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Record Low Yields Help Make 2012 Memorable

DEC 18, 2012 12:45pm ET
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There was volatility, uncertainty, and even turmoil in the municipal market in 2012, but that didn't stop investors from buying up every bond in sight.

Municipal experts said 2012 was a banner year — as both demand and mutual fund inflows were strong and the market hit record levels — particularly in the third quarter — even in the face of much uncertainty about government finances and the market's unease about future tax policy.

"2012 is memorable for the yield slide to the lowest levels in 40 or more years," said a public finance banker at a large New York firm. "That was propelled by Fed policy, moderate supply, and huge rollover demand."

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The intermediate and long end of the curve fell to record lows in late November as the 20-Bond Index of 20-year general obligation yields dipped to 3.29% — the lowest level since Sept. 2, 1965 when it was also 3.29%. The trend has been somewhat reversed in December by a sharp sell-off, driven by heavy supply, profit taking and investor concern about the future of tax exemption for munis.

Despite the backup in yields this month, the 30-year general obligation yield on Monday was at a 2.71%, according to Municipal Market Data — a nosedive from the 3.57% yield achieved on Jan. 3.

Year to date, volume is up over 30%, as total issuance through the first 11 months of the year registered at $343.8 billion among 11,849 issues as of Dec. 1, according to Thomson Reuters.

But that was not enough to satiate the appetite for paper as investors looked for yield.

Robust demand from a broad-based audience helped impact the market significantly as supply for much of the year was unable to match the demand from individuals, U.S. banks, and mutual funds, noted Peter Hayes, managing director and head of the municipal bond group at BlackRock Inc.

"This supply-demand imbalance was supportive of not only a low-rate environment, but was a large proponent in credit-spread tightening," Hayes explained. "Strong and ongoing demand created greater positive returns in addition to the compelling income reward from buying munis."

The relative value of municipals to Treasuries helped boost demand throughout the year and made munis more expensive relative to Treasurys over time. As of Monday, 30-year municipals were yielding 94.4% of the yield of comparable Treasuries, according to MMD.

"While there were many memorable moments that took place in the tax-exempt market this year the one that really changed our strategy was the sensational and consistent demand for municipals throughout the year," Hayes explained.

He cited the more than $50 billion of mutual fund inflows the market has seen so far year to date, and added that the flows, on average, have been greater than $1 billion weekly.

"When you take into account we are coming off of a double-digit performance year in 2011, this is fascinating," Hayes said. Yields were at all-time lows at the end of 2011, and made municipals the year's best performing fixed-rate sector with a 10.7% total return, according to LPL Financial.

"The market underestimated just how much sustainable demand there would be for safe, income-driven assets — given all of the uncertainty 2012 possessed," he continued. "Following such a strong performance year in 2011, this caught many investors who were predicting more muted returns to remain more fully invested throughout the year. We maintained a longer duration bias for a majority of the year than we had envisioned coming into the year."

The fiscal climate overseas was a major driver of the buying opportunity among conservative investors seeking a safe place for cash at a time when fed policy makers were ironing out final revisions to their "QE3" monetary policy and lawmakers were toying with the idea of eliminating municipals' tax exemption, experts said.

"The crisis in Greece, and then in Spain, left bond investors more concerned with the return of capital versus the return on capital," explained Michael Pietronico, chief executive officer at Miller Tabak Asset Management. "The municipal market got swept up in the continued globalization of bond markets as the European fiscal crisis brought waves of buyers into U.S. Treasuries, thus dragging tax-free yields lower too," he continued.

The historically-low rates boosted supply — and created a flood of debt refundings.

Meanwhile, switching from a national scope to the local markets, experts said one of the other memorable events of 2012 involved the shakey financial health of some cities. In California three cities — Mammoth Lakes, San Bernardino and Stockton — filed for bankruptcy in 2012, causing credit concerns to ripple through the market.

However, Nat Singer, managing director of Swap Financial Group, said the enactment in November of Proposition 30 in California helped rectify some of the state's financial woes, and demonstrated the dramatic differences between municipal and corporate credits — the ability, and willingness, to raise taxes if and when necessary.

"While the outcome may have been aided by some expert political strategy, in the end a majority of the constituents in California voted to increase taxes to get the State's fiscal house in order," Singer said. "Combine this with the pension reform in Wisconsin and the potential reform in Rhode Island, and the case for municipal credits being inherently stronger than similarly-rated corporate credits became solidified," he explained.

Coming tomorrow: As the market prepares to ring in the New Year, municipal experts say they have mostly positive expectations when it comes to interest rates, credit quality, investor demand, and the viability of municipals' tax-exemption in 2013.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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