Municipal Bond Market Update - Feb 16, 2010

MARKET UPDATE

Prices appear to be increasingly aggressive, but there is no obvious trigger for a near-term reversal—in addition, support is being aided by low tax-exempt primary issuance.

RECOMMENDATION

Positive momentum remains intact across the yield curve, with strong recent gains being realized in early intermediates (5-15yrs). This section of the curve is slowly beginning to read as overbought, in particular at the 5yr; however, the conditions for a weakening do not appear to be present. Thus, levels may grow increasingly speculative and credit spreads more aggressive. By contrast, the long end of the yield curve has had a more diffident reception, leaving room for prices to either rise or fall in the near term if large institutional accounts continue to take gains.

INVESTING STRATEGY

Rating aggressive investing in safe-sector paper poses somewhat more risk as the agencies more readily consider downgrades; however, there has been no indication of a rising systemic risk of payment defaults for these bonds.

SUMMARY

Once again, tax-exempt municipal bonds outperformed the Treasury market last week, although this may have been due to inattention during a holiday-shortened trading schedule and the large East Coast snowstorms. Still, demand remains exceptionally strong, fueled by investors fleeing the tax-exempt money funds and looking for a safe shelter from rising income tax rates. This week, the new issue calendar begins to pick up, and there is speculation of a renewed downdraft for Treasuries. These may make current, long bond prices harder to protect, with a downside potential likely limited to losses as seen in late January. News of Harrisburg has amplified investor concerns over a broad muni sector collapse. However, Harrisburg’s issues (its inability and unwillingness to service an outsize obligation for the local incinerator plant) are an outlier to the broader market and, because of related bond insurance, are unlikely to create any near-term payment defaults on bondholders. The repayment of regular city debt service has not been questioned. We also note that Moody’s recent update of its relative default statistics (now though 2009) reinforce the perspective of security. Investment grade bonds rated by Moody’s have had an average cumulative, 10-year default rate of just 0.06% since 1970; that statistic falls further to 0.01% for general obligation bonds alone. By contrast, investment grade corporate bonds had a 2.50% default rate over the same period.