The municipal bond market’s sharp rally in 2014 reflects a strong decline in Treasury yields, where the 10-year and 30-year yield was off 18 and 19 basis points over the same period, notes Citi in its recent research report.
George Friedlander and team at Citi Research believe there has been at least a bit of a “January effect” pattern behind the solid performance.
Munis’ recent rally
The Citi analysts note that since year-end, the municipal bond market has rallied with 10-year triple-A yields down 16 basis points and 30-year yields down 26 basis points. The following table captures the municipal bond’s changes since year-end:
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The analysts point out that a very large portion of that rally simply reflects a mirroring of the large decline in Treasury yields, where the 10-year and 30-year yield was off 18 and 19 basis points over the same period.
The Citi analysts attribute the recent Treasury market’s rise to signs indicating economic growth may be falling behind expectations, thereby potentially slowing anticipated Fed moves.
A bit of a “January effect”
The Citi analysts note that the muni market has slightly outpaced Treasuries on the long end with Treasury yields dropping sharply and quickly and credit spreads beginning to tighten. The analysts believe this clearly indicates that there has been at least a bit of a “January effect” pattern behind the solid performance.
The analysts point out historically January effect patterns have often been partly or fully discounted by the time the calendar rolled over, but that didn’t happen this time, with yields rising modestly and the yield curve steepening over most of December. Thus the Citi analysts believe the rally started almost on cue when the market reopened in early January.
Factors aiding solid performance
George Friedlander and team at Citi Research believe other factors too aided to the very solid tone so far in 2014. Some of them include: (a) willingness of dealers to rebuild inventories to a degree in the face of a sharply stronger market tone, (b) dealers lightened up as much as they could during December, (c) the reversal of tax selling pressure as investors put proceeds back to work after a holiday hiatus.
Limited upside for taxable munis
Turning their focus towards taxable munis, the Citi analysts note the year started well for taxable munis, with taxable munis’ spreads tightened across the board by an average of 5 bp, continuing their strong performance, which started at the end of 2013. The analysts point out that over the same time-frame, long-dated industrials widened by 2 bp, pushing spread differential between the two products wider by 7 bp. This can be deduced from the following graph:
The Citi analysts believe at current levels, taxable muni spreads are trading just 5 bp wide to their all-time lows. Considering Citi’s official target for the year is only 3-8 bp of tightening, the analysts believe very limited upside exists for taxable munis from current levels, and hence switch their stance to neutral for this asset class.
To facilitate better performance tracking of their trade recommendations, the Citi analysts, in their recent research report, have introduced a model municipal portfolio. The following table captures Citi’s proposed municipal portfolio: