Muni yields have dropped and the yield curve has flattened. Why? One reason is lack of supply.
But why the lack of supply? Supply is commonly defined as new issuance to finance public purpose projects around the country. Issuance itself is subject to a number of factors, not least of which is predictable seasonality. Generally speaking, at the end of the second quarter, issuance tends to intensify as municipalities approach their fiscal year ends, predominantly at the end of June. In July and August, there is a natural lull as people take vacations and the market receives less attention. Finally, in the last quarter of the year, the pace of issuance generally picks up again as bankers seek to book deals before the year ends.
But seasonality really only constitutes "noise" over the underlying supply "signal," and that signal remains weak. Since the global financial crisis and the subsequent recession, municipalities remain wary of increasing their citizens' tax burdens. Property values have been restated, leading to lower tax bases, with some companies relocating while others have gone out of business, resulting in lost jobs. Uncertain revenue streams have prevented expansion of capital programs at many local levels, hence this has resulted in far less supply than one might anticipate given what current low interest rates could support. Demand for munis, by contrast, has remained robust. We entered 2016 coming off the back of two strong years in 2014 and 2015, and investors comfortable with, if not reliant upon, steady income from the muni space. And in the face of persistent uncertainty in both the domestic U.S. and international markets, munis have continued to provide investors with low correlation to other asset classes, and strong credit quality, in addition to positive performance for the past three years according to the Barclays muni bond indices.1
This is clearly illustrated by muni fund flows versus issuance over the past three years, as well as year-to-date 2016.
Municipal Bond Fund Flows
Municipal Bond New Issuances
One way of addressing the supply issue, would be for Congress to launch a national infrastructure financing program akin to the Build America Bond (NYSEARCA:BAB) program launched by President Obama in February 2009 in the wake of the global financial crisis. Such a move would serve not only to provide much needed, and, in some cases vital, infrastructure improvement, but also, through fiscal policy, to take the onus for stimulating growth from the Federal Reserve alone. In addition, while sidestepping any need for municipalities themselves to raise taxes, it could, like BAB, have an immediate effect.
Post Specific Disclosures
1 As measured by the Barclays Municipal Bond Index and the Barclays High-Yield Municipal Bond Index. The Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year. The Barclays High-Yield Municipal Bond Index is considered representative of the broad market for below investment grade, tax-exempt bonds with a maturity of at least one year.
Correlation, in the world of finance, is a statistical measure of how two securities move in relation to each other.
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