New York - In January, the fourth quarter moved into the rear view mirror. Market participants felt a collective sense of relief.
Municipal bonds, however, were the beneficiary of the uncertainty as interest rates fell while investors sought safety. Absent too was any major legislation for market participants to consider.
For municipals, January played out as typically expected with strong demand and lackluster new issue supply. This formula (known as the January effect) was supportive of valuations and the Bloomberg/Barclays Municipal Bond Index returned 0.76% for the month, the best January return for municipals since 2016.
There are a few clouds of uncertainty on the horizon including Brexit, China's growth outlook and ongoing domestic policy wrangling. We remain focused however on U.S. growth as we are closing in on the longest expansion on record.
Supply and demand in munis
Looking at the supply/demand picture in the muni market, while January 2019 experienced slightly higher supply than January 2018, the loss of advanced refundings continued to weigh on new issue supply in the market.
New issue supply in January was $24.1 billion, which was 12% higher than January 2018 issuance, but still 15% lower than the monthly average over last year. Net issuance came to -$1 billion. February gross issuance is expected to be approximately $26 billion and net issuance is expected to be -$4 billion.
We continue to expect a supportive technical environment.
Where we see value
We favor short- to intermediate-term maturities for both attractive yields and lower interest rate risk, as compared to longer maturities. Strong retail demand and a decline in issuance have led to municipal outperformance relative to taxable alternatives.
Despite tightening muni-to-Treasury ratios in the front half of the curve, we do not foresee any near-term weakness since munis are on the richer end of the historical range. We believe municipals still offer value for individual investors in the highest tax brackets and are likely to continue to be well supported.
Absolute yields on the front end continue to draw interest from investors looking to allocate to a high-quality, fixed-income asset class, especially in the wake of the equity volatility witnessed in the fourth quarter 2018. In the current yield environment, an investor is able to capture 85% of all the yield available on the 30-year curve by going out just 15 years, and 60% of the curve by going out five years.
While the front end offers a defensive posture and yields are near a decade high, we do remind investors that the muni curve actually steepened last year.
The Fed weighs in
At the January meeting, the Federal Reserve left the fed funds rate unchanged but surprised the markets with a more dovish tone by removing language indicating further rate increases, and emphasizing patience.
We believe that inflation is the key data point that the Fed will monitor as it considers whether or not to increase interest rates from here.
However, we think the Fed's new "patient" stance signals it will be ready and willing to act based on future data. Whether that data is stronger or weaker is the uncertainty that makes markets challenging to predict, and we think that could make the historical stability of the muni bonds all the more attractive.
Bottom line: Despite tightening muni-to-Treasury ratios, we believe munis still offer value for individual investors in the highest tax brackets and are likely to be well supported in the months ahead.
An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Longer-term bonds typically are more sensitive to interest-rate changes than shorter-term bonds. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher-rated investments. Derivative instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk.
© Eaton Vance
© Eaton Vance
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