Thalia H. Meehan, CFA, and Paul M. Drury, CFA

Tightening supply lifts muni market

Thalia H. Meehan, CFA, and Paul M. Drury, CFA , Portfolio Managers, 12/16/2014

Shifting priorities for state and local municipalities is limiting new issuance in the municipal bond market, and supply has not kept pace with a rising demand.

Municipal bond issuance is down nearly 10% year-to-date through September 2014 compared with the same period in 2013.* The decline in the volume of new bonds is attributed to decisions by state and local governments to take on fewer projects and turn their fiscal attention toward funding employee pensions and other fixed costs in their budgets.

Municipal bond issuance

Sources of demand are shifting Meanwhile, demand from traditional tax-sensitive retail investors has been solid. Also, new crossover buyers and hedge fund investors have been drawn to the competitive yields and relative value offered by municipal bonds. These sources of demand have driven positive inflows to tax-free mutual funds, primarily tax-free high-yield and intermediate-term bond funds.

With interest rates low and fundamental credit quality improving, investors have also sought out the yields offered by riskier municipal bonds further out on the maturity spectrum, as well as those in the lower-rated, higher-yielding sectors.

Credit outlook is positive The fundamental credit outlook for municipal bonds remains favorable, in our view. In 2013, bankruptcy filings represented 0.07% of the $3.6 trillion municipal bond market, an amount dwarfed by the 7.55% default rate of global corporate bonds, reported by Moody’s Investors Service.

The trend has continued year-to-date in 2014 and, in our opinion, defaults are not likely to increase meaningfully in the near future. There are outliers, such as Detroit and Puerto Rico, but these are isolated credit situations.

At the state level, budgets have improved broadly, and most state fiscal situations are stable. State tax receipts increased for 16 consecutive quarters from 2010 to 2013, according to the National Conference of State Legislatures.

*Source: The Bond Buyer.