INSIGHTS

On December 10, 2018

AAM Viewpoints – Let’s Get Technical…With Municipals

More often than not, fixed income investors are reminded of the notion that the only thing certain about today’s bond markets is that there’s nothing certain about today’s bond markets. While the rising interest rate narrative has held true for most of the year, last week’s massive risk-off movement may have left some market participants second guessing their investment strategies going forward. The renewed flattening of the U.S. Treasury yield curve, along with the acute inversion on the short end, suggests that Federal Reserve contractionary measures may have finally caught up with economic growth. There’s no question that this week’s FOMC (Federal Open Market Committee) meeting will heavily influence market movements into year-end and carry over into 2019.

Among the best performers across all fixed income asset classes, tax-exempt municipals have maintained a healthy lead over Treasuries and corporate bonds throughout 2018. Through December 6, the broad Bloomberg Barclays Municipal Market benchmark has returned +0.78% while the U.S. Aggregate Index posted a -1.14% loss for the year. What makes this outperformance even more impressive is that municipals have been broadly hampered by ramifications of tax reform since the start of the year. This nearly 200 basis point margin has been largely attributed to positive technical factors isolated to the tax-exempt market.

Generally speaking, municipal new issuance plays a critical role in dictating day-to-day market performance. At the issuer level, it is no secret that states and municipalities structure their debt financing around the fiscal year (but are also influenced by the calendar year). If all else is equal, these supply patterns provide a level of predictability for market participants. This is why municipal traders look to weekly new issue calendars and monthly visible supply figures to help them price their inventories and bid for certain bonds accordingly.

Here are some of the most prominent month-by-month technical events that tend to take place on an annual basis:

January: The start of the year traditionally brings in fresh inquiries and robust demand as municipal investors race to reinvest their cash flows from January 1st maturities and July 1st interest payments, by far one of the heaviest reinvestment periods of the year. Since a municipal issuer needs approximately three weeks to bring a deal to market, supply usually does not ramp up until the third or fourth week of the month. This demand/supply imbalance is widely known as the “January Effect.” 

February: Positive market technicals tend to carry over into the first two weeks of February, especially if January issuance was net negative (when cash returned from maturities/calls/interest income totals is greater than monthly supply).

March: March has historically been a negative performing month as the supply calendar is likely to be heavier by the end of the first quarter.

April: Municipal bonds have been known to be the investment vehicle of choice when investors look for liquidity to pay for taxes owed to the government. Municipal bid wanted lists historically grow in the few weeks leading up to Tax Day, especially if the previous year was a profitable one for equities.

May: May has been a toss-up month for municipals; all else equal, supply and demand should be balanced by May.

June: June 30^th marks an end to most state fiscal calendar years so issuance should be flowing in the weeks leading up to month-end. Once again, because of increases to supply, June has been typically a negative performing month for the municipal market.

July: July has been historically one of the most profitable months for the municipal market. Related to the fiscal calendar start date, a considerable portion of bonds outstanding carry a July 1st maturity date. The combination of increased cash flows returned to investors and the slowing of issuance during the early summer weeks leaves municipal investors with few options other than the secondary market, which tends to be bid up during this period.

August: Similar to equity markets, municipals experience a trading lull during the slow summer weeks. With fewer block trades moving the municipal curve, performance tends to be flat in August.

September: The market has been typically groggy during the first weeks of September as states and municipalities target the fourth quarter to issue their final deals of the calendar year.

October: The October-November period has historically produced the largest supply surges of the year for the municipal market. By Thanksgiving week, issuers have gone into “now or never” mode as they only have seven full weeks or less (accounting for bond market holidays like Columbus Day or Veterans Day) to bring their deals to market before the holiday season breaks up the momentum.

November: Supply should continue to flood markets up until Thanksgiving week.

December: Seasoned municipal bond investors know that the month of December tends to be one of the best times to buy tax-exempt debt. The holiday season typically signals less market participation, less issuance, as well as tax-loss harvesting. All these factors combined have provided investors with opportunity to source value on the secondary market.

Familiarity with technical events should provide municipal participants with a basic blueprint for how the market is expected to behave over the course of the year. Investors have the potential to actively maneuver through the calendar year and source value advantageously during pockets of weakness. However, it goes without saying that technical analysis has its obvious limits and time invested in the market along with interest income are typically the most important drivers of long-term performance. Additionally, any combination of macroeconomic, fiscal, and/or political events of the hour could minimize the effect of technical factors and direct the general trajectory of municipal performance. All of these factors considered, an understanding of municipal market technicals has the potential to provide investors with some sense of direction in this increasingly uncertain environment.

CRN: 2018-1203-7071R