Market Review
Economy Softens; Yields Decline
Increasingly weak economic data and renewed European sovereign debt fears dominated bond market activity in May. Rising food and energy prices constrained consumer spending in other areas. Labor market data revealed a decline in job creation rather than an expected improvement. As a result, analysts reduced their GDP estimates for the year and the debate intensified over the sustainability of the economic recovery. Additionally in May, renewed sovereign debt fears in Greece, Portugal, Ireland and Spain generated a flight to quality and U.S. Treasuries.
Yields declined sharply, reflecting these factors. However, the risk of higher yields remains given the U.S. debt ceiling and budget deficit situation. Moody’s warned of a rating downgrade if Congress fails to make progress on an agreement by mid-July. In this event, higher rates are a real possibility.
Tax-Exempt Market
Very Low Supply Drives Yields Down
Tax-exempt bonds recorded one of the strongest months on record in May, outperforming Treasuries despite continued outflows from mutual funds. New-issue supply remained at historically low levels and future supply projections were ratcheted down for the rest of the year. This lack of supply provided firm support for tax-exempts.
Additionally, the overall tone in the municipal market improved in May. Reports emerged of increased tax receipts at the state level, supporting budget-balancing efforts as the new fiscal year begins. Furthermore, the vast majority of states are reaching some sort of budget resolution in a timely manner (as shown in the map below).
For Treasuries and municipals, the longer the maturity, the higher the return in May. Yields in the 10- to 15-year maturity range declined the most, as investors reached for yield in longer maturities where the yield curve is steeper. As a result, the yield curve flattened. Lower quality tax-exempt bonds also outperformed higher quality tax-exempts as investors continued to reach for yield.
Taxable Market
Taxable Munis Outperform Again on No Supply
Taxable municipals followed tax-exempts and outperformed most taxable fixed-income sectors during the month. Lack of supply and attractive yields relative to other taxable sectors boosted the appeal of taxable munis. Corporate issuance continued unabated as corporations rushed to lock in low rates at favorable spreads. Spreads remained firm at tight levels.
Municipal Credit Commentary
State Revenues Improving
After declining for two years, state tax revenue collections are projected to increase in FY2011, reflecting economic improvement as well as increases in various fees and taxes. Revenues are also projected to increase in FY2012, although at a lower rate, as the economy slowly improves. For most states the fiscal situation has clearly improved. This improvement is reflected in the more positive tone surrounding the municipal bond market.
While we are pleased to see improvement, we are not altering our cautious outlook. Municipalities continue to face considerable economic headwinds. State revenues are still roughly 3.1 percent lower than prerecession levels. Additionally, many states have depleted rainy day funds and general fund balances are at historically low levels. The elimination of certain federal government aid, such as stimulus funds and Medicaid funding, will leave a significant gap in state budgets in FY2012. Furthermore, in many instances state budgets have been balanced at the expense of local municipalities.
Breckinridge Strategy
Holding Steady in Uncertain Times
Breckinridge continues to target a neutral duration and barbelled structure given today’s many uncertainties and low rates. The barbell structure protects portfolios if rates rise. At the same time it allows participation in rallies if rates decline. During this period of very low rates, spread compression and uncertain or deteriorating credit quality, we remain committed to high quality portfolios.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification.
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