Municipal Bond Update - August 10, 2010

MARKET UPDATE

Steady investor interest, weak fundamental data, and light supply driving yields to new lows.

RECOMMENDATION

Asset preservation buyers should continue to focus on the first ten years, despite extreme low yields. However, price momentum has begun to suffer and there is some risk of setback at the very front near term. Total return assumptions have begun to look up in the 12-17yr area where positive momentum has dragged neutral/cheap valuations into positive territory. Farther out on the curve, valuations continue to look concessionary, but momentum also implies that appreciation isn’t here yet. Issuers should take advantage of low yields and persistent demand.

INVESTING STRATEGY

Tobacco bonds are carrying large yields, magnifying the downside risks in selling these bonds following S&P’s renewed credit warnings. But remember that the Master Settlement by which these are paid conveys a fixed dollar amount to the states, so, while the schedule of repayments might (and almost surely will) continue to extend, ultimate principal repayment is still very likely.

SUMMARY

The summer rally continues, with high grade yields falling further into historic lows as the economic context. The weak jobs reading and more abundant concerns over long-term growth, have assuaged near-term inflation fears. Primary and secondary market scarcity remain pronounced, even as individual investors invest directly or through mutual funds to shield income from future rising tax rates. This last pressure will likely increase as the Bush tax cuts are more widely discussed into and after the November election. This week, expect more of the same, although August’s thin summer staffing and investor interest typically makes developments somewhat less predictable. This week we look at the Senate’s passage of the State Aid bill, which will provide a near-term boost to credit quality but has implications elsewhere, including unemployment aid borrowing from the Feds. We also examine S&P’s CreditWatch for tobacco bonds, and the Treasury committee’s report on systemic risks in the municipal sector. Finally, defaults and credit impairments continue their recent trends: defaulted principal is creeping upward as more revenue and special projects turn from reserve usage to payment default, but activity is almost exclusively focused on “risky sector” non-rated issuers.