The municipal bond market through the first three months of 2011 was particularly choppy, culminating in March with one of the most muddled trading environments we’ve experienced in quite some time. To discuss March’s performance, it’s important to examine the events that led us to this point.

As a result of a favorable price-to-yield relationship, municipal mutual funds experienced a net cash inflow of $32.2 billion during the first 10 months of 2010. This increase can be primarily attributed to lackluster returns in other asset classes where investors have historically parked cash during uncertain equity markets.

More interesting is what occurred during the next four months that drove supply and demand to such an imbalance. Net cash outflows from municipal mutual funds totaled $37.7 billion from November 2010 to February 2011. This was caused by three main events:

• Build American Bonds program expiration. With the expiration of Build America Bonds, issuers accelerated debt issuance plans in order to receive the federal subsidy. Subsequently, this saturated the market, outpaced demand, and eroded prices.

  • New long-term issuance spiked in October to December 2010 to $122.5 billion, then plummeted to $48.2 billion between January and March 2011.
• Media frenzy. Exacerbating supply problems was the near constant media attention.
• Tax cut extension. Extension of tax cuts, which simultaneously reduced the need to shelter income and drove less muni-focused asset managers to seek more absolute return strategies in the equity markets given the perceived negative sentiment and risk/return imbalance in municipals.

From the demand side, investors remained bearish, given the negative media coverage, especially as budgetary deficits, pensions, and healthcare costs continued to dictate market opinions. However, the real underlying factor was that historically investors had a perceived level of protection buying a non-rated issuer as long as it was also wrapped with bond insurance, thereby negating the need for in-depth credit research. Considering the near extinction of highly rated bond insurers, many investors are reluctant to buy lesser known, smaller name issuers over more prominent ones. This dynamic exposes the true imbalance exhibited in March – investment decisions were not being made based on quality.

This paradigm was also observed through significant pricing variability in which price discovery for short end, highly-rated issuers was relatively accurate, while longer maturities of lesser known names (regardless of rating), generated fewer and wider spread bids.

This convergence of factors can be seen in the average monthly price, which fell from $100.77 in June 2010 all the way to $92.08 in January 2011, with corresponding yield-to-maturity of 5.14% to 5.75%, respectively.

Justin Formas, CAIA
Director, Credit Research
April 11, 2011


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