Municipal Fixed Income | September 2011
Low levels of municipal bond issuance may provide technical pricing support during the low-yield environmentBy Lyle J. Fitterer, CFA, CPA, and Robert J. Miller— Senior Portfolio Managers, Municipal Bond Fund
Historically, the third quarter (specifically July and August) is a strong period for investor demand of municipal bonds because the increase in reinvestment activity of semi-annual coupon payments and principal creates more technical demand for new securities. Concurrently, new municipal bond issuance during this period is also typically low, which creates a relative scarcity of investment options. This combination of higher demand and lower supply creates an upward technical force on municipal bond prices, which may continue to support prices in the near term.
New municipal bond issuance at lowest level in past 10 yearsThis year, the level of municipal supply is even lower than in past years, with average weekly sales trending far below historical levels. Bloomberg data indicated that municipal bond sales had a weekly average of $4.1 billion through September 9—the lowest weekly rate since 2003, when Bloomberg first began tracking the data. Although weekly issuance had ticked higher to $5.2 billion per week during July, as many states entered a new fiscal year, the rate of issuance trended lower during August. This trend may reverse modestly in the near term because low interest rates often create a constructive environment for new debt issuance. Nevertheless, supply for the remainder of 2011 is expected to fall far short of historical averages, potentially resulting in continued technical price support for municipal securities in the secondary market.
Current political focus is on budget balancing rather than funding capital projectsPerhaps one of the more influential factors on the level of municipal supply has been the U.S. political environment. In 2011, more than half the states inaugurated new governors. Additionally, countless numbers of other new state and local officials were also installed across the country. The focuses during the early portion of their terms were budget gaps and pension issues, rather than funding capital projects, which would lead to more municipal bond issuance. Only in recent months have we seen some municipalities begin to consider funding longer-term projects that will require raising capital as they enter a new fiscal year. Many local and state governments may take advantage of the low-yield environment for both new issuance and the refinancing of existing debt, but those trends have not yet manifested significantly.
Low supply provides price support in low-yield environment, but we remain cautiousIn our view, the low level of supply should provide technical support if demand remains tepid as investors continue to shift their assets elsewhere in search of higher yields. However, we believe a cautious approach to municipal investing is prudent in a low-supply environment. First, if new issuance slows further or trading volumes fall, price discovery may be limited within the marketplace. More specifically, it could become difficult for market participants and pricing agencies to accurately price certain bonds and sectors if the number of bonds trading is limited.
Second, since supply is extremely light, there may be a misperception that the market will be able to absorb any significant increase in supply that would characterize a "full" new-issuance calendar, which has not been the case since the fall of 2010.
Concluding observationsWhile we expect supply to increase over the remainder of the calendar year, it will likely remain constrained by historical standards as municipal governments continue to implement greater fiscal conservatism. Considering the current low-supply environment and its risks, including limited price discovery, we are likely to be more patient with many of our holdings until we identify investment opportunities through our fundamental credit research approach. While our investment approach may remain cautious, we are optimistic that these technical conditions should continue to provide some additional price support for municipal bonds.
Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. The use of derivatives may reduce returns and/or increase volatility. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to active trading risk, high-yield securities risk, and municipal securities risk. Consult the fund's prospectus for additional information on these and other risks. A portion of the fund's income may be subject to federal, state, and/or local income taxes or the alternative minimum tax (AMT). Any capital gains distributions may be taxable.