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After The Dust Settles - Friday, 10/26/2012

Even after the election decides the next leadership team, as well as the framework or "platform" on which political initiatives will likely drive expectations, I believe market fundamentals will continue to frame current opportunities in the municipal bond market:

  • The Federal Reserve is expected to keep rates low for months to come.
  • To date, there have been 46 consecutive weeks of positive inflows into municipal bond ETFs and mutual funds, reaching approximately $45 billion.
  • The ratio of investment-grade municipal bond yields to 10-year U.S. Treasury yields, while moving to, if not through, 100%, in my opinion, still presents municipals as an attractive value on a taxable-equivalent basis.
  • Major bank portfolio buying has augmented strength on the demand side, which, I believe, is stimulated in part by unattractive lending alternatives and higher deposit requirements of Basel III and Dodd-Frank agreements.
  • Although yield spreads have contracted, I believe there is still room for further positive moves if the current trend of spread-narrowing continues for (1) high-yield municipals to investment-grade municipals, as well as for (2) low investment-grade municipals (BAA) to highest investment-grade municipals (AAA).
  • A dwindling of reported defaults in the municipal marketplace appears to have buttressed investors' confidence in municipal credit quality in the short-term.

Now through December will be a time for planning a 2013 strategy. I believe we can count on investors settling on choices for allocating their resources or rebalancing their portfolios — after the dust settles.

 

Morningstar Muni Category Flows YTD: $45.4 Billion
Morningstar Chart
Source: Morningstar as of September 30, 2012



Comparative Yields on a Tax-Equivalent Basis
Comparative Yields on a Tax-Equivalent Basis Chart
Source: Bloomberg as of 10/22/2012. For illustrative purposes only. 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.

*Tax-equivalent yield is used by investors to compare yields on taxable and tax-exempt securities after accounting for federal taxes (excluding AMT). Taxable-equivalent yield represents the yield a taxable bond would have to earn in order to match — after taxes — the yield available on a tax-exempt municipal bond. Taxable-Equivalent Yield = Tax Free Municipal Bond Yield/(1-Tax Rate). Tax-equivalent yield was calculated based on federal income tax rates. State, local and alterative minimum taxes have not been considered in the analysis. Yields are based on yield to worst, which is the lowest yield that a buyer can expect among the reasonable alternatives, such as yield to maturity, yield to call and yield to refunding.


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