And so it begins. Taking a cue from the financial markets’ calmer behavior in recent weeks, the Federal Reserve Open Market Committee (FOMC) ended months of speculation by announcing it will start to reduce its bond purchase program to $75 billion from $85 billion a month. Even then, the $10 billion reduction was just a baby step designed to get the message across without shocking the market. The Fed also went to great lengths to reaffirm its dovish stance regarding the outlook for rates.
The FOMC’s decision was a recognition that the US economy may finally be on a sustainable, albeit still modest, growth path. Just to drive the point home, the final Q3 GDP growth number was revised this morning to a shocking 4.1%, up sharply from the previous 3.6% estimate. While this pace is clearly unsustainable and can be traced to significant inventory accumulation, it is nonetheless quite impressive.
So far, equity investors have responded more enthusiastically to the Fed announcement than their counterparts in fixed-income, with the Dow hitting a fresh record high. Although the initial response from bond traders was relatively muted, the benchmark Treasury yields rose sharply yesterday, with the 10 year note hitting a high of about 2.96%. It has since settled back below 2.90%.
The biggest impact, however, has been a significant flattening of the Treasury curve from 5 out to 30 years: the 5- to 10-year maturities have sold off while 30-year bonds have rallied. Compared to where we started out this month, the 5-30 year spread and the 10-30 year spread have narrowed by about 15 basis points and 10 basis points, respectively.
For now, it’s still unclear what could be driving this market response. On the one hand, it could just be year-end profit-taking, since the curve steepened trade has worked out so well for traders all year. On the other hand, the market could be expressing optimism that the Fed will be able to sustain economic growth without stoking inflation, a sentiment not inconsistent with the current collapse in gold prices to a three-year low. Only time will tell.
A steadily recovering economy should be supportive of credit-oriented opportunities.
The municipal curve also weakened and flattened in sympathy with its taxable counterpart, with the 5- to 15-year maturities taking the brunt of the cuts.
The belly of the tax-exempt curve was, in fact, in a more vulnerable position by virtue of having outperformed Treasuries over the last few months. Heading into Wednesday’s FOMC meeting, muni-to-Treasury ratios in the intermediate maturities had fallen to their lows for the year: the 5-year and 10- year ratios stood at only 77% and 95%, respectively. The only remaining value spots were at either extreme of the curve: the two year and thirty year ratios remained above 100%, at 101% and 107%, respectively.
Ironically, the most attractive part of the curve, assuming a slow upward grind but no major breakout in rates next year, might actually be the long end. We realize this may sound counterintuitive but, in a flat to slowly rising rate environment, coupon income should account for the bulk of your return next year. It stands to reason you should try to get as much coupon as possible within your duration parameters. Thus, given the historic steepness of the muni curve, the optimal structure for investors could be a high coupon/longer maturity bond with a short call provision, to keep duration within a manageable range while capturing a very attractive tax-exempt income stream.
Investors with greater income needs and a greater degree of risk tolerance should revisit the high yield muni sector, broadly defined to include any bond whose performance will be driven more by credit factors than by duration. A steadily recovering economy should be supportive of credit-oriented opportunities. As we’ve mentioned before, high yield issues continue to benefit from an attractive combination of wider spreads and higher absolute yield levels. As always, just make sure you do your credit research or work with professionals who do.
The Fed’s announcement does remove a major source of market anxiety but it arrived too late to affect muni supply and demand dynamics for the rest of the year. Muni bond fund shareholders continue to head for the exit, ostensibly to capture tax losses after a dismal performance year. Lipper reported another week of fund outflows this week, marking the 30th straight week money has left the market. Weekly reporting funds recorded outflows of $1.71 billion, down only slightly from $1.90 billion last week.
Thankfully, the visible supply has also dwindled to nothing for the rest of the year, sparing us a significant backup in yield. In fact, from a technical standpoint, the steadily shrinking size of the muni market has been the only factor saving us from even worse underperformance this year.
According to our friends at Barclays, once we get past all the year-end noise, any degree of clarity on Fed policy should help stabilize fund flows. We would tend to agree with that argument. A modest but orderly rise in rates is not necessarily a bad outcome, and the global economy remains fragile enough that any spike in rates will just prove temporary. With top marginal tax brackets already in the high 40% for most investors, the taxable-equivalent yield on munis is already hard to beat. Once we get into the first quarter of 2014, the relative value case for tax-exempts should become that much clearer, particularly if the Puerto Rico situation does get resolved one way or another.
Muni Bond Insights will not be published next Tuesday, which happens to be Christmas Eve. We’ll be back on the 27th with our Outlook and Strategy recommendations for next year. Until then, we do want to wish all our readers a most wonderful holiday season.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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