Weekly Municipal Bond Outlook - Tobacco Bond Issuance Shows Promise

MARKET UPDATE

The correction is likely over; a more positive bias ahead.

RECOMMENDATION

Last week’s correction has added very good value to the long end of the yield curve; we expect presently negative momentum there will shift this week giving good near-term performance prospects. In the longer-term, this area of the curve will still outperform Treasuries, but as Treasury yields rise, losses are more likely for un-hedged accounts. By contrast, the front of the yield curve is feeling enormous demand strength that could persist for some time. This is the best source of near-term liquidity. Price momentum is strongest among intermediates as retail investors stretched for yields; this remains the most favorable area in which to do so.

INVESTING STRATEGY

Tight credit spreads will at some point lead to lower rated and high yield issuance. We remain bullish on tobacco bond issuance this year as states look to shift the risk future tobacco shipments onto investors while patching near-term budget gaps.

SUMMARY

With buyers feeling some trepidation over low nominal yields, rich relative valuation to Treasuries, concerns over a diminished BAB presence in 2010, and eroding credit quality, the municipal bond market experienced a modest correction at the end of January. However, weakness appears to have faded, in particular with the President’s weekend announcement of a proposal to expand the BAB program. As part of the President’s initial budget plan, this proposal still has a long way to go before becoming law, but it should re-assure many long bond holders that BABs are unlikely to go away at year-end. It could also reasonably lead to a renewed rally in long tax-exempt paper, on expectations of future scarcity in tax-exempt high grades. Also supportive of near-term performance is the resilience of tighter credit spreads amid last week’s rising yields. High yield mutual funds showed 3x the performance of national funds in January while both short and long-end evaluations have trended much tighter to high grades all year. Finally, the SEC has adopted reforms to its money market rule 2a7 that will reasonably lead to choosier, more conservatively run tax-exempt money funds, implying an even stronger downward pressure on both floating and early curve yields. This proposal could have more wide ranging impacts on tax-exempts (some potentially negative), but details are not yet publicly available.