How To Interpret January Effect And Munis

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Given the passing of 2016 and the advent of a new year, it's time to take a closer look at an enduring, albeit inconsistent, market phenomenon, the "January Effect," and what it may mean for municipal bonds in particular at the start of 2017.

What is the January Effect?

The January Effect is a rise in asset prices often (but not always) observed throughout the month of January. There are a number of theories as to why this happens. A leading hypothesis is that many investors, eager to offset capital gains taxes, engage in tax-loss harvesting at the end of the fiscal year. This can depress asset prices. At the start of the new year, these investors then re-establish positions in the market, pushing up asset prices once again.

As seen in the chart below, in eight out of the last 10 calendar years, both high yield and investment grade municipal bonds have posted positive returns in the month of January.

Municipal Bond Performance: A Look at the "January Effect"
January Month Total Returns 2007-2016

Source: Bloomberg Barclays. Data as of 12/31/16. Index definitions below. Past performance is no guarantee of future results.

The big question now is: Are muni bonds going to experience the January Effect this year? We think so given what we believe is a unique environment.

2017: A Unique Supply and Demand Dynamic in Muni Bonds

Fixed income suffered a bit of a reversal in fortunes after the surprise results of the 2016 U.S. presidential election. Having recorded steady gains throughout the year, by the end of November, much of these gains had been erased by continuing uncertainty regarding the president-elect's tax and spending plans as well as the U.S. Federal Reserve's decision to raise the Federal funds' rate 0.25% on December 14. However, the resulting precipitous drop in fixed income also served as a tax-loss harvesting opportunity not seen in municipals since 2013.

Add to that the roughly $46 billion worth of calls and maturing bonds that came due at year-end, and there is a tremendous amount of cash (demand) that will need to be redeployed into fixed income this month. Even if half of this cash finds its way back into muni bonds, demand will almost certainly outstrip the current supply expected.

The Outlook for January

Opportunistic tax-loss selling, $46 billion in maturities and coupon payments, and constrained supplies in municipal bonds all point to one thing: the January Effect may be a "slam dunk." This is, perhaps, not all that surprising. As we have seen above, the January Effect for munis has been fairly common.

In this year's case, tax-loss selling at the end of 2016 will likely augment the imbalance in supply and demand. Investors who have taken advantage of tax-loss selling opportunities at the end of 2016 in our view will need to re-establish new positions with limited supply. This could push asset prices higher: a textbook January Effect.

The Bottom Line

This year's potential January Effect, manifested in a rise in asset prices, could look more pronounced than usual - thanks to a confluence of various factors, most notably investors' need to redeploy an unusually large amount of cash, augmented at the end of 2016 from opportunistic tax-loss selling. The Fed's decision to raise rates also contributed to this tax-loss selling.

We will, however, have to wait for several weeks to see what happens.

1The Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the investment grade tax-exempt bond market. The Bloomberg Barclays High Yield Municipal Bond Index is a rules-based, market-value-weighted index engineered for the below investment grade tax-exempt bond market.

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