Muni bonds ought to have had a rough week, with outflows more than doubling from $875 million to $1.9 billion and more than $11 billion in new issuing, but a Volcker Rule exception and a few other positive trends actually caused them to recover.
Doubling of Muni bonds fund outflows
“Despite a combination of factors that might have been expected to generate significant distress, which include the heaviest new issue supply of the year, a week-over-week doubling of bond fund outflows, and some signs of tax loss selling, the market ended the week with slightly lower yields than it began,” write Citi analysts George Friedlander, Mikhail Foux, and Vikram Rai.
These outflows continue a six-month trend of declining assets even worse than what investors experienced during the crisis.
Volcker Rule grants muni bond exception
Probably the most significant event for muni bonds this week was the finalization of a Volcker Rule exception. “In the initial proposed rules, only direct obligations of state and local government were exempted from limitations on proprietary trading; in the final rules, all munis, including agencies and authorities—i.e., a large proportion of revenue bonds—were exempted from the restrictions,” they write. This means that municipal bonds are one of the few markets where banks can still engage in proprietary trading, so investors can expect a boost in demand and liquidity.
The Citi report also points out that the heavy issuances last week is an artifact of much lighter issuances for the next few weeks because Christmas and New Year’s both fall on a Wednesday this year. They also expect total issuances for 2014 to fall to $285 billion compared to about $325 billion this year, so the recent spike in activity isn’t as worrying as it could be.
Retail demand for muni bonds strong despite recent outflows
The enormous outflows, instead of being a sign of underlying problems, are more likely tax-loss selling of profitable bonds before the end of the year. “Direct retail demand has actually been quite solid of late,” says the Citi report. “The five-day moving average of net buys in odd-lot form, at $1.22 billion, was near highs for 2012, and it was 28% above the 200-day moving average.”
Looking to 2014, Friedlander, Foux, and Rai don’t think tapering poses a serious threat to muni bonds, and that investors should be more concerned about rising short term rates than the end of QE. With forward guidance extending into 2015, short-term interest rates shouldn’t be an issue next year.
