Market Review as of 12/31/2014

The U.S. municipal bond market (as represented by the Barclays Municipal Bond Index1) continued to advance in the fourth quarter of 2014.  Municipal bond supply increased considerably during the quarter due to some large new issues and increased refunding activity.  The large new-issue supply weighed somewhat on the performance of the municipal market, limiting the decrease in yields.

Individual investor demand remained solidly positive during the quarter, with continuing interest in all ranges of maturities and credit quality.  Longer-maturity issues continued to outperform their shorter-dated counterparts, as investors sought additional yield. 

In general, lower-rated bonds performed in line with higher-rated issues during the quarter, although there was a wide range of returns and select portions of the high-yield market outperformed. Within investment grade, investors continued to favor the higher yields available on the lower rating tiers, with ‘BBB’ rated securities generating the strongest performance during the quarter. Overall credit quality remained strong in the municipal bond market.

The ratio of Treasury bond yields relative to municipal bond yields widened during the quarter, as Treasury securities outperformed short-, intermediate-, and long-term maturities. 

Although domestic economic growth strengthened, there still were no signs of inflation, as oil prices fell and the Federal Reserve (the “Fed”) continued to remain on hold with interest-rate changes. The generally stable environment for municipal finance, which had helped support the municipal bond market’s performance in recent quarters, remained in place. A December 2014 report from the Rockefeller Institute noted that state tax collections resumed growth in the third quarter of 2014, after declines in the first half of the year.2 The report stated that state revenue collections “are expected to show continued growth throughout the rest of state fiscal year 2015.”

Two major issuers whose well-publicized difficulties sparked volatility in 2013 continued their efforts to resolve their difficulties during the fourth quarter. Detroit received court approval for its restructuring plan during the quarter, allowing the city to emerge from bankruptcy. Puerto Rico’s moves to address its fiscal challenges included approving a tax increase in order to fund a new bond issue during the first calendar quarter of 2015. The commonwealth continued to move toward an expected restructuring of its power authority.

At the federal government level, there were no legislative developments that had a material impact upon municipals. The Securities and Exchange Commission (SEC) did propose more trading information disclosure by dealers of municipal securities, which could benefit some market participants.

Outlook

While there are challenges of increased market volatility and uncertainty regarding the Fed’s upcoming interest rate moves, municipal yields continue to provide investors with compelling tax-equivalent returns, as valuations relative to other fixed-income asset classes remain attractive and historical default rates remain low. The volume of new issues of municipal bonds has risen in recent months, after a slow start coming into 2014, as increased refunding activity and low interest rates continue to attract issuers to the market. The outstanding supply of bonds, however, has been decreasing due to bond maturities and early redemptions, therefore net supply continues to be negative. This aspect of the market is favorable for performance because market participants are likely to reinvest proceeds from called and matured bonds. Demand from new cash invested also should continue to provide support to the asset class, as increased tax rates improve relative valuations on an after-tax basis. It is likely, then, that this trend of a positive supply and demand dynamic will continue into 2015.

Despite the strong returns of lower-rated bonds in 2014, credit spreads still remain attractive compared with pre-crisis levels, while overall credit fundamentals of the market continue to improve. This combination suggests that lower-quality bonds could continue to outperform going forward. Longer maturities outperformed considerably in 2014, as the yield curve was relatively steep and enticed investors to extend maturities. Since the Fed has indicated its intention to increase short-term rates during the second half of 2015, the yield curve is likely to flatten, with shorter rates rising more than longer rates. However, the pace of rate changes, and the magnitude of those changes will determine which maturities will outperform in 2015. While it is likely that longer maturities will outperform in 2015, this outcome is contingent on two major factors: the level of economic growth and whether inflation will continue to stay low.

While there have been a few negative outliers with regard to the health of states, most notably pension issues in New Jersey and Illinois, states are doing well overall, as the economy is providing steady growth and tax revenues are rising. High-grade small states such as Alaska, which are largely dependent upon oil, will need to cut budgets due to decreased revenues. Such states are likely to have a minor impact on the overall municipal market, as they are small issuers. On a federal level, continued political discussion around the benefits of the tax exemption could affect the municipal market. While the dynamic of the municipal bond market has changed considerably over the past few years, municipal bonds continue to offer the combination of a high credit-quality profile and strong tax-equivalent returns to investors. 

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