Municipals

Tax-exempt performance for the second quarter of 2011 remained at strong levels on the heels of another quarter of muted new issuance flows. New issue supply year-to-date has been consistently running below 2010’s levels by approximately 50%. This significant below-trend issuance, combined with a drop in perceived headline risk for the sector and a rebound in demand patterns after the April 15 tax filing deadline, contributed to 10-year tax-exempt yields falling by 44 basis points (bps). Tax-exempts also outperformed Treasuries, with 10-year municipal tax-adjusted yield spreads to Treasuries contracting by 34 bps during the quarter.

Even with the strong overall performance, municipals did run into some underperformance over the last six weeks of the quarter. After 10-year tax-exempt yields reached a 6-month low of 2.59% on May 19, new issuance began to spike to approximately $6 billion per week through the end of June. Total new issuance for June was $31.5 billion, which was an increase of 89% relative to the year-to-date average of $16.5 billion per month through May. Although the municipal market seemingly had the benefit of solid technicals from approximately $46 billion in reinvestment dollars from June 1 coupon/call/maturity flows, the low absolute yield environment and supply overhang concerns led to an increase in 10-year yields by 16 bps. These factors also resulted in the steepening of the slope of the yield curve by 18 bps from 2 to 10-years and 10 year municipal tax-adjusted yield spreads to Treasuries to widen by 25 bps.

Supply for the remainder of the year should continue to drive relative performance. Now that practically all of the states have balanced budgets in place, financing of budgeted spending initiatives that were held up with protracted austerity-induced budget battles should now be working their way into the new issue calendar. The consensus estimates are for supply to reach approximately $25 billion per month during the second half of the year. With July and August historically seeing modest new issue calendars, the expectation should be for a heavier new issue cycle to develop for the latter portion of the third quarter and into the fourth quarter.

While supply is expected to remain modest over the next two to three months, the market should see strong positive demand flows from the continued reinvestment of heavy July 1 and August 1 coupons, calls and maturities. Demand has also improved as investors have become less fearful of putting money to work in the sector, with year-to-date municipal defaults failing to come anywhere close to the most extreme predictions of defaults in the “hundreds of billions” range. The perceived reduction in headline risk has resulted in a dramatic improvement in the curtailment of weekly mutual fund outflows, which are now at a 4-week moving average of -$35.6 million. That’s a significant improvement relative to the 4-week average of -$2.1 billion of weekly outflows as of January 5, 2011.

Additionally, there are signs that the fiscal profiles for the states are experiencing improving trends, which should continue to help assuage fears about future default prospects. U.S. states and localities have been reporting consistent revenue growth, with tax collections in the first quarter reporting an increase of 4.7% over the first quarter of 2010, resulting in the sixth straight quarter of growth. As this slow growth trend continues, combined with the austerity and reform measures that have already been adopted, the fiscal outlook for the states should continue to see slow improvement.

Our outlook for the third quarter is for the tax-exempt market to perform well, given the favorable technical backdrop of expected modest supply conditions and for demand to remain firm as heavy reinvestment flows come into the sector. We also expect that the market should experience a much weaker tone in October and November on a dramatic shift in technicals. If we see substantial outperformance during the next two months on any supply/demand imbalances, ahead of the expected weaker technicals expected for the fourth quarter, we will monitor opportunities to execute the cross-over strategy and target for investment those sectors that provide a better total return profile relative to the tax-exempt sector.

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.

Municipal market performance during the 1st quarter of 2011 exhibited a nice rebound from the disastrous performance of the 4th quarter of 2010. After tax-exempt 10-year yield levels reached a two-year high of 3.46% on January 17th, rates fell 56 basis points (bps) to 2.90% on March 17th. Municipals also performed very well relative to the taxable sector during this timeframe, with tax-adjusted yield spreads to Treasuries contracting by 68 bps. The catalyst for this performance was a combination of strong demand flows from crossover investors who were taking advantage of very attractive relative valuations, and a dearth of new issue supply that’s on pace to achieve 11-year lows in total new issuance for the year.

However, since March 17th, 10-year rates have moved higher by 24 bps as a result of the typical demand weakness that’s prevalent at this time of year. Reinvestment flows of coupons/calls/maturities are at their lowest point of the year between March 1st and May 1st, and selling of municipals typically gains momentum ahead of the tax-filing deadline of mid-April. Investors have also been very apprehensive about investing in the market ahead of what’s expected to be a pickup in new issue supply during the latter portion of the 2nd quarter.

Thus far in 2011, new issue supply has come in at a total of $46.9 billion, which is 55% below the same period in 2010 and 44% below the 5-year average. Record issuance in the 4th quarter of 2010 that was pushed into the market ahead of the expiration of the Build America Bond program is seen as one of the major causes for the drop. Additionally, with 10-year rates reaching a two-year high in mid-January, much higher funding levels is also considered to be a key contributor to the slowdown.

One additional explanation for the supply drought, which could also portend higher supply later this quarter, is related to the current delays exhibited in the budgetary process of the states. There is typically an inherent “black-out” period for new issuance  during the first two months of the year as states grapple with planning and passing their budgets. Delays this year have been exacerbated by the election of 27 new governors, who have initiated significant austerity measures to close budget gaps. Some of these austerity measures have included fights with unions over collective bargaining rights, along with the adoption of significant reforms to pensions. These battles, along with the extensive debates surrounding the right mix of spending cuts and/or tax hikes to close an estimated $112 billion in budget deficits, have resulted in delays of any bonding initiatives that are tied to the adoption of a balanced budget.

As the budgeting process comes closer to an end, and with most states starting their fiscal years on July 1st, the expectation for a heavier supply cycle is expected for May and June. If this supply increase is significant, we expect to see relative valuations for municipals move to more attractive levels and provide an entry point for additional investment into the sector. A more favorable technical profile should develop after June 30th, as demand should increase substantially from a significant increase in reinvestment flows from coupons/calls/maturities. Consequently,  we expect to see a tightening-bias in tax-adjusted yield levels relative to Treasuries during the summer months. Once that occurs, we will look toward opportunities in reducing our tax-exempt exposure and redeploying the proceeds into sectors with better total return prospects.

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 tax-exempt municipal market exhibited very strong performance over the third quarter. Exceptionally strong seasonal demand was the primary catalyst, as reinvestment of proceeds from coupons/calls/maturities averaged $44 billion in July and August. Tax-exempt new-issue supply over this period came in at only $18.5 billion. This significant supply/demand imbalance resulted in yields in 10-yrs falling by 41 basis points for the quarter, which was in line with the 42 basis points move lower in yield for the 10-year Treasury.

However, performance for September into the first week of October (6th) was drastically weaker. The combination of expected heavy new issuance patterns, a dramatic drop in reinvestment flows, and a very low absolute yield environment contributed to a dramatic sell-off that culminated with municipal yields in 10-yrs rising by 31 basis points. The 10-year Treasury bond was unchanged over the same period.

The resulting underperformance left tax-exempt nominal yields exceeding that of Treasury yields across the curve, and grossed-up tax-exempt yield spread levels versus Treasuries reaching 1-year highs of 116 basis points in 10-yrs. These attractive relative valuations triggered crossover/sector-rotation buying interest, resulting in spreads moving tighter by 29 basis points to a spread of 87 basis points by October 15th. We now believe that most of the attractive buying opportunities have been captured, with tax-adjusted spread relationships between municipals and Treasuries now closer to historical relationships.

The technical profile going forward for the tax-exempt sector could remain challenging if refinancing supply becomes a major issue over the next 1 to 2 months. Prior to the strong performance of municipals over the last week, refunding/refinancing prospects were becoming challenging, as negative arbitrage was becoming an issue. This condition exists when the yields on Treasuries used to fund the defeasance escrow are too low relative to current municipal yield levels, thus making an advanced refunding/refinancing less feasible. With the significant improvement in the relative valuation profile for municipals over the last 1 1/2 weeks, this condition has moved closer to being mitigated and heavier supply conditions could be in the works.

However, new-money financings are expected to remain fairly muted, with issuers more interested in the cost savings associated with issuing in the taxable market via the Build America Program (BAB). So far in 2010, approximately 33% of total municipal supply has been issued as taxable, resulting in tax-exempt supply running 17% below 2009 levels. That trend is expected to continue into year-end.

With the 35% subsidy level of the BAB’s program effectively expiring at the end of the year, there is an expectation that issuers will rush to the market over the last three months to ensure that the significantly lower funding levels from the program are captured. Estimates for taxable issuance over the last three months are between $30 and $40 billion, which would be very constructive for tax-exempt performance going into year-end. The seasonal demand profile for the sector should see measurable improvement from heavier reinvestment flows on December 1st and January 1st.

In regard to BAB issuance beyond 2010, questions related to the extension of the program still exists. There is a measure in both houses of Congress that propose an extension of the program. Both measures call for a declining level of the federal subsidy to 32% in 2011, while the House version also extends the program into 2012 at a further reduced subsidy level of 30%. It appears unlikely that either of these measures will be addressed ahead of the upcoming mid-term elections in November. The more likely scenario is for the Senate version to be passed in the so-called “lame duck” session after the elections. Should the measure fail there, prospects for adoption in early 2011 is possible, but could become a larger question mark, especially if the overall makeup of Congress shifts to the right.

The failure to extend the program or the eventual expiration of the program by 2012, will eventually result in a thinning of the demand profile for the sector, to the point that it resembles the profile that existed prior to the introduction of the BABs program in 2009. Over the period from 2003 to 2008, taxable municipal issuance amounted to an average of just $26 billion per year, which limited investor participation in the sector. A significant drop from the current issuance levels (year-to-date issuance of $93.5 billion as of September 30th) back to pre-BABs levels will inherently result in less investor focus for the sector. Consequently, that should lead to both some increase in overall liquidity risks and pressure spreads for the weakest credits and sectors in the space to widen, especially if negative headlines related to the overall credit profile for the sector continues to be a concern.

To mitigate these risks, our investment approach in the taxable municipal sector will continue to mirror our investment discipline within the tax-exempt sector: We will only invest in the strongest “AA” and “AAA” rated names from the strongest general obligation (GO) and essential service revenue sectors. The state and local governments targeted from the GO sector will not only exhibit the strongest credit metrics, but will also have demonstrated a very constructive political environment to ensure that budget adjustments, either through tax hikes or reductions in expenditures, are made in a very timely manner.

Issuers that display these attributes are more likely to weather any ongoing fiscal challenges and maintain structural balance in a challenging economic environment, thus helping to minimize downgrade risks going forward. Consequently, our high-quality focus should help maintain valuations and mitigate credit risks, and serve our clients well in both the tax-exempt and taxable municipal markets, especially if the economy contracts and moves back into a recessionary environment.

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. 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 drastically underperformed the taxable market during the second quarter.  Although municipal new issue supply has remained very manageable and demand has steadily increased during the latter part of the quarter, building investor apprehension to add new municipal holdings at very low absolute yield levels provided significant enough headwinds to keep municipals from mustering the necessary follow-through to match the dramatic move in Treasury yields, which fell by 90 basis points in 10 years.

Grossed-up municipal yield spreads versus Treasuries for the quarter widened by 44 to 46 basis points from 5 to 10 years and by 69 to 73 basis points from 15 to 20 years.  However, the municipal market has seen a significant turnaround over the last two weeks.  Since the end of June, both the resulting relative attractiveness of municipals and solid seasonal technicals, have provided a significant boost to municipal demand.  This demand should persist for the remainder of the third quarter.

Favorable technicals have been tied to both a significant drop-off in new issuance supply that’s currently running below 2009 by 21% YTD and from strong reinvestment flows of coupons/calls/maturities that should equate to a total of $140 billion for the three month period of June to August.  We are almost two-thirds of the way through that reinvestment cycle, but new issuance is expected to remain below trend through the remainder of the summer and into the early fall.  That should provide municipals with the additional impetus to continue to outperform over the course of the next few months, especially if Treasuries rates move higher and begin to trade outside of their recent trading band of 2.95% to 3.20%.

As of July 12^th, the slope of the municipal yield curve from 10 to 20 years has steepened by 17 basis points since June 1^st, which resulted both from a sharp rally in the 10 year area of the curve and from increased concerns over the future of the Build America Bond program, which prompted some liquidity concerns for longer-term bonds.  The extension of the program, which was once thought to be almost a certainty, is now in jeopardy after the American Jobs and Closing Tax Loopholes Act, which included the Build America Bond extension, was tabled after being repeatedly blocked in the U.S. Senate.  If the program is not extended, we would expect to see even more compelling arguments for issuers to rush to the market with new taxable issuance before the program expires in December, 2010.  The resulting lack of issuance in the tax-exempt market should provide support for longer-term tax-exempt municipals to perform well into year end.  However, after that point, longer-term municipals could see a weakening bias as issuers return to issuing long-term tax-exempt debt.  At this point, finding passable companion legislation in which to include the Build America Bond extension by year-end is a 50/50 proposition, at best.

Overall, municipals at their current tax-adjusted yield levels continue to look attractive 10 years and longer.  The favorable supply/demand backdrop should continue to improve relative valuations to taxables.  If the Build America extension legislation is not passed this year, we will look to opportunistically pare back our longer-term maturity exposure ahead of what could be a challenging liquidity environment during 2011, when issuers return to issuing long-term debt in the tax-exempt space.

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

This information is 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 respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

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.

The tax-exempt market has entered the final stages of the weak technical environment that resulted from the tax-filing season that ends on April 15^th. Supply/demand imbalances have typically developed during this period as investors raise cash in the tax-exempt market to make tax payments, while new issue supply has traditionally been very heavy in March. This year was true to form, as selling flows were heavy over the last three weeks and tax-exempt new issuance for March came in at $26.7 billion ($40.5 billion total municipal issuance), after averaging only $18.5 billion during the first two months of the year.

The weak technical environment, combined with low reinvestment flows from the proceeds of coupons/calls/maturities, resulted in yields rising in maturities from 5 to 10 years by over 27 to 38 basis points (bps) over a two week period from 3-15-10 to 3-31-10.  Municipals also drastically underperformed Treasuries during this period, with tax-adjusted spreads to Treasuries widening by 25 to 36 bps from 3 to 10 years. Anticipating this weaker relative-performance development, we were active crossover sellers of tax-exempts during the first week of March.

Since the end of March, municipals have continued to experience a modestly weaker tone, but the market has stemmed the selling flows and a better relative-valuation profile to Treasuries has started to attract buyers. Additionally, with the demand for Build America taxable municipal bonds surging, solid “AA”-rated credits in the taxable space are trading at spread levels versus Treasuries that are well-through duration-comparable “AA”-rated tax-exempts 10 yrs and longer.

Consequently, the tax-exempt market looks very attractive relative to their taxable counterparts in this maturity range, and a concerted effort should be made for crossover accounts to swap solid “AA”-rated taxable credits for similar credits in tax-exempts. One example of this trade is to sell taxable Dallas Transportation Build America bonds in 30 years at 90 bps spread to the 30 year Treasury in exchange for tax-exempt Dallas Transportation bonds in 21 years at 197 bps tax-adjusted spread to the interpolated Treasury curve. This trade picks up approximately 71 bps in absolute yield and an additional 107 bps on a curve-spread basis.

The outlook for the tax-exempt market continues to look positive over the long-term as a favorable technical backdrop provides for a yield curve flattening bias. The funding levels available for issuing debt in the taxable market using the Build America 35% subsidy remains dramatically lower than what issuers are able to garner from issuing long-term debt in the tax-exempt market. Consequently, taxable issuance will continue to supplant long-term tax-exempt issuance and provide a build in scarcity value for tax-exempt bonds 10 years and longer. With the expiration of the Bush tax cuts after 2010, which will result in the highest tax bracket increasing from 35% to 39.6%, there should also be an increase in demand from the wealthy. This additional demand should provide additional pressure for yields to recede and another compelling reason for longer-term tax-exempts to outperform the taxable market.

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

This information is 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 respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

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.