Demand for municipal bonds is forecast to be just as robust, if not stronger, in the third quarter.
"The quest for yield is tremendous," Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management, told The Bond Buyer on Friday. "There's so much pent-up demand – it's a real food fight."
A quest for safety and after-tax returns that are attractive compared with riskier alternatives continues to draw investors to the municipal market, as demonstrated by 40 consecutive weeks of positive flows into municipal bond mutual funds.
"We have just experienced a couple of significant events as the second quarter came to an end, which had an impact on the market," Jim Colby, senior municipal strategist at Van Eck Global said in an interview on Friday.
He cited the British vote to leave the European Union as well as the municipal market's stellar performance for the first half of 2016. "On the heels of all that we would expect to see demand to continue to be modest, if not stronger in the third quarter," Colby said.
Weekly reporting municipal funds saw $737.996 million of inflows in the week ended July 6, after inflows of $716.009 million in the previous week, according to data released by Lipper FMI on Friday.
Alan Schankel, municipal strategist at Janney Capital Markets, said the latest flows are a "big difference" and "nice change" from the net outflows the market experienced last year. At the time, flows were negative for the 12 weeks leading up to July 23, according to Lipper. The weekly reporting funds attracted $125.410 million of inflows in the week ended July 22, 2015 – the first time in a three-month span – on the heels of $29.255 million outflows in the previous week, the data showed.
With such strong and consistent flows into municipal bond mutual funds lately, the experts said investors are intent on avoiding the uncertainty and volatility of other fixed-income, taxable, and riskier assets by favoring municipal products – even with muni yields near record lows.
On Friday, the triple-A general obligation bonds due in 2046 were yielding 1.95%, according to Municipal Market Data.
As yields drop, investors will pay more attention to the relative value proposition that municipals offer as opposed to the nominal and absolute yields, Colby said.
"The push and pull in terms of investors continuing to find munis attractive at low levels is counter-balanced by the notion of the comparable taxable equivalent yields – and municipals still offer opportunities," Colby said.
For instance, a 10-year, triple-A rated municipal bond yielding 1.31% has a taxable equivalent yield of 2.17%, while the 30-year triple-A bond at 1.95% has a taxable equivalent yield of 3.23%, according to MMD as of July 7 data.
"Demand is going to continue mainly because the alternatives aren't as attractive as munis and global yields will stay muted," Heckman said.
Bill Walsh, president of Parsippany, N.J.-based broker-dealer and wealth manager Hennion & Walsh, said retail demand in the muni market has been "pretty extraordinary" this year. Investors "favor high quality bonds and can get a better yield after taxes and it gives them a place to invest that is not volatile," he said in an interview on Friday.
Walsh's said his clients are shopping around for various maturities, but largely prefer the 15 to 20-year slope where they are getting the best value due to a flat yield curve. Triple-A bonds due in 2031 and 2036 were yielding 1.59% and 1.82% as of Friday, according to MMD.
On a taxable-equivalent basis, for instance, the 2036 maturity offers 94.7% of the Treasury yield, and an after-tax yield of 3.01%.
Analysts expect those factors to keep demand healthy in the third quarter.
"The hunt for yield in the tax-exempt market is a big deal, and with all the low-yielding investments available, municipals stand out to higher bracket investors" for their after-tax returns, Schankel of Janney said Friday.
Investors, he said, are enticed by the idea of getting "more bang for their buck" on municipal investments, at a time when they are frustrated with absolute yields of between zero and 2% on other investments.
Heckman said he recommends a "sweet spot" between 12 and 15 years as having the most value for his clients.
"Buying coupons from 2.5% to 4% are probably the most attractive here, although we like to see some higher coupons with some cushion if the bonds don't get called, so we are getting compensated for that duration," Heckman said.
Current demand has been strong enough to outweigh near-historic low yields, Brexit concerns, Puerto Rico's defaults, and fiscal turmoil in Chicago and Illinois, Colby pointed out.
Those circumstances shouldn't dampen investor interest going into the third quarter, according to Colby.
"We will continue to have cash come to the market place in the form of coupon payments, maturities, and calls – and also refundings," he said.
Colby said issuance from states like New York in the second half of the year "certainly will keep interest piqued from investors." New York State has plans to issue $6.5 billion over the coming three months, up from $1.65 billion in the third quarter of 2015.
Amid volatility in interest-rates, equities and overseas markets, municipals are expected to remain a safe-haven for investors and offer comparable yield incentives at a time when demand is already seasonally high.
"We see demand being strong for the next couple of months, especially with July and August being decent coupon reinvestment months," Walsh said. "Individual investors are still uneasy with the equity market."
Uncertainty leads to volatility, Walsh said. "That's what's causing people to continue to put money into the tax-free market at such a strong clip," he said. "They see their [stock] portfolios haven't done that well," yet the 2% to 2.5% taxable-equivalent yields on high-quality municipals that his firm's investors prefer are relatively attractive.
"Even though the stock market is on the cusp of making new highs, it's stuck in a trading range," Heckman of U.S. Bank added. "People who don't want to have money in stocks will continue to want to be in bonds."
He said demand will also continue to flourish against the backdrop of increasing forward supply, with low interest rates sparking new issue and refunding volume. The Federal Reserve Board seems to be in no rush to hike rates until later in the year, Heckman added.
Though Friday's stronger-than-expected jobs report showed that U.S. employers added 287,000 to non-farm payrolls – the most since last October – Heckman predicted the Fed still may wait until September to hike rates.
"We just got through two quarters where demand continued to be very, very strong," Colby of Van Eck said. "I'd be hard pressed to argue that equation is going to change significantly in the next quarter. It's very likely demand will continue to hold our market to low rates and pretty strong performance through the next few months."
