Both municipal bonds and Treasuries remained in a narrow trading range in February as markets awaited clarity on tax reform and Fed interest rate policy. Munis were able to outperform Treasuries thanks primarily to limited supply and positive demand. New issuance of $20.7 billion was 40% below the robust level of the month before and 15% below the 10-year average for February.
Since mid-2016, issuance has deviated from its historical seasonal pattern. Issuers seem motivated to pull forward deals due to fears of rising rates, making it more difficult to project supply and its potential impact on performance. Demand for munis remained constructive, with $2.7 billion in inflows for the month. Flows were concentrated in the high yield space as investors chased the sector’s strong performance. Notably, demand waned in the latter part of the month as tax reform returned to the headlines.
Looking ahead, March is one of only two months with an average negative return figure, but investors should not be deterred from the asset class.
We expect the market will continue to be highly correlated to interest rates and driven by the potential effects of tax reform. While lower marginal tax rates may erode some of the value of munis’ tax-exemption, its elimination is unlikely. We maintain a neutral duration stance, favoring the short to intermediate part of the yield curve. Our preferences also lead us toward lower-rated investment-grade credits, the transportation sector and flexible mandates.
After three consecutive months of positive performance, the market has regained 63% of performance lost in November.
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