerns surrounding local credits.

Tightening of credit spreads has been reflective of the improvement in underlying credit fundamentals for the sector. Spreads on 5-year A- and BBB-rated paper have tightened by 45 and 66 bps, respectively, during 2012 and spreads are now back to levels that existed just prior to the 2008 financial crisis. As the municipal market continues to exhibit a generally improving credit profile and fully regains its notoriety as a semi-safe sector, these spread levels should continue to see a tightening bias during the course of 2013.

Technicals should also be supportive for solid municipal performance in 2013. One measure of the demand trends in the municipal market is to examine mutual fund flows. In 2011, tax-exempt funds saw net outflows of $17.9 billion, primarily as a result of heightened credit concerns surrounding predictions of a massive wave of defaults to hit local issuers. As these risks have subsided, and as the prospects for higher marginal tax rates became evident late in the year, 2012 saw a massive turnaround in flows. Municipal mutual funds experienced net inflows of $49.48 billion during 2012, according to Lipper data and, at one point, saw a streak of positive inflows in 65 of the prior 67 weeks as of December 14, 2012. However, in the last two weeks of the year, legislative risks tied to the 28% cap on deductions and exclusions resulted in outflows of $2.7 billion, before moderating in the new year. The risks related to tax-reform and the possible resurrection of the 28% cap discussion may linger over the market and suppress flows until final details have been agreed upon to resolving the debt ceiling and avoiding the sequestration cuts. Outside of these legislative risks, demand should continue to remain solid during 2013.

Supply during 2013 is not expected to put pressure on relative valuations. Consensus estimates for new issuance is $400 billion in 2013, which would be an increase of only 7.2% over 2012’s levels and would be just north of the 10-year average of $385.8 billion. Additionally, with interest rates remaining near all-time lows, refinancings/refundings are expected to remain a major component of new supply. In 2012, total refinancings accounted for a total of 62% of issuance. And, as long as rates remain near historic lows, issuers will continue to target borrowing costs as a source for potential budget savings as part of their overall austerity focus.

The focus on spending restraint should also translate to a continued below-trend in new money issuance for infrastructure spending. The average issuance in this category over the last 2 years has been $148 billion, which is 40% below the average of $248 billion from 2003 through 2010. With local issuers cutting education-related employment by approximately 54,000 during 2012 and with the trend in new money issuance in 2012 down 6% to $143 billion from $153 billion in 2011, it does not appear that there will be a turnaround in project-related financing in 2013. Consequently, refinancing supply should continue to drive the new issuance cycle. Additionally, any substantial move higher in rates could drastically reduce refinancing opportunities. Actual total issuance under this scenario could come in well below consensus estimates, which would be very constructive for municipal relative valuations for 2013.

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.

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.

The municipal market enjoyed a very strong rally during the summer, with supply and demand imbalances continuing to be the driving force behind municipal performance. Although supply during the third quarter was ahead of third quarter 2011’s pace by 10% to $84.9 billion, new issuance was down sharply by 26% versus second quarter 2012’s levels. The sharp drop, combined with the strongest reinvestment flows of the year for coupons/calls/maturities, led to rates falling by 16 to 41 basis points (bps) in maturities 5 years and longer on the yield curve. Municipal tax-adjusted yield spreads to Treasuries also tightened by 15 to 63 bps in the same maturity range. The strongest performance was exhibited in the 12 to 30 year maturity range, as the near-record low interest rate environment and steep yield curve provided the impetus for investors to extend their investment dollars into longer-term maturities.

As we’ve noted in prior commentaries, dramatic changes in the supply cycle will continue to help create volatility in the relative performance for the municipal market. While supply did drop sharply during the third quarter, supply year to date remains 44% ahead of 2011, driven in large part by refinancing/refunding issuance. So far this year, straight refinancings at $117.6 billion are up 91% versus the same point in 2011 and account for 42% of total issuance versus a 5-year historical average of 24.4%. As austerity measures at the state and local level remain a major theme to counteract stagnating-to-falling property tax revenues, cost savings achieved through refinancing currently-callable debt will continue to drive overall new issuance.

Demand should also remain strong as the refinancing wave continues. Investors will continue to be faced with receiving the proceeds of the currently-callable bond structures that have been refinanced. Reinvestment of these proceeds are expected to continue to target the 7 to 30 year area of the very steep yield curve, as the hunger for yield drives investors into longer maturities. Additionally, the mutual fund sector has also continued to see robust inflows all year. Inflows for 2012 so far have totaled $43.2 billion, and inflows of $1.5 billion during the week of October 10, 2012 marked the 45th consecutive week of inflows.

In terms of the near-term outlook for the sector, the fourth quarter is expected to see some challenges in relative performance. Supply is expected to come in at approximately $103 billion, which would be an increase of 8.4% relative to the issuance in the fourth quarter of 2011 and an increase of 23% versus third quarter 2012 issuance. Additionally, demand is expected to moderate quite a bit during the fall, as reinvestment flows of coupons and maturities are typically very weak during October and November, before rebounding to much stronger levels in December, January and February. Consequently, we view the sector as vulnerable to underperformance over the next two months as the market struggles to confront a much heavier supply cycle.

Written by 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.

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.

Supply and demand imbalances during the first quarter of 2012 resulted in a substantial amount of volatility in tax-exempt yield levels. Demand during January and early February was incredibly strong as a result of very heavy roll-over investment of January 1st and February 1st coupons/calls/maturities. This reinvestment demand pressured yields in 10-years to fall by 16 basis points (bps) to a low of 1.67% on January 19th, which created some concerns that absolute yield levels had become too low on maturities 10 years and shorter. Consequently, investors began to target longer maturities in the 15 to 20 year range, which led to a decline of 48 bps in yield on 20-year bonds to a low of 2.70% on February 1st. Since that time, the technical environment has seen a dramatic shift, with demand cooling substantially ahead of the tax-filing season and new-issue supply increasing dramatically. The net result was an increase in 10-year yields of 43 bps over the last two months of the quarter.

Supply during the first quarter was up sharply from last year, primarily as a result of refinancing/refunding of currently-callable structures. Overall supply increased by 63.5% to a total of $78.2 billion, with 47% of this amount directly related to refinancings. That’s an increase of 159% over first quarter 2011 refinancings and a 74% increase over the average refinancing volume for the period 2006 to 2010. The refinancings have been driven in large part by the near-record low interest rate environment and the need for municipalities to garner budgetary savings wherever they can find them.

However, first quarter new money financing of $26.4 billion remains at anemic levels, with a decrease of 3% relative to 2011. When compared to the 5-year average for the period from 2006 to 2010, the percentage decline is substantial with a decrease of 51%. These numbers suggest that most of the austerity measures at the state and local level are still in force and portends a modest new-money issuance cycle for 2012.

In the near term, technicals should gradually improve. After the tax-filing season has passed in mid-April, the market begins to move closer to another upswing in heavier reinvestment flows in May, June and July. Additionally, with most of the refinancing supply targeting currently-callable structures, a large number of investors will receive the proceeds of these calls and will need to redeploy them in the market.

Based on the positive trend for demand flows, the outlook for the municipal market is for relative performance to be positive over the next quarter. But as in the first quarter, the market should continue to experience significant swings in relative valuation levels. Current 10-year tax-adjusted municipal yield spreads versus Treasuries are at 104 bps, which is substantially higher than the 54 bps spread that existed on January 19th. Current spreads also remain well-below the 173 bps spread that existed on October 7, 2011. Consequently, tax-exempt spread levels look to be fairly valued today. However, with approximately 50% of the market’s new-issue supply made up of rate-sensitive refinancings, the market could experience very volatile performance on either a sharp increase in supply or any substantial spike in yields. In the latter case, significant yield increases could reduce the potential savings of refinancings and drastically reduce the pace of supply during 2012, resulting in tax-adjusted spreads tightening dramatically from current levels. In either case, we will continue to closely monitor supply/demand dynamics over the coming quarter and look to trade on imbalance-related opportunities as they occur.

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.

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.

The municipal market experienced the impacts of the “January effect” a month earlier than anticipated.  Very strong roll-over investment of heavy January 1, 2012 coupon/call/maturity proceeds has historically led to very strong municipal relative performance during January and February. However, falling supply conditions in December of 2011, combined with very strong demand across a number of buying segments, resulted in municipal yields falling by 39 basis points (bps) in 10-years during the month. That performance helped cap off an exceptional fourth quarter run that resulted in municipal tax-adjusted yield spreads versus Treasuries to tighten by 53 bps for the quarter.

Strong supply and demand technicals have largely been the driver of relative performance all year for the municipal market. Supply during 2011 totaled only $294.5 billion, which was the lowest level since 2001. Compared to 2010 levels, overall supply dropped 32%, while tax-exempt only supply saw a drop of 7% to a total of $262 billion. The large drop in overall issuance was a direct result of the expiration of the Build America Bond program and the massive austerity measures that municipalities undertook to close budget gaps. The spending-cut theme is likely to continue during 2012, which should keep municipal issuance at muted levels relative to issuance patterns over the last six years that saw average annual volume of $408 billion.

On the demand side, sponsorship for the sector during 2011 has largely been grounded in relative-value investors.  These investors have been enamored with the generous nominal yields available in the municipal market that have been well north of comparable Treasuries across the yield curve. After 10-year municipal nominal spreads reached a peak of  56 bps on October 7, 2011, the buying momentum from relative-value investors, combined with retail demand from heavy December 1, 2011 reinvestment flows of coupon/calls/maturities, resulted in 10-year nominal yields tightening to -5 bps as of year-end. Demand has also benefited from the increase in inflows to tax-exempt mutual funds. Over the last five weeks through the period ending January 4, 2012, inflows have totaled $5.8 billion.

The increase in buying momentum across the retail and mutual fund segments can be attributed to the lack of credit events in the sector during the year. Entering 2011, a number of investors were worried about the wild predictions that defaults could reach $100 to $200 billion. However, defaults have largely been well contained. Through the end of the third quarter of 2011, defaults involving missed payments totaled about $2.6 billion. Additionally, budget-deficit related issues at the state level have also been addressed with spending cuts and tax increases. As a result of the revenue raising measures and economic growth, state revenues have seen increases over the last eight quarters and currently, only four states (WA, CA, NY, and MO) need to address new mid-year budget deficits. Overall, the credit profile for the sector is expected to continue to see slow progress as the economy improves, which should help maintain the buying momentum that the sector has experienced during 2011.

The near term outlook for the municipal sector is to expect relative valuations to remain at current levels through February. New issue supply should remain fairly quiet through January and February, while demand should remain in place as reinvestment flows from January 1, 2012 and February 1, 2012 coupons/calls/maturities enter the market. However, we anticipate that the recent spread-tightening trend has limited potential for further tightening over the next month. Consequently, we will be looking at opportunities to reduce our exposure to the tax-exempt market over the next several weeks. The strong technicals that are in place today are expected to reverse in March and April, when supply typically rises dramatically and reinvestment demand of coupon/calls/maturities falls substantially. The resulting drop in relative valuations and widening of tax-adjusted spreads should provide a compelling re-entry point for investment in 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.

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.

The municipal market continued to see very strong performance during the third quarter of 2011. After 10-year rates fell 41 basis points (bps) during the first half of the year on strong demand flows and low supply conditions, rates in 10-years dropped another 53 bps during the third quarter. Performance for the quarter can largely be attributed to both the continuation of the supply/demand imbalances from the first half of the year and to the substantial rally that occurred in Treasuries.  Treasury 10-year rates fell 125 bps on lower-than-expected economic results and concerns over the European Union’s bailout of Greece.

Demand for municipals has generally been strong all year as the sector continues to allay fears of substantial default risk. Although municipalities continue to face ongoing budget challenges, so far they’ve met these challenges head on with austerity measures that have led to over 680,000 cuts in payroll since the third quarter of 2008. In addition, tax revenues have also seen a steady climb. State and local government revenues rose another 6.9% during the second quarter according to the U.S. Census Bureau, which marked the seventh-straight quarter of growth. These positive developments have resulted in the sector reporting defaults of only $1.1 billion during the year, which is about a quarter of the total exhibited in 2010 and well-below the predictions of over $100 billion.

Although demand has seemingly been consistently strong all year, much heavier supply over the last four weeks through October 7, 2011 resulted in a drastic level of underperformance relative to Treasuries. An average of approximately $8 billion per week came to market during this period, with $9 billion pricing during the first week of October. That helped pressure municipal yields higher by 48 bps in 10-years, while Treasury yields in 10-years were higher by only 16 bps. Additionally, the heavier supply conditions also forced many of the new deals to price at substantial concessions to historical spread levels to clear the market. The overall rise in yields resulted in the relative value profile for the sector to reach 2-year highs on October 7th, with tax-adjusted and nominal yield spreads to Treasuries reaching 172 bps and 56 bps, respectively.

The near-term outlook for the tax-exempt sector is positive. The substantial relative-value attractiveness of the municipal sector should continue to attract a number of buyers, including non-traditional cross-over investors who can’t use tax-exempt income. These buyers are primarily looking at the substantial dislocation in relative valuations as measured by the municipal nominal yield advantage to Treasuries and are betting that these dislocations eventually revert to their historical means. This demand trend is expected to help provide the sector with the needed sponsorship to help absorb what’s expected to be heavier supply flows through the last three months of the year.

Through the first three quarters of 2011, new issue supply has been running below 2010’s levels by approximately 35%; however, the current extremely low yield environment has created a new wave of unexpected refinancing/refunding opportunities for issuers. This potential additional supply, in conjunction with the typical increase in supply that occurs during the fall months, will lead to continued spikes in volatility in tax-adjusted and nominal yield spread relationships. It’s expected that crossover investors, traditional and non-traditional alike, will continue to treat these spikes as buying opportunities. As we move into December 1st and January 1st, demand should also increase as heavier reinvestment flows from coupon/calls/maturities enter the market. These positive demand technicals should result in tax-exempts outperforming Treasuries during the fourth quarter, especially if we see a substantial rise in Treasury rates from current levels.

Gregory A. Bell, CFA, CPA
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.

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.