As we head into this short week after the holiday, there are a couple main themes I think investors should be paying attention to. First, US equity investors are starting to look a bit complacent, providing the opportunity to take advantage of low implied volatility. Second, the recent changes in municipal bond flows suggest some stabilization in that market.
Early last week, the VIX Index (which measures implied volatility on the US large cap S&P 500 Index) reached its lowest level in 9 months. When the VIX is low, it suggests that investors don’t expect much in the way of future volatility – in other words investors are fairly complacent about downside risk.
Historically at about 20, implied volatility in the US traded between 15 and 16 last week. This seems unusually low. While the market is clearly on the mend and valuations still look reasonable, it’s hard to justify below average volatility when you consider all the headwinds still facing equity markets – sovereign debt issues, high US unemployment, a fragile consumer sector, and potential unrest in the Middle East. In particular, when you look at the factors that typically drive market expectations of volatility – credit and economic conditions – you would expect the VIX to be trading around 20 to 25 rather than 15 to 20.
Second topic – back in mid-November we made the call that municipal bond yields were starting to look attractive, even though supply issues were likely to keep pressure on munis over the near term. Since then, municipals sold off sharply in December and January but appear to be stabilizing. First, yields on general obligation municipals are now at a significant premium to taxable Treasuries. Second, supply is coming down from the heightened levels we witnessed back in the fall. And finally, flows out of the sector appear to be bottoming out.
While municipal bond mutual funds just experienced a 14th straight week of outflows, we’re starting to see positive flows into the iShares S&P National AMT-Free Municipal Bond Fund (NYSEARCA:MUB), suggesting that the ETF market may be leading on the recognition of value. For long-term investors looking for yield, the US municipal market now looks to be offering good value. In terms of implementation, given our expectations for rising yields, we would favor a short muni strategy, such as the iShares S&P Short Term National AMT-Free Municipal Bond Fund (NYSEARCA:SUB), to help minimize duration risk.
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