The very same technical factors that underpinned the outperformance by municipal bonds in 2014 are being called into question at the start of 2015. The low absolute level of rates, Treasury market volatility and increased bond supply are marked changes from 2014. As supply is increasing, inflows into municipal bond funds, as reported by Lipper, have slowed. The rush to refinance debt in the face of flagging demand and increasing volatility came to a head in the primary market this past week when a $1 billion Trinity Healthcare deal was pulled. This deal was somewhat complicated because Trinity Healthcare is a multi-state operator and debt was offered through Michigan, Idaho and Maryland conduit financing authorities. Not only was the deal issued in multiple states, but spreads for the Michigan conduit issue versus the Idaho and Maryland conduits were wider – though, remember, this is the same obligor. But this was not the reason the deal was pulled. The underwriting syndicate was unable to sell enough of the longer maturity debt due to volatility, particularly on the long end of the curve. Prior to the financial crisis, investment banks would likely have held the unsold bonds on their balance sheet, hedged them and waited to sell the bonds later. This type of risk appetite has waned due to regulatory changes and more stringent capital requirements.
This past week’s technical indicators show that most of the factors that contributed to the 2014 muni bond rally are dissipating, that complexities of conduit financing create opportunities for SNWAM to add value to client accounts, and that regulatory shifts have diminished traditional liquidity providers. SNWAM is still positive on municipal bonds, and though we see credit quality generally improving or flattening out, we do not expect the level of returns earned in 2014 to materialize in 2015.
Sources: SNWAM Trading, Bloomberg News and Lipper