Market Review as of 12/31/2015

The U.S. municipal bond market (as represented by the Barclays Municipal Bond Index1) continued to advance in the fourth quarter, surpassing the returns of other notable asset classes during the period. While municipal bond supply remained ahead of the prior year’s pace, supply during the quarter remained relatively slow when compared with that of the fourth quarter of the prior year.

While many other asset classes experienced significant volatility during the period, individual investor demand for municipal bonds remained strong, as these bonds posted attractive returns on a relative basis. Consequently, municipal fund flows, based on information from Lipper U.S. fund flows, peaked towards the end of the fourth quarter. Longer-maturity municipal bonds outperformed shorter-maturity municipal bonds, and longer-maturity municipal bonds generally outperformed Treasuries of similar maturities during the quarter.

Lower-quality bonds generally outperformed higher-quality bonds during the fourth quarter, due to the incremental yield available in such credits. Generally, with the exception of Puerto Rico bonds, the high-yield municipal market outperformed investment-grade municipals. Excluding a few issuers, overall municipal credit quality remained stable in an economic environment marked by steady growth and low inflation.

High-profile issuers, such as Illinois, Puerto Rico, and New Jersey, continued to remain in the spotlight during the past quarter, as struggles over pension issues and the political constraints caused by budget-balancing activities endured. Subject to a few stipulations that need to be met in 2016, the Puerto Rico Electric and Power Authority (PREPA) reached an agreement with a large portion of its creditors to restructure its debt, leading PREPA to gain 23%, consequently making it the best performer within the Commonwealth for the year. Despite isolated pockets of distress, overall creditworthiness continues to improve, as most states’ finances experienced rising revenues, while maintaining balanced budgets. At the federal level, there was no new legislation that had a material impact on the municipal market. 

Outlook

During the third quarter, investors were concerned with the timing and magnitude of future interest-rate hikes by the U.S. Federal Reserve, amid global market volatility. While these concerns posed challenges for the market, municipal returns overall surpassed that of other notable asset classes during the period. While demand remained subdued during the third quarter, it is likely that it may increase going forward, as the combination of strong relative performance and a low-rate environment has turned more attention toward municipal debt. Municipal yields continue to provide investors with compelling taxable-equivalent income, and default rates remain low. Although supply thus far in 2015 persisted at a relatively high level when compared with last year’s pace, the majority of issuance was for refunding purposes. Going forward, the volume of supply likely will depend on the direction of future interest-rate moves.

While yield ratios of municipals to Treasuries are still higher when compared with pre-crisis levels, Treasury rates have experienced more volatility in recent periods. The Federal Reserve has communicated concerns of developments overseas and pressure on inflation in the short term. This suggests that interest rates may remain low in the near term, which is a positive environment for municipal bonds. While lower-rated bonds have posted strong returns in past years, credit-quality trends suggest that lower-quality bonds could outperform in the quarters to come, as demand for incremental yield in a low interest-rate environment and steady economic growth have supported credit quality of municipal issuers. While the pace and the magnitude of interest-rate changes will determine which maturities will outperform in the upcoming quarters, it is likely that longer maturities will outperform, as longer bonds may provide a significant income advantage to investors, given the steepness of the 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 have experienced rising revenues, with the exception of those states that are heavily dependent upon energy. State governments have displayed effective fiscal management, as they continue to balance their budgets while keeping expense increases minimal. Although a few high-profile issuers, such as New Jersey and Illinois, are hampered by challenges, including pension reform and funding of pension liabilities, it is important to focus on overall creditworthiness, which is expected to remain strong. While the dynamic of the municipal bond market has changed considerably over the past few years, municipal bonds overall have continued to offer the combination of a high credit-quality profile and strong tax-equivalent returns to investors.

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