Summary

Municipals have seen modest losses continue in the last few weeks. Despite strong demand from individuals attracted by slightly higher yields, institutional investors remain concerned that future supply will saturate the market and force yields higher.

Indeed, underwriters continued to price new loans to sell quickly last week, meaning potential sellers unwilling to adopt a sale mentality were once more left carrying paper losses. This week, a $1.5 billion to $2 billion State of Wisconsin loan, along with next week's $4 billion California loan, represent substantial tests of the market's ability to contain losses.

On the other hand, we expect both of these issues will be offered with substantially higher yields to attract investor dollars that have been waiting for exactly this opportunity. And favorable sales could give some buyers' confidence that a bottom has been reached. Regardless, we continue to recommend that buyers wait, and not stretch, for yield.

However, issuers may also benefit from waiting. A new federal proposal to provide U.S. Treasury guaranties on all new general obligation bonds is reason enough to defer borrowing plans for a few months.

Market Update

Federal intervention may represent significant upside.

Recommendation

The 5-year continues to offer concessions to current buyers. We recommend that total return buyers look to buy related high grade bonds. We also exhort more income-oriented buying of insured, safe-sector loans that have lost investment grade ratings.

Pre-refunded bonds have better liquidity and near-term price performance. We also advise generic caution with respect to health care issuers, but higher yields in this sector are creating attractive opportunities for selected credits.

Credit Strategy

Future supply, and potential rating-related weakness in California and Puerto Rico paper, means deferring related in-state purchases for awhile, although pre-refunded bonds continue to grow more scarce and should thus be part of near-term total return allocations. Investors should also consider high yield ETFs for incremental tax-exempt yield (at the expense of likely NAV volatility).
Matt Fabian is managing director at Municipal Market Advisors.

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