The Technical Case For Continuing To Love Municipal Bonds

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Includes: BTA, EVLMC, FPT, GMMB, ITM, ITML, ITMS, MEAR, MLN, MUI, MUNI, NBH, NID, SBI, SHM, SMB, SMMU, SUB, VKMMX
by: Andres Capital Management

Summary

Despite the low interest rate environment, State and Local governments are reluctant to borrow for new money purposes.

Demand continues to grow for tax-exempt municipal securities as supply shrinks creating enhanced value for investors.

Europeans and a host of Japanese, Chinese and others have discovered a sovereign market (The United States Municipal Bond Market) almost as highly regarded as US Treasuries.

There’s also a perfect storm of technicals to support the municipal investor.

Despite the low interest rate environment, State and Local governments are reluctant to borrow for new money purposes. Revenue flows into their coffers are at best growing anemically, and most are grappling with pension fund liability issues. Municipalities, faced with a broad array of spending pressures have opted to maintain budgetary discipline and borrow less in the face of revenue uncertainties. Municipal investors are the beneficiaries of reduced new issue volume and a series of unique technical factors that are driving value in the municipal market.

Let’s look at these technical factors in some detail

Demand continues to grow for tax-exempt municipal securities as supply shrinks creating enhanced value for investors.

Municipalities have over the last few years taken advantage of market levels by swapping/refunding their high coupon debt for low coupon current market debt. This refunding phenomenon has basically run its course and contributed to the decline in new issue supply. Much of the refundings that took place were issued with 5.0% coupons, driving tremendous cash flow into investors' hands. This occurred as professional investors insisted on larger coupons in compensation for the early retirement of their holdings.

Huge cash flows and deal volume that is declining by approximately 15% and you have a situation where there is simply “too much money chasing too few securities.” The estimated differential between new issues scheduled and cash flow from retiring and maturing debt plus coupon payments just in June is more than $30 Billion.

Europeans and a host of Japanese, Chinese and others have discovered a sovereign market (The United States Municipal Bond Market) almost as highly regarded as US Treasuries, and almost comparable in yields when compared to their own sovereign notes. The demand from foreign entities has been unprecedented. One suspects that so long as the European and Asian governments’ borrowing rates are so low, some of these flows will continue unabated.

Federal Reserve activity will also play a role, at least indirectly, and when they raise short-term rates, it shrinks the pool even further. Most market participants called for lower volume this year, primarily for two reasons. First, they didn’t believe rates would stay this low in 2017, and second, they knew the low hanging fruit of potential refundings has been mostly picked. So far, they’ve been right. Volume is down 10% through May and in June, it will only be 72% of last June’s number this year ($37.8 billion vs. $52.6 billion last year)

Here at Andres Capital, we don’t see any empirical evidence to suggest inflation will be a threat to bond investing in 2017. We are in the late stages of the business cycle, the Fed is tightening for non-economic reasons, equity valuations are vulnerable, economic growth data indicates fatigue and geo-political instability abounds. We believe the 30-year bull market in bonds is alive and well.

As far as municipals are concerned, there’s also a perfect storm of technicals to support the municipal investor. The curve is compressed at 179 basis points front to back for AAA bonds and 198 for AA names. In keeping with our conviction that you’re still not being paid to buy the longest duration, nevertheless, this compression and flattening forces us out the curve to 19 years from our previous target of 17 years.

The AAA and AA curves are also at their cheapest versus the treasury curve in that maturity range. We still insist on 5% coupons and at least 5 or more years of call protection. We favor AA and A-rated essential services revenue bonds with 5.0% coupons and at least 5 years or more of call protection.

Year

US Treasuries

Yield

Municipal

AAA

Municipal

AA

AAA as a percent of UST

AA as a percent of UST

2

1.32

0.91

0.96

68.9

72.7

5

1.70

1.22

1.32

71.8

77.7

10

2.12

1.86

2.06

87.7

97.2

15

2.28

2.32

2.56

101.8

112.3

20

2.48

2.58

2.81

104.0

113.3

30

2.77

2.71

2.96

97.5

106.8

Treasury quotes courtesy of Bloomberg. Municipal quotes courtesy of Thomson Reuters TM3.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Our clients own high-grade Municipals