Bond Market Perspectives | Week of January 20, 2014

posted 1/28/2014 in Investments

Highlights

  • The bond market is off to a strong early start -- particularly municipal bonds.
  • Valuations, lower yields, and the upcoming difficult March period suggest the current pace of municipal bonds is not sustainable.
  • We believe municipal bonds will stay on track for flat to slightly positive gains in 2014 asdiscussed in our Outlook 2014: The Investor's Almanac.


Municipal Rush

Oscar nominations were released last week and absent from the list of best picture nominees was one of my personal favorites, Rush. As a Formula One fan, I was biased of course and thought the real life drama of the James Hunt and Niki Lauda pursuit of the world championship was a great story. Understandably, the Academy of Motion Picture of Arts and Sciences perhaps sought more profound stories. A good start is a key to success in any racing event. In financial markets, bonds have enjoyed a strong start to 2014 with the Barclays Aggregate Bond Index up nearly 1% in just two-and-a-half weeks of trading. One sector that has rushed off the starting line is municipal bonds, up 1.5% in just 16 trading days in 2014.


Success in auto racing is often determined by the team and its preparation of the car for the specific course conditions. In the municipal market, unique market factors such as heavy supply can create headwinds that offset favorable factors such as attractive valuations and lead to difficult performance.


The start of January typically brings two favorable dynamics together for municipal bond investors: low new issue supply and reinvestment demand. The start of any new year usually sees limited new issuance, and January is one the larger months of maturing bonds-often creating a favorable demand dynamic as investors reinvest maturing bond proceeds into new bonds. These two factors help explain why the beginning of January is typically a seasonally strong period for the municipal bond market [Figure 1]. So far January 2014 has held true to form.

Diminishing investor redemptions and taxable market strength added to the strength of the municipal quick start. The week ending January 8, 2014 saw the smallest dollar amount of mutual fund outflows since the week ending May 8, 2013, according to the Investment Company Institute (ICI), and helped keep secondary market selling pressure at its most subdued since early May 2013 [Figure 2]. Selling pressure may be finally exhausted after outflows totaled $68 billion since early May 2013.


The coming week is likely to keep municipal bonds on the straight-a-way and see a continuation of
the current trends. New issuance for the current week is scheduled to be a below-average $4 billion and secondary selling pressure remains subdued, suggesting municipal bonds may hold recent gains for the week ahead.


Will municipal bonds maintain their early lead through the many twists and turns of 2014? The
current pace of performance is not sustainable and upcoming challenges indicate a slowdown is
likely.

  • Valuations. The average 10-year AAA municipal-to-Treasury yield ratio has decreased as municipal bond yields have declined further than comparable Treasury yields [Figure 3]. The higher the municipal-to-Treasury yield ratio, the more attractive municipal bonds are relative to Treasuries and vice versa. The current ratio has declined to 91%, a level that has halted further valuation improvement in the past. Valuations remain attractive when compared over the long term, but over the near term may give investors pause.
  • Lower yields. Municipal bond yields have reached or are approaching three-month lows, which may reduce investor demand. The last time yields reached similar levels, in October 2013, demand weakened. Lower yields alone may not be a hurdle but simply make the municipal bond market more dependent on taxable bond market strength given the improvement in valuations noted above. We see a further decline in Treasury yields as very limited given economic data continue to reflect an improving economy.              
Around the Bend
In just over one month, a consistently negative seasonal trend may impact the municipal market

starting in early March and lasting through early April. This seasonal weakness is typically due to
tax-related sales and seasonal weakness in the Treasury market. As Figure 1illustrates, March is
historically the most difficult for the municipal bond market with an average monthly return of
-0.24%. Seasonal trends do not always hold true, but with economic growth accelerating and the
Federal Reserve reducing bond purchases investors need to be cautious.


The Finish Line

We continue to find municipal bonds one of the more attractive bond sectors for 2014, but after
jumping out to a 1.5% gain through mid-January, the municipal market is due for downshift.
Investing is a marathon not a race. Low supply suggests that municipal bonds may hold recent gains
over the near term but challenges lie ahead in now-higher valuations, lower yields, and a typically
difficult month of March. On balance, the breadth of economic data continues to reflect improving growth that will likely drive yields higher over the course of the year. This makes for a challenging course that we believe keeps municipal bonds on track for flat to slightly positive gains in 2014 as discussed in our Outlook 2014: The Investor's Almanac.
 
 
 
 
IMPORTANT DISCLOSURES


The opinions voiced in this material are for general information only and are not intended to
provide specific advice or recommendations for any individual. To determine which investment(s)
may be appropriate for you, consult your financial advisor prior to investing. All performance
reference is historical and is no guarantee of future results. All indices are unmanaged and cannot
be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges.
Index performance is not indicative of the performance of any investment. Past performance is no
guarantee of future results.


This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.


The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.


An obligation rated 'AAA' has the highest rating assigned by Standard & Poor's. The obligor's
capacity to meet its financial commitment on the obligation is extremely strong.


Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields
will decline as interest rates rise, and bonds are subject to availability and change in price.


Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely
payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed
principal value. However, the value of fund shares is not guaranteed and will fluctuate.


Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior
to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the
alternative minimum tax. Federally tax-free but other state and local taxes may apply.


Stock and mutual fund investing involves risk including loss of principal.


The Investment Company Institute (ICI) is the national association of U.S. investment companies,
including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment
trusts (UITs). Members of ICI manage total assets of $11.18 trillion and serve nearly 90 million
shareholders.


The municipal-to-Treasury yield compares the current yield of municipal bonds to US Treasuries of
the same maturity. If the ratio is at 100%, it indicates that the yield on a AAA-rated municipal bond is the same as a Treasury security of the same maturity. The ratio can be used as a gauge of price levels of municipal bonds relative to Treasuries.


INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and
dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and
asset-backed securities.The Standard & Poor's 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.


The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade
municipal bonds with maturities of at least one year. All indices are unmanaged and include
reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of
future results.


This research material has been prepared by LPL Financial.


To the extent you are receiving investment advice from a separately registered independent
investment advisor, please note that LPL Financial is not an affiliate of and makes no
representation with respect to such entity.


   Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed
                    by any Government Agency | Not a Bank/Credit Union Deposit


Tracking #1-236893 Exp. 01/15


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
 
The financial consultants of Wealth Management are registered representatives with and Securities are offered through LPL Financial. Member FINRA/SIPC. Insurance products offered through LPL Financial or its licensed affiliates.
 
                                    Not FDIC/NCUA Insured Not Bank/Credit Union
                                              Guaranteed May Lose Value
                    Not Insured by any Federal Government Agency Not a Bank Deposit
 
This newsletter was created using Newsletter OnDemand, powered by Wealth Management Systems Inc.

Blog and News
BrokerCheck