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Municipals Keep on Marching

When asked whether municipal bonds can continue their record-setting ways, one of the most common refrains from market participants is: "why not?"

The combination of a protracted period of paltry benchmark interest rates, elevated aversion to risk, and the absence of even a whiff of inflation can continue to support municipal bonds at historic levels in what is already a remarkable summer for state and local government debt, many market participants say.

Muni bonds have set a new record for lowest yield 10 times this month, based on Municipal Market Data's benchmark triple-A 10-year municipal scale. The 10-year closed Thursday at a yield of 2.3%, which is 27 basis points stronger than the record that existed in 2009. The average price for a municipal bond has climbed 2.6% since the summer solstice, according to the S&P AMT-Free National Municipal Bond Index.

Neil Klein, who manages private accounts at Carrett Asset Management, said demand for munis has heightened due to the eroding appetite for risk among investors worn down by a volatile stock market.

"You've seen a significant flight to quality, and that's where a big part of the demand for municipal bonds has come from: the flight to quality out of riskier asset classes," Klein said.

In short, its been a long time since the municipal bond market had a bad day.

Municipals have not sold off by more than a basis point since mid-June, according to the MMD 10-year triple-A scale. And experts see little fuel for a correction, despite the scorching pace of falling yields. Many market participants say the dynamics that led to these record low yields show no signs of changing, and there is no obvious impediment on the horizon.

"The feeling is that it's going to continue," a municipal trader on the West Coast said. "Just when you think [the rally] has run its course, out comes another trade."

Minuscule Treasury rates are the primary factor supporting rates at such low levels. Sickly risk appetites and nonexistent inflation have yanked Treasury rates inexorably downward. The two-year Treasury yield has collapsed to less than 0.5% from 1% at the end of April. Ten-year Treasury yields have plunged more than a percentage point in that time, to 2.63%.

Munis have historically moved in tandem with Treasuries, and low risk-free rates provide an anchor for municipal rates where they are. As a relatively safe asset class, investors have traditionally demanded a return on municipal bonds at a fairly stable relation to the return on Treasuries.

While the Treasury market may be supporting municipal bonds generally, many market participants say the rally in munis has been further bolstered by an imbalance between supply and demand.

"Technical factors supporting the municipal market remain firmly in place," John Dillon, municipal strategist at Morgan Stanley Smith Barney, wrote in a report this week.

The West Coast trader said both sides of the supply-demand equation argue for continuing strength.

Demand for munis remains robust. Investors entrusted $19 billion to municipal bond mutual funds in the first half of the year, according to the Investment Company Institute, after flooding the industry with a record $69 billion of new money in 2009.

Flows have picked up again in the last few weeks, ICI data shows, with more than $1.2 billion in net inflows in each of the first two weeks of August.

Mutual funds now manage $514.85 billion in municipals, according to Lipper FMI, which represents 18.2% of the $2.8 trillion in state and local government debt outstanding.

Investors looking for safe places to store their money have little opportunity to earn much return in the current environment. The average yield on a tax-free money market fund is just 0.03%, according to iMoneyNet. A savings account at a bank yields less than 1% on average, according to Bankrate.com.

Since other safe instruments also carry low yields, municipals remain competitive even with rates where they are, said Todd Curtis, who manages a $326 million Arizona mutual fund for the Aquila Group of Funds.

"If you look at them as a safe asset class within your portfolio, they're really a steal," Curtis said. "Versus anything else you could buy, from a money market fund to a Treasury note, they're still attractive."

The consistent demand for municipals has been met with a shrinking supply of new bonds.

On the surface, supply does not seem to have changed. State and local governments floated $238.45 billion in debt this year through Aug. 13, according to Bloomberg LP — if anything an increase from recent years. However, the composition of the debt has shifted as taxable Build America Bonds have poured into the municipal bond market.

For decades, the muni industry revolved almost exclusively around bonds with tax-free interest payments. Mutual funds, account managers, and profitable insurance companies grew accustomed to a steady stream of municipal debt exempt from taxes.

From 2004 to 2008, municipalities issued nearly $2 trillion of debt, of which less than 7% was taxable.

That changed last year when the federal government enacted the American Recovery and Reinvestment Act, which authorized municipalities to sell a type of subsidized taxable debt known as Build America Bonds.

Municipalities have sold $128.36 billion of BABs since the program kicked off in April 2009.

The program's success has channeled a growing portion of municipal borrowing into the taxable market. Based on Bloomberg data, a third of municipal borrowing this year has been through taxable bonds.

Conversely, the supply of new tax-exempt bonds has shriveled. The $160.75 billion in tax-exempt paper municipalities sold during the first 32 full weeks of this year is the lowest total for that time period since 2006. It represents a decline of 16% from last year, and nearly 29% since the peak of issuance in 2007.

"The taxable to tax-free mix has changed dramatically," Alan Schankel, managing director at Janney Montgomery Scott, wrote in a report this week. "The net result [is] fewer new tax-free issues, with volume of new tax-frees for 2010 expected to be the lowest in 10 years."

Municipalities are selling an average of about $5 billion in tax-exempt bonds a week this year, compared with $6.5 billion in 2007.

Support from the Treasury market, rampant demand, and weak tax-free supply have brought a mallet down on muni yields. The triple-A 10-year has strengthened 27 basis points in August alone.

It is hard to imagine anyone is happy about nominal yields at these levels, said Gary Gildersleeve, a portfolio manager at Evercore Wealth Management.

Still, with BABs siphoning supply from the tax-exempt market and mutual funds continuing to garner new cash and putting it to work, it is difficult to foresee when the scenario will reverse, he said.

"It's possible to see low rates be sustained for a while," Gildersleeve said.

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