The seasonal "January Effect" may be compounding the supply challenges facing municipal investors after the tax overhaul prompted issuers to accelerate deals at the end of 2017.
Some municipal experts are saying the January Effect is more acute than in previous years. This year, approximately $22 billion in principal redemptions is expected to be returned to investors this month, up from $18.4 billion in January 2017, according to data compiled by Bank of America Merrill Lynch.
The so-called January Effect is typically characterized by a period of rising municipal prices when heightened demand occurs amid a supply shortage in the early weeks of a new year.
Some municipal investors – especially those that still have Jan. 1 and Jan. 15 calls and redemptions to contend with – are finding themselves in an especially precarious position this year.
Peter Delahunt, the managing director of municipals at Raymond James & Associates, said the “January Effect” typically results from a supply/demand imbalance that occurs while the new issue supply ebbs at the beginning of the year when demand is expected to pick up due to the influx of monies from the Jan. 1 and Jan. 15 principal and interest redemptions being rolled-over.
“Much of the record volume in December pulled back the potential supply for January, which led to an anticipated super January Effect,” Delahunt explained.
That scenario is more dramatic this year thanks to the tax law changes that prompted the premature arrival of a record $62.5 billion of volume back in December.
“That should keep typically-low January supply even lower creating scarcity value for bonds at a time where many investors are looking to reinvest coupon interest and proceeds,” Jeff MacDonald, head of fixed income strategies at Fiduciary Trust, said last week.
“While January is typically a heavy month for coupons and maturities, this year is expected to be a record when it comes to total coupon payments, calls and maturities,” he added. The “large return of capital to muni investors will exacerbate the supply/demand dynamic typical of the traditionally observed ‘January Effect.’
However, experts differ on their definition of the seasonal phenomenon – and disagree over its timing, intensity, and overall existence in this year’s market.
“Depending on who you ask, the definition of the January Effect in the municipal market varies,” said Christopher Brigati, managing director and head of municipal trading at Advisors Asset Management.
He associates the phenomenon with both the seasonal cash available to investors as a result of January 1 coupon payments, call redemptions and maturities, along with the resulting buying activity that creates a rally.
“Prior to the end of 2017, the January Effect for the new year was expected to be quite significant and arguably much more pronounced than in recent history,” Brigati said.
But since the relevant portion of the supply anticipated for January 2018 issuance was accelerated forward due to the threat of tax law changes, he said the January Effect has not materialized to the degree the market anticipated.
“There is a possibility that the January Effect is only delayed, not dismissed, with the bounty of redemption cash seeking a home in 2018,” Brigati said. “Retail investors have not yet been aggressive buyers of the market, perhaps with the expectation that higher yields are on the horizon.”
As of Jan. 17, the generic, triple-A general obligation scale in 30 years yielded 2.69%, according to the data tracker Municipal Market Data. The same benchmark yielded 2.88% exactly a year earlier on Jan. 17, 2017.
“We think the net result of the limited January Effect on the municipal market will be positive,” Brigati said. “Essentially, we believe it will provide a better entry point for buyers of bonds early in 2018 on a relative basis versus U.S. Treasury yields.”
The ratios of municipals to Treasuries as of Jan. 17 was 81.7% in 10 years and 94.6% in 30 years, according to MMD.
While it’s true that municipal new issuance took a breather in the beginning of this month, volume is still “striking” after December’s “monster” $62 billion calendar, Peter Block, managing director of credit research at Ramirez & Co. said in a weekly municipal strategy report on Jan. 8.
“The municipal January Effect is again operative – despite the current 30-day visible supply of negative $10 billion,” Block wrote in the report. “We expect gross supply in January to ramp up, but come in lower than the average $26 billion monthly derived from our $317 billion total gross issuance projection.”
Supply-hungry investors have been left with extremely low volume since the start of the New Year and are expected to face slim pickings for most of the first quarter and beyond, the experts said.
“With $60 billion-plus for December it's gone from feast to famine,” said John Mousseau, director of fixed income at Cumberland Advisors who described the seasonal January Effect as “exacerbated.”
MacDonald expected it to be more “acute” than usual.
Others said the market experiences the January Effect ahead of the New Year, after year-end tax-loss selling, which aids the seasonal imbalance in supply and demand ahead of the typical January supply drought. Investors who reap the tax loss opportunities look to replace those positions in January when Jan. 1 and Jan. 15 calls and redemptions lead to pent up demand for paper at a time of limited supply.
George Friedlander, managing partner at Court Street Group Research LLC, is among those who say the January Effect occurs in December, but agreed it was “extreme” and likely led to “very slow issuance” during the first quarter.
In his “Marketing and Financing Outlook for 2018,” Friedlander said he expects a sharp decline in new-issue supply relative to the approximately $436 billion in 2017.
“Total supply in 2018 could easily drop 25% to the $320 billion range as issuers who rushed to market move to the sidelines, and refundings drop by close to $100 billion” he wrote.
Though they differ on the actual timing of the so-called January Effect, experts said the extreme supply scarcity expected in 2018 will make for strong technicals and outperformance in the municipal market later this year.
“The most meaningful factor driving technicals in the market this year is the recently passed tax reform legislation,” MacDonald of Fiduciary said.
“In the long run, the limited supply of new issue paper in 2018 will start to drive the buying patterns and basic economic theory tells us that, all things being equal, lower supply relative to demand drives prices higher,” Brigati said. “Even if overall interest rates rise, we think municipal performance in 2018 should outpace that of U.S. Treasury debt.”
On the heels of the heightened volatility in December over the impending tax bills and record monthly issuance, Mark Paris, head of municipals at Invesco, said he expects volume in 2018 to be significantly lower than in recent years.
Paris expects municipals to outperform other fixed income sectors going into the first half of 2018.
“We believe that the 2018 technical picture will prove to be a positive for the municipal market as the elimination of advance refundings and the high fourth quarter issuance of 2017 should significantly reduce overall 2018 new-issue supply,” Paris said in an interview on Jan. 12. “This should lead to strong technicals in the muni market, steady if not tighter ratios, and, in general, more dollars chasing fewer bonds.”
“Market technicals are lining up constructively for January and should ultimately be price-supportive as strong reinvestment against lower supply kicks in,” Block of Ramirez said in his report.
“For the time being we are cautious on the market, concerned about still-low absolute rates, tight credit spreads, and compressed ratios,” with the 5-year at 73% of the Treasury counterpart, Block added.
Some municipal strategists said these circumstances could lead to potential negative consequences following seasonal phenomena, like the January Effect.
“Retail hears the expert talking heads, such as Bill Gross and Warren Buffet, who are warning of higher rates and advocating for smart investors to buy stocks,” Delahunt of Raymond James said. “Equity markets are continuing to make new record highs, drawing more attention,” at a time when the Fed plans to raise rates, affirming investors’ fears, he added.
As a result, Delahunt said, some retail account managers may choose not to roll their principal and interest redemptions back into munis in the backdrop of the allure of the equity market.
Overall, the result of the impact of the January Effect and January reinvestment season on the municipal market will be noticeable but manageable throughout the remaining 11 months of 2018, the experts said.
“The negative effect on tax exempt bond sales is likely to carry over into 2018 as the termination of the advanced refunding concept constituted a substantial share of annual municipal supply,” Richard Ciccarone, president and chief executive officer of Merritt Research Services LLC, said last week.
Ciccarone noted that after the major 1986 tax reform act became effective, a similar slump in issuance occurred during the first quarter of 1986. “Gradually, as both borrowers and investment bankers adjusted to the new rules and new opportunities, the market eventually moved on to new supply records in subsequent years,” he said.
“Both issuers and investors have begun to adjust to the new environment and will likely continue to do so as we move throughout 2018,” MacDonald of Fiduciary added.