Market Review as of 09/30/2015

The U.S. municipal bond market (as represented by the Barclays Municipal Bond Index1) posted positive returns in each of the three months of this year’s third quarter, showing a performance reversal from that of the second quarter. While municipal bond supply remained ahead of the prior year’s pace, supply shrunk considerably toward the end of the third quarter.

Despite recent strength in demand toward the end of the third quarter, individual investor demand remained generally weak during the period, as investors were concerned about the impact that monetary policy decisions by the Federal Reserve might have on the timing and magnitude of prospective interest-rate hikes. Municipal bonds showed resiliency during the quarter, as returns of municipal bonds surpassed that of other notable asset classes. Longer-maturity municipal bonds outperformed shorter-maturity municipal bonds during the quarter. While longer-maturity municipal bonds generally performed in line with Treasuries of similar maturities, municipal bonds with shorter maturities lagged their Treasury counterparts, as Treasury bonds rallied during the period.

In the third quarter, high-yield bonds generally outperformed investment-grade bonds, due to the incremental yield available in such credits. While the high-yield municipal market was heavily affected by the negative returns of Puerto Rico bonds in the year-to-date period, bonds in the commonwealth posted slightly positive returns for the third quarter. Otherwise, overall 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, remained in the spotlight during the past quarter, as struggles over pension issues and the political constraints caused by budget-balancing activities endured. Despite these pockets of distress, overall creditworthiness continues to improve, as most states’ finances experienced rising revenues while maintaining balanced budgets. 


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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