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Munis' Strength Provides Eye-Catching Opportunities for Investors

JAN 28, 2014 5:37pm ET
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Municipals have caught the attention of analysts as they outperformed Treasuries and posted their best start to a year since 2009.

A slew of research reports in the last month have touted the opportunities in the tax-exempt asset class, especially in the past week, as interest rates rallied and municipal prices firmed. Analysts credited everything from the return of mutual fund inflows and low volume to U.S. economic concerns and volatility overseas.

Triet M. Nguyen, managing partner at Axios Advisors LLC, said a risk-off trade in the global markets triggered by the deceleration of Chinese economic growth has spilled into municipals.

"Given all the turmoil overseas, is it any wonder investors are rediscovering municipals for their attractive risk-adjusted return characteristics?" he wrote Jan. 24 as triple-A general obligation bonds maturing in 30 years closed at a 3.78% yield, after ending at a 3.90% two days earlier, according to Municipal Market Data.

"Municipal bond yields have come down at a slightly faster pace than U.S. Treasury bond yields, helping to push up bond prices," J.R. Rieger, a vice president of fixed income at Standard & Poor's Dow Jones indices, said in a Jan. 23 report.

Treasuries softened Tuesday, with the 10-year and 30-year yields each ticking up one basis point to 2.77% and 3.69%, respectively. The two-year was unchanged at 0.36%.

In addition, the S&P National AMT-Free Municipal Bond Index tracking investment-grade bonds started 2014 with a positive total return of 2.07%, according to Rieger's data. "The average yield of bonds in the index has fallen by 32 basis points since year-end, outpacing the drop in yield of the 10-year U.S. Treasury bond," he noted.

Nguyen, a 32-year veteran analyst, said improving technical factors are a key driver of the tax-exempt sector's recent outperformance.

"Shrugging off all the volatility on the taxable side, the municipal market has quietly outperformed Treasuries in the final weeks of 2013 and so far into the new year," Nguyen wrote.

On Monday, municipals yielded 103.3% of their Treasury counterparts in 30 years as reported by MMD. That remains higher than the 10-year average of 101.2%, which indicates that "municipal bonds are still relatively cheap from a historical perspective," wrote Dorian Jamison, a municipal analyst at Wells Fargo Advisors.

This can attract demand from nontraditional municipal buyers and helps support municipal bond valuations, Jamison said.

The strength came on the heels of a recent supply shortage and uncertainty about economic recovery that drove yields down last week, capping a three-week rally to start the year.

"The strong start has much to do with favorable technicals, including low supply and traditionally strong January reinvestment," Alan Schankel, managing director of credit research at Janney Montgomery Scott told The Bond Buyer on Tuesday.

Weekly reporting mutual funds recorded a second week of inflows for the week ended Jan. 22, adding $86 million after the prior week's inflows of $103 million ended 33 consecutive weeks of losses, according to Lipper FMI data. The recent inflows and January reinvestment has "provided a select buying opportunity for municipal bond investors who want to put cash to work," Jamison said.

Late 2013 tax selling is another factor in munis' strong start. "It's been many years since we've seen the combination of significant losses in the municipal market and strong gains in equities," he said. "Once the selling pressure diminished, prices had the opportunity to bounce back."

In addition, "the 3.8% Medicare tax and higher top federal bracket make municipal tax exemption more valuable than it has been in many years," Schankel said. "Also, the negative aura of tax reform and related threats to tax exemption seem more remote with Washington gridlock.."

The environment bodes well for cash-laden investors, Jamison said. "The trend toward a steepening yield curve is indicative of a market that expects to see long-term interest rates rise, particularly as the Fed begins tapering its purchases of Treasury securities in earnest," Jamison wrote. The yield curve has flattened 60 basis points to 373 basis points, as of Jan. 17, a six month low, according to Jamison.

Despite the recent strength, the market is also vulnerable to changes in supply, upcoming jobs data and additional Treasury weakness, analysts agreed. "It remains to be seen whether this new-found market strength will hold when real supply returns to the market," Nguyen said.

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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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