1st Quarter 2011 Municipal Bond Highlights
• Short maturity yields are low
• Long end yields have corrected
• Yield curve is historically steep
• Credit spreads are attractive
Municipal bonds suffered a decline in price after an apocalyptic prognostication from layman during the 4th quarter of 2010. Suggestions that the municipal market faced defaults in excess of $100 billion resulted in a wholesale exodus from the sector. As we mentioned in our last municipal market piece in January, this flight from the sector resulted in a good buying opportunity. As the headlines subsided during 2011, municipal bonds managed to outperform US Treasuries for the 1st quarter.
The yield to maturity on AAA rated bonds in 5 years was essentially unchanged, while the yield to maturity on both 2 year and 30 year AAA municipal bonds fell during the quarter. In contrast to the investment grade corporate market, municipal credit spreads did move wider during the period with AA rated 10 year spreads reaching 27bps from 20bps and 20 year BBB rated spreads pushing out to 170bps from 150bps. The widening in spreads reflected continued selling of lower rated credits as mutual fund liquidations persisted throughout the period.
Overall, the Barclay’s Municipal Bond index (average maturity of 13.5 years) returned 0.51% for the quarter compared to 0.42% for the Aggregate Bond index. The five- and ten-year Municipal index (more comparable to the Aggregate Index) returned 0.61% and 0.76%, respectively.
The selling pressure, a result of heightened headline risk and fear of rising interest rates, coincided with a sharp decline in municipal new issue supply. Borrowers, who issued a lot of bonds in the fourth quarter of 2010 (ahead of expiring BAB program), stayed on the sidelines during the first quarter of 2011. Fiscal deficits, curtailed infrastructure programs and unease in the market place forced issuers to delay or postpone bond offerings. As the quarter progressed, the decline in new supply helped to support bond prices, despite an improving economy and a divided Federal Reserve.
With fears of higher long term rates, market participants appear to be focusing buying in the 1 to 5 year maturity range, in an effort to earn a small amount of income without taking too much interest rate risk. The buying is focused on AA and AAA rated paper, leaving little liquidity for longer dated, lower rated credits.
We view this as an opportunity to make further enhancements to an intermediate municipal portfolio. Given our views on a strengthening economy and an overly aggressive monetary policy stance, we view interest rates, particularly on the short end, to be too low. State and local revenues continued to increase during the fourth quarter of 2010 as reported by the US Census Bureau.
Revenues have been estimated to have increased further during the 1st quarter of 2011, helping to repair the damaged caused by the recession. The over exaggerated spike in municipal defaults, pontificated by non-market participants in 2010 has yet to materialize.
With this in mind we have been adding to lower rated investment grade municipal bonds, in an effort to increase income as an improving economy helps rebuild municipal budgets from the revenue side. The progress, although with still much further to go, on the expenditure side is also encouraging.
Given our views that short term interest rates are too low, we have been incrementally implementing a barbell maturity structure, buying 20 year maturities and floating rate notes, while selling short and intermediate maturities. We continue to maintain a shorter duration position than the 5 year Barclay’s Municipal Index.