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Perspective published on July 1, 2016

Launched: The Flight to Quality in Municipals

The history of the potato chip dates back to 1853, when a restaurant patron complained to chef George Crum that the French-fried potatoes he served at his New England restaurant were too thick. In retaliation, an irritated Crum sliced the potatoes as thin as possible, fried them in grease and returned them to the customer.[1] From an unpleasant situation, a now-beloved crunchy treat was born.

Some investors have made their own valuable discoveries amid a rocky market environment. While not as tasty as potato chips, municipal bonds have seen inflows rise as investors have discovered municipals as an attractive flight-to-quality option.

In recent weeks, municipal yields have declined sharply on strong demand. Municipal bond yields plummeted to historic lows across the curve in June, with the 10-year AAA municipal falling to a record low of 1.33 percent the last week of the month. At the long end, municipal yields outperformed Treasuries. The 30-year municipal bond yield fell more than 40bps during the month and the 30-year ratio fell to 85.8 percent on June 24 – an all-time low. Municipal yields in the short end could not quite keep up with the precipitous fall in 1-year and 3-year Treasury bond yields.[2] Nonetheless, the bid for municipal bonds has been very strong amid broader volatile markets. In traditional demand channels, mutual funds poured $716M into municipal bonds the week ending June 29th, marking the 39th consecutive week of inflows and pushing the year-to-date aggregate to $33B, per Lipper.

In addition to the traditional buyer, various types of investors are boosting the flight-to-quality bid for municipals. Two of the biggest culprits:

  • Foreign investors. Negative rates around the world have driven foreign investors to U.S. fixed income markets, particularly Treasuries and municipals. Fed Flow of Funds data show that foreign investors increased their municipal holdings by US$6.7 billion over the last year and US$2 billion during the first quarter. Municipal holdings of US$89.2 billion were held outside the United States at the end of the first quarter, versus US$87.2 billion at the end of 2015 and US$80.4 billion at the end of 2014.[3]
  • Investors seeking stability, but aiming for higher yields than Treasury bonds. Few asset classes have been frothier than U.S. Treasury bonds in recent months, as investors have piled into Treasuries as a safe haven. Following the U.K.’s Brexit announcement, the 10-year yield fell to a four-year low of 1.43 percent. However, investment-grade municipal bonds can offer stable credit fundamentals with higher yields. Aside from pockets of weakness (such as oil-affected states, today’s Puerto Rico default or ongoing pension-afflicted budgets in some areas), municipals are benefiting from slow but steady growth in the U.S. economy, an improving housing market and better performance in commodities.

The strong performance of municipal bonds puts the constructive supply/demand trends on display. Investors see higher-quality municipal names such as California state general obligation (GO) bonds (Aa3/AA-), Georgia state GO bonds (Aaa/AAA) or New York MTA bonds (A1/AA-) as low-risk alternatives that can perform well in periods of market uproar. Meanwhile, the size of the municipal market has been roughly unchanged in recent years, as net new supply has been paltry.[4] As an example, a $550 million, 10-year local GO from Harris County, Texas (Aa2/NR), was 22 times oversubscribed and saw its yield lowered by 13bps in the new-issue market this month.

Investors globally are trying to make the best trade-offs between risk and return. Municipal bonds have benefited from investors seeking to counterbalance unruly markets, and we have participated in the resulting rally. We continue to think that high-grade municipal bonds are a solid choice for investors seeking reliable income, and we maintain that fundamental credit analysis is key to avoiding pockets of risk that could be underpriced by the markets.

[1] The Lemelson-MIT Program, Massachusetts Institute of Technology.

[2] MMA, as of June 2016.

[3] Board of Governors, the U.S. Federal Reserve, as of June 9, 2016.

[4] The Bond Buyer, as of June 2016.

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 or portfolio characteristics 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. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.