Tuesday, January 17, 2012

New fund flows and limited supply provide support to the muni market

The municipal bond (muni) market in the US has been on fire lately. Seems investors have discounted Meredith Whitney's famous dire forecast.
SFGate: Investors in the $3.7 trillion U.S. municipal-bond market are buying long-term debt at the fastest pace since the eve of Meredith Whitney's 2010 prediction of "hundreds of billions of dollars" of public-borrower defaults.
As the chart below from JPMorgan shows, the flows into muni funds represent at least a partial reversal of what was occurring in this market the same time last year.

Muni fund flows (source:JPMorgan)

The market has responded strongly to these inflows with the S&P Municipal Bond Index outperforming treasuries by nearly 2% during the past month.

S&P Muni Index vs. the iBoxx US treasury index (Bloomberg)
Furthermore it looks like the supply of new bonds is not expected to increase substantially. JPMorgan forecasts $350 billion of issuance in 2012 or 20% above what we saw in 2011. That seems like a bunch of new supply, but much of it represents refinancing of existing bonds. A number of municipalities are projected to be taking advantage of lower rates and calling their existing debt. In fact as the chart below shows, the net new supply of munis for 2012 is expected to stay close to flat (the negative numbers on the chart indicate a net reduction - more bonds being called than issued).

Net new supply of municipal bonds - 2012 forecast vs. 5-year average (source: JPMorgan)
Clearly risks to the downside remain.  A disruption in global credit markets could quickly widen municipal bond spreads.  A less likely scenario is a sharp steepening of the US treasury curve that may hurt the longer term munis.  These risks aside however, the limited supply and low rates should provide sufficient support to the muni market, as flows into fixed income funds continue


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