Highlights

  • June was a fairly active month in terms of municipal bond issuance and headlines, yet the market ended close to unchanged.
  • Demand held firm while the net-negative supply scenario remained intact, underpinning muni pricing.
  • Troubled Puerto Rico returned to headlines when it passed a law that would allow public corporations to default on their obligations.

Market Overview

June typically is not a friendly month for the tax-exempt asset class, but 2014 has not been a typical year. While it was an active month overall, municipals essentially ended it flat, but hit the mid-year point emphatically in the black with a year-to-date (YTD) return above 6%. Performance was again supported by weak U.S. economic data, as first quarter gross domestic product growth was revised downward to -2.9%. A still-accommodative Fed also gave the market comfort.

While new issuance was stronger than in prior months, the favorable supply/demand dynamic that has driven performance YTD remained a tailwind in June. Issuance for the month was $34 billion, consistent with the five-year average for June. More notably, however, this was up 32% from last month. Issuance is now down only 16% compared to last year, and munis remain on pace for $300 billion in total issuance for 2014 (still an estimated net-negative supply of $40 billion). Demand, meanwhile, came in at roughly $2.2 billion for the month, bringing the YTD figure to $10.6 billion. Flows continue to be concentrated in high yield, intermediate and flexible strategies.

The strong technical picture is accompanied by improving fundamentals across municipal issuers. That said, the market did see an interesting mix of stories in June, as good news in California was offset by less favorable events in New Jersey and Puerto Rico (more on these below). Overall, the market took the developments in stride.

"June typically is not a friendly month for munis, but 2014 has not been a typical year."

Current Strategy
Duration
  • Short
Yield Curve
  • Barbell (0-2 and 15-20 years)
Overweight Sectors
  • State tax-backed and essential-service bonds, particularly the Southwest (TX), Plains and Southeast (VA) regions
  • Locals in lien-status states, particularly CA school districts
  • Dedicated-tax bonds

Underweight Sectors

  • Land-secured, senior-living and pre-refunded bonds
  • Student loans
  • Local tax-backed issues, particularly in AL, NV, AZ, MI, IL, RI and PR

Making Headlines

California: Moody’s became the first ratings agency to upgrade California’s general obligation (GO) debt from A1 to Aa3, its highest rating in over a decade. The upgrade was based on declining debt metrics, strong liquidity, robust employment growth and recent governance changes. S&P and Fitch may take similar action, but would likely keep the state’s debt in the single-A category. The upcoming expirations of temporary tax hikes (sales tax in 2016 and personal income tax in 2018) may give the agencies some pause.

New Jersey: Capping a highly volatile budget season, a Superior Court judge ruled that Gov. Chris Christie’s order to withhold $884 million in pension payments was justified by the state’s serious fiscal situation, stressing that this is an emergency move for this fiscal year only. The governor was found to have acted legally under the Disaster Control Act in breaching the contractual pension promise. While noting “irreparable harm” to the unions, the judge deemed that the governor’s action doesn’t threaten government employees’ pension payments in the next few years, but making the pension payments would have impaired essential civil services.

Puerto Rico: The island’s struggle to keep its head above water approached a climax with the signing of new legislation that would allow ailing public corporations to restructure debt through a local process akin to bankruptcy. The legislation, which does not apply to Puerto Rico’s GO debt or to its COFINA (sales tax) bonds, was fast-tracked at the Legislature and cleared by both the Senate and the House in just hours. The new law would apply to at least $22 billion of debt owed by public corporations, providing for an organized process through which debt can be cut or reduced. The Puerto Rico Electric Power Authority (PREPA) and the Highway & Transportation Authority, two big drags on public coffers, are seen as prime candidates for debt restructuring. The law stoked default concerns and quickly prompted ratings downgrades to PREPA, other public entities and even the island’s GO and sales tax debt.

By the Numbers

The S&P Municipal Bond Index returned -0.09% in June and 6.08% YTD. Returns were essentially sideways across the curve, with the short end faring the best. High yield significantly underperformed the broader market for the month, but remains ahead YTD. Across sectors, land-backed and housing led, while public power and utilities lagged.

Strategy and Outlook

We maintain a barbell approach to both credit and the yield curve, favoring maturities below two years on one end (for trading flexibility) and above 15 years on the other. While short-term and intermediate munis are looking expensive, longer maturities continue to appear attractive versus Treasuries and, we believe, represent the best absolute and relative value. Going forward, performance will likely be derived from security selection and the ability to rotate sectors and adjust duration as conditions warrant. We expect this will be particularly important as summer apathy sets in and as events in Puerto Rico evolve, potentially presenting opportunities to capture value in the market.

Monthly Change in Yields
AAA Muni Yield (%) Treasury Yield (%)
Term 5/31/14 6/30/14 5/31/14 6/30/14
2 years 0.29 0.28
0.38 0.46
5 years 1.15 1.20
1.54 1.63
10 years 2.16 2.26
2.48 2.53
30 years 3.26 3.28
3.33 3.36
Municipal and Treasury Curves, 6/30/14

 

Municipal Performance Analysis
June 2014 YTD 2014
S&P Municipal Bond Index -0.09% 6.08%
Long maturities (20+ yrs.) -0.10 10.09
Intermediate maturities (3-14 yrs.) -0.13 4.60
Short maturities (6 mos.-3 yrs.) 0.01 0.74
High yield -1.31 8.54
Pre-refunded bonds 0.00 1.20
General obligation (GO) bonds -0.05 5.20
Regions
California 0.05 7.04
Florida 0.09 6.10
New Jersey -0.36 6.00
New York 0.03 5.62
Pennsylvania 0.03 6.33
Puerto Rico -4.26 5.93

Source: S&P Indices.

Adapt to Thrive: Age-Old Wisdom for Modern-Day Munis

The municipal bond market has evolved considerably over the years. The key to thriving in the current environment: the ability to adapt and thorough credit research.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 7, 2014, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader.

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