Municipal Bond Weekly Outlook

MARKET UPDATE

At some point, muni prices will likely weaken more emphatically, but we remain optimistic for the near term.

RECOMMENDATION

As expected, momentum has brought positive gains and tighter credit spreads, in particular where retail likes to buy bonds (2-10yrs). Compared with recent levels at least, most of the curve looks somewhat underpriced, so there should still be room to run. Mid-intermediates (12-16) are carrying the most concessionary prices and should provide best long-term liquidity at current levels. This may also be the best region for total return in 2010, although long end relative value may be the best bet in our sector (assuming we don’t revisit another 4q08 economic collapse and associated flight to safety flows—not the safest of assumptions)

INVESTING STRATEGY

High grade paper should hold its value best, but mid-grade and selected high yield are better for income. State and local downgrades may create opportunities to buy additional if less liquid income throughout the year. Formerly insured, now unrated safe sector paper remains a strong income buy if you can find it.

SUMMARY

Municipal bonds survived last week with slightly lower yields, a flatter yield curve, tighter credit spreads, and aggressive price bumps in many of the larger primary market loans. These were all despite a large new issue calendar, another downgrade for California, and a rally in Treasuries that made tax-exempts a relative drag on performance. It must be January, where the new issue calendar is feeding tax-exempt reinvestment needs and where zero interest money funds are again fueling large mutual fund inflows. Still, near-term challenges are emerging via resistance to further gains in high grade bonds because of low nominal yields and perhaps because of state budget travails and associated downgrade risks. Last week, institutional selling reached a level that in recent years has signaled a lack of confidence in further gains, tighter credit spreads in bond evaluations support this notion, and the credit default swap market is calling for a pull back. These potentially negative trends may break against a lighter new issue calendar this week, in particular with respect to high grade paper that the retail investor loves, and dealers’ interest in moving unsold balances from last week’s sales. Thus we still see a bias to lower yields, but the evidence for at least a temporary correction is building.

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