After a large rate increase early in the month, munis recovered to post positive results in August. Rates were volatile throughout the month, more so in the US Treasury space with munis following directionally. While not impervious to the broader pattern of rate movements, municipals were able to outperform Treasuries as a general stabilization in domestic economic data, coupled with periods of resolve in Europe, pushed US government bond yields to multi-month highs.
Monthly municipal issuance totaled $31.8 billion, a 33.6% increase versus August 2011 and slightly larger than anticipated, but in line with historic averages. As has been the case for some time, refunding volume accounted for a large portion of the supply, representing approximately 40%. Supply continued to be met with strong demand, as illustrated by healthy flows ($6.1 billion for the month) into municipal bond mutual funds. Flows once again were heaviest in long-duration and high-yield funds, evidence of the continued investor search for yield.
Although a favorable month overall, the modest size of the August gain (0.23%) reminds us that July’s solid returns are unsustainable over a long period and that the market is approaching a seasonally unfriendly period in terms of supply/demand patterns. We expect August will mark the final month of net negative supply. If historic precedent holds, September and October will represent a less favorable period for municipal market technicals, with supply outstripping demand.
Munis continued to make headlines, with Barron’s profiling best- and worst-run states and pointing out troubles we’ve been keenly attuned to around large unfunded pension liabilities in Illinois, Connecticut, New Jersey and Hawaii. The article also singled out Puerto Rico, an area we have underweighted for some time. Warren Buffett’s Berkshire Hathaway terminated credit default swaps insuring $8.25 billion in municipal debt, ending a five-year bullish bet on state finances. While this was broadly seen as a response to local bankruptcy risk, it actually appeared to be more of a tactical trade in certain securities.
Notable among states was the Illinois legislature’s failure to take action on its budget problems and pension reform, leading to a one-notch rating downgraded by S&P. Meanwhile, the agency affirmed New York State’s rating of AA and upgraded the outlook from stable to positive based on the state’s movement toward a structurally balanced budget. In Michigan, local officials found an innovative solution to improve Pontiac’s fiscal position. The Caa1-rated city sold its sewer system to Oakland County for $58 million, which enabled the city to eliminate its general fund deficit. Finally, Moody’s announced its intention to review its ratings of California cities due to escalating default risk. Ratings revisions are anticipated within the next two months. We maintain our underweight in local governments, especially California issuers in the Central Valley and Inland Empire.
The S&P Municipal Bond Index returned 0.23% in August and 5.99% year-to-date. Credit spreads (high yield vs. GOs) tightened slightly on the month, but high yield continued to outperform, beating the main index by 55 basis points (bps) for the month and 728 bps year-to-date. We anticipate a pause in the high yield run heading into the upcoming period of seasonal weakness, which is likely to be accompanied by a broader “risk-off” sentiment given the macro uncertainties around US economic and policy issues ahead of the November elections.
We shifted from a long to a neutral duration stance in early September given the market’s strong performance year-to-date and the expected shift in seasonal factors. While assuming a less aggressive duration position, we also intend to take advantage of net positive supply to remain invested. New issues continue to present opportunity to enter the market at attractive levels, particularly relative to the secondary market. We believe an emphasis on income and capital preservation is prudent in the coming months as the market enters a period of greater uncertainty and potentially heightened volatility.