Last week, several reporting sources for fund flows recorded a change in course. Cash flowing into municipal bond funds in aggregate recorded the first positive week in the past two months. The monthly numbers are still negative but I believe the turn may signal that the recent swoon is over.This event does not make a trend but I believe it has ended one. So what might the reasons be for an improved outlook? 

Municipal bond investors may not think of themselves as "doers" as much as they think of themselves as "receivers" (of tax-free income). I offer here an example of how muni investors can regard themselves as both, by supporting green initiatives¹ when buying tax-free bonds.

"Lake Wobegon, where all the women are strong, all the men are good looking, and all the children are above average." – Garrison Keillor

Shall we compare the municipal market to the fictional Lake Wobegon? This asset class continues, in my view, to exhibit solid, stable characteristics that I believe make it nearly impervious to the exogenous volatilities of the world around it.

Municipal bond ETFs have begun to move into what I think of as the "mature" stages of a fund’s life. Now that several have five-year track records, some with substantial assets under management, I believe that an independent assessment of this product innovation can potentially provide investors and advisors with insight based on the very same analytical approach and detail they are accustomed to for other asset classes.

The $3.7 trillion municipal bond market resides largely in the domain of individual investors, whether through direct purchases or financial intermediaries. Monday was tax day — a day when investors can truly realize the benefits of municipal investments.

One of the truly unique features of the idiosyncratic municipal bond market is that the exempt nature of the income from issuers extends beyond what we know to be the 50 states. In fact, because the United States has territorial control over certain islands, they, in turn, have the ability to access the capital markets of the United States by issuing municipal securities which are exempt from federal as well as local income taxes for U.S. taxpayers.

The lyrics of "I Can See Clearly Now," a 1972 hit song, came to mind recently when I was revisiting one investment theme that is commonly raised around this time of year as individuals prepare to pay their taxes and consider strategies for tweaking their portfolios: which performs better — active or passive management?

Watch my latest video which focuses on:

• Near-Term Outlook and Performance Drivers
• Impact of Sequestration on the Market
• Considerations in Light of the Great Rotation

Beware the Ides of March

Yes, yes, this Shakespearean reference is a little over the top but it has been readily observed by many authors that the month of March has often been a cruel one for participants in the municipal bond market. In this year — MMXIII — it just so happens that we have had, so far, a stellar 10% rise in the Dow in tandem with the dual crises of sequestration and Federal government funding (shutdown), creating headlines that I believe place doubt ahead of decision in the minds of fixed income investors.

As I attempted in the first installment, I offer a high level overview to generalize my view on the credit quality of a vast expanse of states, cities and local issuers of municipal bonds. I believe ratings do matter because, not only do they represent a measure of differentiation and separation of value for some 60,000 issuers, but in the long run, they may serve as an affirmation of the soundness and strength of tax-exempt investments.

Many portfolio manager commentaries from large, well-known investment companies have, over the past several weeks, generated thoughts about the murky future of the markets and economy. Several appear to lead with the suggestion that an unseen hand is poised to pull on a figurative lever to categorically change broad strategy (asset allocation) from bonds to stocks; this would be called "The Great Rotation." Others offer suggestions that the current strategy of asset allocation, which has taken us to significant returns over the past 24 months, is about to combust; this would be called "Bursting the Bubble." Because of the eye-catching phraseology involved, I fear that readers may feel that these potentialities are faits accomplis.

Let's give credit where credit is due: recently, Forbes published an article that to some might seem like the kind of article that sits on the shelf until there is a slow news day and the editor is looking for a filler piece. In fact, this article raises a number of important points that, in my opinion, all touch upon the national economic recovery and just may be the locus of the revival of small business and wealth creation.

Looming under the somewhat Byzantine headline name, Sequestration, are automatic cuts to government spending that may include planned reimbursements to state and local issuers of Build America Bonds (BABs). BABs are taxable municipal bonds, authorized as a stimulus program under the 2009 American Recovery and Reinvestment Act. The federal government promised rebates to the issuers equal to 35% of their interest costs as an incentive to raise capital for "shovel ready" projects. Many market participants considered it to be a highly successful program.

With the political ripples of the "cliff" and inauguration finally reaching the edge of the pond, the markets appear to be once again fully engaged in the dissection of domestic economic releases, earnings and European monetary drama. The elements that I believe sparked a year-end selloff have now receded, allowing municipals to push forward with a month-to-date gain of 0.62% as of January 25, 2013. New flows into municipals, along with cash from calls, maturities and coupon payments are again positive, overwhelming a meager January supply: a formula that is prevalent in most years, coined the "January Effect."

One point which I believe is universally made regarding the municipal bond market is that the overall credit quality (the implied security) of the issues brought to the market not only underpins the attraction of municipals as an asset class, but separates it very distinctly from other fixed-income choices.

If there is one certainty that I believe municipal bond investors can lean upon as we fully commit to writing 2013 in our check registers, it is the seemingly perpetual uncertainty regarding the political deliberations about to resume in Washington, which again could include discussions about capping the benefit of the tax-free coupon. Ask yourself, "What has changed since the November elections?" and you'll probably answer, "Nothing." However, with the adjusted personal income tax rates now at higher levels, this statement is not entirely true; the market has been living with this cloud of uncertainty going on five months or more.

Watch my latest Video Viewpoint on:

• Year-End Volatility
• States & Municipalities
• Measuring Impacts of Puerto Rico Downgrade
• U.S. Fiscal Debate

In the eleventh hour of the first night of 2013, Congress passed legislation which, among tax increases and other items, left the municipal bond coupon tax-free and unscathed. As you undoubtedly know by now, the bill provides for extensions of the Bush era tax cuts and credits and permanently "patches" the Alternative Minimum Tax (AMT) going forward.

Month-to-date, and really it is over the last eight business days, munis have sold off in dramatic fashion (now, drama in muniland is far from what is experienced in equities or treasuries). The Barclays Municipal Bond Index is down 1.66% and even the High Yield Index is down 1.08%. The representative Aaa yield curve – MMD – has risen by over 40 basis points in that time in a move that likely has many dealers shaken and investors confused.

For all the professionals who embraced the strong market performance of municipal bonds year-to-date, I attribute the sudden break in the positive trend to the confluence of the following events leading to what could be called a "muni perfect storm":

I believe that 2013 promises to stand in contrast to the linear upward moves for municipal bonds in 2012. There appears to be conflicting expectations about new issue supply, so my conservative view is to say that volume has the potential to be +/- 10% of that of 2012. Much depends on a solution out of Washington concerning taxes, entitlements and federal support for state and local government programs.

The municipal market continues to be well-bid by evidence of continued strong flows into muni funds. I believe we can expect the demand side of the equation to drive the market through yearend.

Amid all the questions and uncertainties whirling around Washington in the aftermath of the presidential election, the image of higher personal income taxes — fiscal cliff or not — is coming into sharper focus. In what could become known as the next "Great Compromise," I believe taxes are almost assuredly going higher. We may also have to throw capital gains taxes into the stew of tweaks and twists to which congressional leaders may need to agree. What is there for individual investors to do?

In the aftermath of Hurricane Sandy, more than just the massive property destruction has been revealed to municipal participants as needing dire attention. National and local infrastructures have been weakened and are at the mercy of natural disasters that now seem to be occurring more regularly. From power supply and transportation to drinking water, Sandy exposed most of the projects and programs that constitute "public purpose" and define municipal finance as damaged and in need of repair.

Watch my latest interview with TheStreet.com.

Without dispute, the superstorm named Sandy has, and will continue to deliver, wide-ranging repercussions to the communities of the Mid-Atlantic and Northeast United States. Below I mention only a few of the many issues our country will tackle, but I believe these points are indisputable:  

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...

In September, Montana senator, Max Baucus, requested the Congressional Committee on Taxation to recommend revenue generating ideas. The Committee's report, which was released on October 11, included a repeal of the interest exclusion from municipals, calling the interest "tax expenditure."

Muni index performance has generally been good this year...I believe we can expect continued good performance but with the following two caveats...

This week began with a firm tone as I believe the secondary market seems poised for municipal bond prices to move higher. Dealers appeared comfortable with current municipal market levels and we have seen increased interest in the shorter end of the curve.

"Always borrow money from a pessimist he doesn’t expect to be paid back." - Unknown

Not only aren't investors in municipals pessimists, but these lenders are also optimistic that they’ll get their money back with interest. Perhaps this is a reversal of expectations.

Municipal bond yields have sunk to near historic lows. Sector and quality spreads continue to narrow. To date, municipal bond performance is on pace with that of last year's. In my opinion, this has been driven by returning confidence in municipal credit quality and demand continuing to overwhelm supply.

Watch our latest muni video which focuses on my short-term outlook and assessment of the potential fiscal cliff.

A year ago, as the world struggled to recover from global recession, S&P made history by downgrading the credit rating of the United States — a first for the country long considered a safe haven. Common wisdom dictated that the inevitable consequence would be a rush to dump U.S. Treasuries as investors took the downgrade as a sign of instability in the U.S. markets.

Muni Nation asked Alexandra Lebenthal, President and CEO of Lebenthal & Company, to identify the most important changes in the municipal market over the past year, and here is her perspective: Recent changes have been significant, perhaps more so than at any other time in my company's long history...As a result, we have seen individuals turn their municipal investing activities dramatically toward separately managed accounts, mutual funds and ETFs, as opposed to buying and managing individual bonds.

Often we look for macro issues and trends to help define direction and opportunity in the municipal bond market as a whole. However, there is an element of potential opportunity in the narrower realm of the pre-refunded municipal bond segment. As of June 25, 2012, these bonds offered higher yields compared to those of tax-free money market funds, 1.05% versus 0.02% respectively.¹ 

The secondary market for municipal bonds has been somewhat subdued the past several days. The broad market successfully absorbed over $10 billion in new issues last week, with some selling of high-grade muni bonds in the secondary market, possibly to fund purchases or restructure segments of existing portfolios. Municipal bond yields have been moving slightly lower but have generally underperformed U.S. Treasuries, which I believe makes their relative valuations look all the more appealing to non-traditional managers looking for potential trading opportunities.

With investor sentiment now shaded by the daily changes in market direction for both equities and fixed income, I suggest that we are faced with a changed investment paradigm, at least in the near term. While Europe tries to extricate itself from economic doom and gloom, many major equity indices struggle to post positive year-to-date returns¹. In my opinion, as shown in the table below, inflows into fixed income may be an indication that it is currently the preferred asset class over equities. More specifically, I believe municipal bonds have generally offered investors some sense of stability. The Barclays Municipal Bond Index² returned 3.43% year-to-date, with an average coupon of 4.90%³. This generated enough return to help investors weather momentary downturns in market value.

If you have not asked yourself this question, then you may either be blissfully unaware of the cacophony raised as investors rush out the exit marked "equity" based on fund flow data from Morningstar, or your expectations might be so low for investment returns that you've turned to watching re-runs of AMC's Mad Men. With everything seemingly in freefall – including yields – I offer my opinion as follows:

I've taken a little liberty with a familiar saying to suggest that for municipals, I am not booking my three-month summer vacation just yet. Month-to-date and year-to-date performance of all muni high-yield bond sectors (with the exception of tobacco) has been positive. The technicals of demand overpowering supply, which I've previously written about, are still in place.

Muni High Yield has been a top-performing segment among municipal bonds, with a total return of 7.75% YTD through April 30, 2012, for Barclays Municipal High Yield Index¹.  I believe that the dynamic which has propelled performance in the investment grade muni market is also at play for muni high yield: demand is overwhelming supply. 

The municipal bond market has experienced a significant rally — slow but steady — for nearly three weeks. Supportive data and technicals have pushed the market higher. Despite spreads which point at municipals as a value purchase, surprise news (i.e., Meredith Whitney's prediction of mass defaults in 2010) can erect barriers to further advances. Recently, the market had to digest commentary discussing:

Municipal yield curve steepness was a significant contributor to 2011 municipal bond returns, and it currently remains so. Because recent changes in yields have been fairly consistent across maturities, the intermediate part of the curve (10 to 14 years) — where yield differences of as much as 25 basis points currently exist between each maturity — continues to be a focal point. Thus, investors should consider how best to assess the combined risks associated with credit and maturity.

In contrast to what, historically, has been normal for the end of April, municipal performance ended the month on a very positive note. The Barclays Capital Municipal Bond Index¹ was ahead by 1.15%² and the Barclays Capital High Yield Municipal Bond Index¹ nearly doubled that at 2.23%²...Cash flow from maturities and called bonds, according to street source Siebert Brandford Shank & Co., is estimated to be higher this May by nearly $3 billion over last year. Average monthly reinvestment into municipal bonds in 2011 was $22 billion, but it is already $1 billion higher in 2012.

With flows continuing to favor municipals, BBB-rated munis are receiving recommendations as their spreads to investment-grade muni bonds continue to compress. Even in a rising rate environment, the less volatile BBBs have historically outperformed investment-grade munis and have provided a potential cushion to a diversified portfolio.

This week we arrived at Tax Freedom Day, the first day of the year in which the nation as a whole has theoretically earned enough income to fund its annual tax burden. I can only speculate that the slowdown of inflows into munis is possibly related to investors allocating their financial resources to tax obligations. I do not presume that they are using any muni facility for funding purposes but the drop in activity is not unexpected at this time of the year.

An equity market rebound, such as we witnessed yesterday (+181 points as measured by the DJIA¹), usually spells doom for the fixed-income markets. Additionally, the revelation that Bill Gross has reduced his holdings in U.S. Treasuries by 4-5% would further the notion that the day would go badly for bonds. And with the Treasury auction of $13billion of 30 year-bonds...

Governmental issuers of municipal bonds will continue under scrutiny as long as unemployment remains above 8% and the soft housing market continues. This focus is warranted due to concerns over muni bond price declines for issuers struggling with economic recovery.

Both Wednesday (3/28) and Thursday (3/29), municipal prices regained lost ground, especially in the intermediate part of the curve. Why? 1) New issue supply fell by nearly 50% week over week; 2) Bernanke's testimony implied more Fed stimulus to support employment; and 3) Data showed no meaningful improvement in the housing sector.

After suffering under the recent pressure of significant new-issue supply, the muni market recovered its footing and ended this week with a positive finish. Demand is being driven by arbitrageurs ("arbs"), who are attracted to the intermediate part of the yield curve, where the ratio of high-grade muni to Treasury yields is above 110%. Near term, muni new-issue supply is expected to ebb somewhat, which should help to support prices heading into the Easter/Passover break.

Markets go up and down, and money is made and lost as the ebbs and flows of opportunities coincide or diverge. Great fortunes can be made by placing risky bets. However, the probability of achieving such success is fairly small, which leads to an age-old question: How can prudent investors craft a risk-appropriate strategy?

We have seen and heard the term default brought into play for the municipal bond market in a significant way over the past 18 months, but never more so than in the six months subsequent to Meredith Whitney's pronouncements from her December 19, 2011 appearance on 60 Minutes. Sparing the details, her suggestions sent the municipal market into a tailspin during the first half of 2011. What she did not make clear was the all-important distinction between the terms "default" and "bankruptcy" as they apply to municipal bonds. In the muni universe, these terms have significantly different meanings than in the corporate world...

Municipal bonds are "Main Street investments," with an estimated 73% of the $3.7 trillion in outstanding principal owned by households or mutual funds¹. On the other hand, municipal bonds are traded in an over-the-counter (OTC) market where dealers create liquidity. Main Street depends on Wall Street, and vice versa, with both sides benefitting.... Enter the Volcker Rule which seeks to limit proprietary portfolio trading by banks.... thousands of revenue muni bonds that depend on dealer liquidity are not exempt, and are vulnerable to the Rule's unintended consequences.

Municipal high yields, thus far in 2012, continue to be priced at attractive spreads....Looking forward, I believe that investment grade municipals will remain fairly stable given the Federal Reserve's stance. However, given the type of issuers that dominate the muni high yield space (airlines, oil services, paper, chemicals, autos, health care services, etc.), it is my opinion that if the economy improves, then a total return opportunity could be realized in high yield if the two Indices revert to their long-term average relationship of 272 basis points.

 

A particular saying I used to hear around the office of my first job was, "let's throw it against the wall and see if it sticks", comparing the testing of new ideas to the testing of properly cooked spaghetti. I was reminded of this analogy as I read several recent articles with headlines like "Obama Seeks to Curb Muni Bond Tax Breaks, Again." Sparing you the minutiae, the recent Obama 2013 budget plan repeats much of what was originally in the hands of the "Super Committee" last fall. The committee was charged with repairing the deficit, and its guidelines included initiatives to reduce, if not completely repeal, the tax benefits currently offered by municipal bonds.

As I anticipate another season of "America's Favorite Pastime," I cannot help but feel that the past two months of strong performance for municipals will likely level out into a more traditional pattern, much like when reality meets expectations with spring baseball. I think demand-generated performance will very likely be met with an elevated supply of new muni bonds. This in turn may bring on a slew of news headlines that are likely to moderate the current environment of positive sentiment and, in my view, cause the muni market to correct. Watch my latest video: Muni Health Check 1Q'12 >>  

Returns for municipal bonds YTD in 2012 represents third strongest start to a year since 1990 (2.31% YTD as of 1/31/2012)^†. Investors are rushing back to municipals as evidenced by strong inflows of $6 billion in January. A combination of factors are boosting investor demand: a lower supply of muni bonds given the tepid new issuance calendar, and renewed acceptance of munis as a harbor of credit quality and liquidity. Also, persistent headlines on Europe’s troubles continue to pressure investors to seek safety in U.S. Treasuries, which in turn supports municipal bond returns.

The continuation of strong cash flows, elevating municipal asset levels for investment platforms has led to a resumption of positive performance for virtually all sectors of the muni market in January. The Barclays Capital Municipal Bond Index posted a 2.31% gain for the month, and the Barclays Capital High Yield Municipal Bond Index was up by 3.68%. This illustrates both the strong search and demand for yield, as well as the renewed confidence in an asset class which was shunned just a year earlier.

The municipal bond market has been on a seven-week march to all-time low rates (yields), as the chart below shows. Given the voracious appetite that investors have had for munis, I would have expected that the natural order would be for the market to take a pause — even to back-up a bit as investors reassess relative value. Traders have begun to refer to bonds trading at NOSEBLEED prices, suggestive of a market moving too high, too fast.

Perhaps it was a combination of views expressed last week by the likes of PIMCO, Barron’s and The Wall Street Journal, touting the merits and benefits of the municipal bond market, but interest is clearly being expressed by buyers gobbling up investment grade bonds in spasms of transactions. Many municipal bond positions have already traded at levels of 5 -10 basis points lower in yield from opening offers, which translates to higher prices....GAME ON.

The January effect — coupon payments and maturing bonds — are fueling muni demand despite sharp volatility in U.S. Treasuries. The technical offset to the "real" market, however, is the "roll" which occurred at the first of the year. For example, bonds that were classified as 15-year maturities on 12/30/11 were reclassified as 14-year maturities as of 1/1/12.... I expect intermediates will be the biggest beneficiary of the roll because the yield curve has been steepest in the area of the curve they occupy: 6 to 16 years. 

I strongly debate that describing the U.S. municipal bond marketplace as a "backwater," "insular" or a "shadow asset class" is inaccurate and inappropriate. As restated by the Federal Reserve, with a little push from the analysts at Citigroup, U.S. muni bonds are currently a confirmed $3.7 trillion marketplace (up from a previous valuation of $2.1 trillion in 2010), with average credit quality, among its more than 60,000 issuers, currently in the double-A range.