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.