Market Review as of 03/31/2015

The U.S. municipal bond market (as represented by the Barclays Municipal Bond Index1) continued to advance in the first quarter of 2015. The supply of newly issued municipal bonds was high, exceeding expectations throughout the quarter. Refunding issuance to refinance outstanding bonds in the low interest-rate environment increased significantly, while new money issuance for new projects did not grow. The large new-issue supply weighed somewhat on the returns for the municipal market.

Individual investor demand was positive throughout the quarter, although it was not as strong as it was during the final quarter of 2014. Longer maturities outperformed their shorter-dated counterparts, as the bond market continued to surprise forecasters. Interest rates defied expectations by not rising, as inflation remained dormant and U.S. economic growth was restrained by weakness in other parts of the globe.

In general, bonds in the lower investment-grade and high-yield categories outperformed higher-rated bonds due to continued investor demand for incremental yield. Credit quality remained stable in an economic environment marked by steady, if unspectacular, growth and low inflation.

Municipal bonds slightly outperformed U.S. Treasury securities on the long end of the yield curve, while slightly underperforming on the short end. Yield ratios of municipals to Treasuries remained higher than historical averages on maturities of 10 years and longer.

The generally stable environment for municipal finance, which had helped support the municipal bond market’s performance in recent quarters, remained in place. A February 2015 report2 from the Rockefeller Institute stated that state revenue collections are expected to show “continuous and steady growth in the coming quarters due to the disappearing impact of the federal fiscal cliff.” The report said the outlook for the remainder of fiscal year 2015 remains positive in most states. “However, oil-rich states are facing heightened fiscal challenges due to drops in oil prices,” the report added.

Among high-profile issuers, Puerto Rico remained in the spotlight as the commonwealth continues to work through its economic and financial issues.  A group of investors were negotiating with the Puerto Rico Electric Power Authority over a potential restructuring, while the Puerto Rican government was working toward bringing a new bond issue backed by petroleum taxes.  These issues put pressure on Puerto Rican bonds and led to much uncertainty about future outcomes.

Outlook

Similar to other fixed-income markets, increased interest-rate volatility in February and uncertainty about the timing and magnitude of interest-rate hikes this year have posed challenges to the municipal market. Despite recent volatility, demand for municipal bonds has remained relatively strong. Municipal yields continue to provide investors with compelling taxable-equivalent income, as valuations relative to other fixed-income asset classes continue to be favorable, despite outsized returns in 2014, and historical default rates remain low. Supply persisted at a relatively high level through the first quarter of 2015, which was a stark contrast compared with early 2014. However, issuance has mainly consisted of refunding deals that significantly outpaced the minimal new-money supply. 

While increased refunding activity has attracted issuers to the market, the net supply of outstanding municipal bonds continues to fall, recently hitting the lowest level in more than four years, according to Bloomberg. Although it is likely that this pattern of strong refunding activity will continue, this trend can be affected by both dramatic movements in interest rates and the possibility of increased pressure on municipalities in financing infrastructure needs, which could spur higher levels of new-money issuance.

Despite the strong returns posted by lower-rated bonds in recent quarters, such bonds could still outperform going forward, as continued demand for incremental yield in a low interest-rate environment and steady economic growth have supported credit quality of municipal issuers. While the pace of rate changes and the magnitude of those changes will determine which maturities will outperform in the upcoming quarters, it is likely that longer maturities will continue to outperform, as longer bonds may provide a significant income advantage to investors given the still steep yield curve.

With respect to the financial health at the state level, it is important to distinguish between the isolated fiscal challenges and the strong overall health of states. Many states, with high tax revenues accompanied by effective fiscal management, have continued to manage their balance sheets toward earning higher ratings from credit agencies. While a few states, such as New Jersey and Illinois, are hampered by challenges such as pension reform and funding of pension liabilities, it is important to focus on the state’s ability to find a long-term solution to finance future obligations despite constitutional hurdles. The postponement of finding this solution can potentially increase pressure going forward in states such as Illinois and New Jersey. Conversely, New York and California, in addition to collecting high tax revenues in a steady economic environment, benefited from appreciating values in real estate, which, consequently, improved local and state balance sheets. As the supply and demand dynamic continues to be favorable, municipal bonds offer the combination of both a high credit-quality profile and attractive taxable-equivalent income to investors. 

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