Third Quarter 2009 Tax-Exempt Muni Bond Market Review
October 15, 2009
Author(s):
Third Quarter 2009 Fixed Income Sector Returns (Pre-Tax)*
Third Quarter 2009 Fixed Income Return Per Unit of Duration*
*as of 9/30/09. Source: Barclays Capital.
The municipal bond market continued to benefit from limited new tax-exempt issuance and strong demand throughout the third quarter. This supply/ demand imbalance has driven municipal yields to historic low levels. Tax-exempt issuance declined as a result of municipalities’ ability to tap the taxable investor through the Build America Bond Program, with almost 20% of year-to-date issuance coming as taxable municipal debt. These Build America Bonds have been well received by the investor community and have given municipalities another means of financing. This program is currently slated to expire at the end of 2010, but discussions of extending this program are underway. Demand for municipal bonds has been fueled by the perception that Federal income tax rates will likely increase in the coming years and the relative safety that municipal credits offer. As tax-exempt supply slowed and demand increased, the search for more yield by traditional investors ensued. Many investors extended the duration of their holdings or pursued lower rated securities in search of higher yields. As a result, the municipal yield curve flattened and credit spreads narrowed.
Despite increased confidence in lower rated credits by some investors, we believe that municipalities will continue to struggle to balance budgets in the coming year as tax receipts historically lag an economic recovery. Credit spreads have narrowed at the same time overall municipal interest rates have declined. The increased demand for more yield created significant returns for lower quality bonds with the Barclays Capital U.S. Municipal Bond Index showing BBB bonds outperforming AAA bonds by more than 750 bps during the third quarter. The municipal market, while facing some difficult economic times, is still a sector where the majority of issuance is higher quality. During periods when investors reach for higher yields, the demand for the limited supply of lower quality bonds generally results in outperformance by lower rated issues. While defaults in the municipal market are rare, the number of downgrades has risen significantly by the rating agencies. We continue to favor the longer term benefit of owning higher quality municipals in a laddered portfolio, not only for capital preservation but also for the tax efficiency that this strategy offers.
Past performance is no guarantee of future results. Indices are gross of fees and are not available for direct investment. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
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