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By Rom Badilla, CFA

Several months ago, we covered that municipal bond supply emanating from new projects has remained low from a historical perspective which has been driven by resistance on a state and local level in starting new projects. This trend should continue as politicians are reluctant to spend in a budget-constrained environment.

While this trend should continue for new money, refunding issuance should be robust for the final months of 2012. This mad rush to acquire funding is fueled by the low interest rate environment and the uncertainty surrounding the Fiscal Cliff scheduled for the onset of 2013. According to RBC Capital Markets Head of U.S. Municipal Strategy, Chris Mauro, the markets could see healthy doses of supply which is a reversal from the quiet summer. In their latest U.S. Municipal Notes, he wrote the following:

Assuming what we believe is an attainable run rate of $8 billion/week in 10 of the remaining 13 weeks of the year (those weeks that will not be affected by the major holidays), the fourth quarter should see $80-$90 billion of supply brought to the market. We note that this volume would be consistent with historical averages.

With this supply, issuance in the fourth quarter should be focused on the intermediate part of the yield curve if recent trends continue. This in turn should translate to outperformance for holders of longer-dated municipal bonds as yields fall relative to the rest of the curve.

Through August, 57.6% of 2012 issuance has been concentrated in the 0-20 year maturity range. From 2006-2010, issuance in maturities 20 years and shorter accounted for just 43.1% of total volume. Furthermore, issuance in the long end of the curve (26 years and out) has comprised just 28.6% of issuance through August, as opposed to the 42.9% it accounted for from 2006 to 2010. This drop off in supply of longer dated issuance, along with strong investor demand for yield, has been a major contributor to the flattening of the yield curve this year. Since the beginning of the year, the Municipal Market Data AAA 10-year yield has fallen 17 basis points while 30 year yield has fallen 69. Continued tepid issuance of longer-dated maturities should extend this trend and provide technical support to this segment of the market through year-end.

Source: Limited Supply May Drive Gains For Long Dated Municipal Bond Holders