Municipal Bond Monthly Fixed Income Strategy

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1 PORTFOLIO STRATEGY & RESEARCH GROUP DECEMBER 19, 212 Municipal Bond Monthly Fixed Income Strategy Circuit Breaker or Delay of Game? The majority of our thoughts on the 212 market and our outlook are contained in our Year-End Review & 213 Outlook (R&O) report entitled Outperformance & Diminishing Returns published on December 12, 212. This month s edition of the Municipal Bond Monthly is intended to simply offer an addendum to that text with a final snapshot of what has transpired during the last week. Typically, there would not be much to discuss at this point of the year, but this is not a typical year. With the municipal bond market preparing to wind down the 212 calendar year, primary market issuance has now experienced its customary year-end halt. After one of the largest weeks of the year, at over $1 billion, new issuance plummeted this week to under $3 billion. That respite in supply may have arrived just in time, as the tone of the market had turned decidedly negative in recent trading sessions. What has happened? Will the weakness continue in the coming weeks or will the seasonal circuit breaker of miniscule primary market issuance amid heavy bond redemptions (maturing bonds and coupon payments in December and January) work to mitigate or avert additional losses? In this edition, we discuss: Sharp changes in new-issue supply Year-over-year metrics for December Market turbulence in recent sessions Potential causes of volatility Fiscal cliff thoughts Near-term market response scenarios JOHN M DILLON MSSB North America - Morgan Stanley Smith Barney LLC Chief Municipal Bond Strategist Managing Director John.Dillon2@mssb.com MATTHEW GASTALL MSSB North America - Morgan Stanley Smith Barney LLC Municipal Bond Strategist Vice President Matthew.Gastall@mssb.com INVESTMENT THESIS With the fiscal cliff occupying center stage, both marginal tax rates and the longevity of the federal exemption for municipal bonds hang in the balance. Although market trading during the weeks surrounding the year-end calendar change is normally subdued due to the absence of a significant new-issue calendar, it appears that this year s favorable technicals may be trumped by volatility related to the aforementioned uncertainty. With this in mind, municipal value should be benchmarked against performance of the broader UST market (rather than in absolute yield levels), as any required adjustments to the municipal asset class will likely need to be viewed in isolation from broader UST adjustments (if any). Municipal relative value ratios, which have recently risen to 11% from 9%, should serve as a valuable indicator in this respect for the near term. Figure 1. MBWD PAR Index (Bid-Wanted Items) Par-Value (Millions) Dollar Amount of Bid-Wanted Items /2/1 9/3/1 12/5/1 3/8/11 6/9/11 9/1/11 12/12/11 3/14/12 6/15/12 9/16/12 12/18/12 Source: Bloomberg as of 12/18/12 This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. This is not a research report and was not prepared by the Research departments of Morgan Stanley Smith Barney LLC, Morgan Stanley & Co. LLC, or Citigroup Global Markets Inc. It was prepared by Morgan Stanley Smith Barney sales, trading or other non-research personnel. Past performance is not necessarily a guide to future performance. Please refer to important information, disclosures, and qualifications at the end of this material.

2 FIXED INCOME STRATEGY / DECEMBER 19, 212 Circuit Breaker or Delay of Game? The majority of our thoughts on the 212 market and our outlook are contained in our Year-End Review & 213 Outlook (R&O) report entitled Outperformance & Diminishing Returns published on December 12, 212. This month s edition of the Municipal Bond Monthly is intended to simply offer an addendum to that text with a final snapshot of what has transpired during the last week. Typically, there would not be much to discuss at this point of the year, but this is not a typical year. With the municipal bond market preparing to wind down the 212 calendar year, primary market issuance has now experienced its customary year-end halt. After one of the largest weeks of the year, at over $1 billion, new issuance plummeted this week to under $3 billion. That respite in supply may have arrived just in time, as the tone of the market had turned decidedly negative in recent trading sessions. What has happened? Will the weakness continue in the coming weeks, or will the seasonal circuit breaker of miniscule primary market issuance amid heavy bond redemptions (maturing bonds and coupon payments in December and January) work to mitigate or avert additional losses? Of course, the fiscal cliff will be working its way into the conversation. Before moving in that direction, however, it is also worthwhile to examine a few muni-specific factors that define the current landscape, the first of which is the simple fact that last week s supply, among the largest of 212, arrived just in time to meet the lowest yield levels in almost 5 years. There was also an article in The Wall Street Journal on December 12, 212 regarding risks to the current federal tax exemption for municipals that seemed to resonate with individual investors. While the article contained no new information for market pundits (including ourselves) who have been communicating such risks for quite some time, it did prompt numerous client inquiries and conversations. The concept here appears similar to marketing sitcoms in syndication: if you haven t seen it, it s new to you. The article coincided with the start of the municipal sell-off. That said, we will be keeping a close eye on municipal mutual fund flows this week for any related reaction, as there have been only two negative weeks thus far in 212, both of which were easily explained away by tax time and Hurricane Sandy. As we noted in our R&O report, the relevancy of fund flows will likely grow in 213. If fund flows remain decidedly positive, there may be a soothing effect. If negative, the development could exacerbate the currently heavy tone and carry it into the new year. Figure 2. New-Issue Supply Average (2-211) vs. 212 YTD 45 4 Averag e 212 Supply Par Value (Billions) January February March April May June July August September October November December Source: The Bond Buyer as of 12/17/12 Please refer to important information, disclosures and qualifications at the end of this material. 2

3 FIXED INCOME STRATEGY / DECEMBER 19, 212 Figure 3. Timeline of 1-Yr AAA MMD Yield & 1-Yr UST Yield 1-Yr AAA MMD 1-Yr UST Yield (%) /1/212 12/3/212 12/5/212 12/7/212 12/9/212 12/11/212 12/13/212 12/15/212 12/17/212 Source: Thomson Reuters Municipal Market Data as of 12/18/12 The third development worth mentioning was the rating downgrade of Puerto Rico s general obligation debt and other related securities by Moody s on December 13, 212. The twonotch downgrade brought the general obligation rating to Baa3 from Baa1 and a negative outlook was applied. Although the timing and magnitude of the move may have been unexpected, the action itself probably wasn t. In fact, we quoted Standard & Poor s (not Moody s) in our Election Reflection note of November 9, stating However, we still believe that there is at least a one-in-three chance that we may lower these ratings later this year or in early 213. While various market participants may argue whether the rating adjustment is already priced in, the action is nonetheless important, as Puerto Rico paper is widely dispersed throughout the marketplace. It is also important in terms of timing, as secondary market liquidity, generally speaking, is somewhat thinner in the final weeks of the year. Any absence in Puerto Rico-specific liquidity could magnify the scale of related transactions. Accordingly, market adjustments could be exaggerated or appear outsized during an otherwise quiet period. The primary takeaway is that looks can be deceiving during the next few weeks and municipal bond investors should proceed with caution until visibility improves. Finally, we arrive at our fiscal cliff thoughts. With the very latest news reportedly being that Speaker Boehner and the GOP have proposed letting tax rates rise for those with incomes above the $1 million level (with strings attached), the ball appears back on the Democrats side of the court, who have reportedly indicated an adjusted $4k level (up from the original $2k/$25k level). Should there be an agreement that includes raising the top rate(s) back to or near Clinton-era levels, the tone of the municipal market may improve, but recall that President Obama s original proposal includes limiting the value of the municipal federal exemption (the 28% cap), which could more than offset any perceived benefit of higher marginal rates. Meanwhile, any agreement that averts the fiscal cliff could invite near-term rate risk in the form of higher benchmark US Treasury (UST) yields. This combination could result in near-term municipal underperformance in an otherwise down market for USTs. If the cap is removed and the marginal rates rise, we could see municipal outperformance in an otherwise down market for USTs. While one could argue that it s all relative and we re in an extraordinarily low rate environment for an extended period (as Chairman Bernanke s comments last week suggest), an appropriate response would be that relative value for municipal bonds (versus US Treasuries) is only now (at 11%) beginning to look compelling compared to levels just a few months back (+11%). To be sure, some of the recent muni weakness can be attributed to rising yields (fiscal cliff related) in the broader UST markets, but the balance highlights municipal underperformance for the aforementioned reasons. Please refer to important information, disclosures and qualifications at the end of this material. 3

4 FIXED INCOME STRATEGY / DECEMBER 19, 212 Figure 4. MBWD PAR Index (Bid-Wanted Items) Dollar Amount of B id-wanted Items 15 Par-Value (Millions) /2/1 9/3/1 12/5/1 3/8/11 6/9/11 9/1/11 12/12/11 3/14/12 6/15/12 9/16/12 12/18/12 Source: Bloomberg as of 12/18/12 Evidencing the muni-specific weakness are institutional bids wanted lists, according to Bloomberg (please see accompanying chart), which both last week and this week posted daily readings more than twice as large (by par amount) than the year-to-date average. Although it is important to note that not all bonds will trade, these are indications of potential selling into the market. Benchmark 1-year municipal bond yields have also adjusted higher, by approximately 34 basis points since December 9. As we noted in our R&O, municipal investors should also be aware of a potential two-step process: higher tax rates now and the potential for tax reform later. As for the choice in our title, we re still hoping for the circuit breaker, but suspect we could receive a very limited delay of game instead. New-Issue Supply Total issuance for last month finished approximately 11% lower than that of November 211 (at $33.1 billion vs. $37.2 billion, respectively), as activity throughout the primary market experienced some temporary periods of deceleration as a result of Hurricane Sandy (though many of the deals postponed subsequently came to the market at a later date), the Presidential Election and the Thanksgiving holiday. At the same time, it is critical to emphasize that last November s levels of issuance were substantial, as issuers accelerated their refunding efforts and the novelty of fiscal austerity began to fade. Regardless of the aforementioned low yearover-year (YOY) post, last month s volume was still only slightly lower than the $33.2 billion average logged for the month of November between 2 and 211. Figure 5. New-Issue Supply (212 YTD through November) Par Value (Billions) Tax-Exempt Taxable Minimum Tax January February March April May June July August September October November Source: The Bond Buyer as of 12/17/12 As we frequently discuss, one of the predominant themes of this year s market was the prominent supply/demand imbalance prevalent between net issuance levels (which is total supply after accounting for all bond redemptions and calls) and prospective buyers. Regardless of this year s final levels of new-issue municipal bond supply (of over $347 billion), net issuance will most likely conclude the year at a negligible number, mostly as a result of this year s accelerated amount of refunding activity. This imbalance was, once again, Please refer to important information, disclosures and qualifications at the end of this material. 4

5 FIXED INCOME STRATEGY / DECEMBER 19, 212 notably apparent throughout November. Consequently, this constructive technical backdrop (for bond prices) assisted this month s post-election rally, as market strength was further intensified by periods of low new-issue supply. For the year, total new-issue municipal bond supply was $347.1 billion at the conclusion of November, 31.8% higher on a year-to-date (YTD) YOY basis. When considering December s monthly average of $3.1 billion recorded between 2 and 211, this year s final levels of issuance will most likely finish higher than our +2 to +25% revised projection for 212 s volume. Not surprisingly, refunding deals continued to spearhead activity throughout this year s primary market, and were higher by 76.2% YTD YOY at the end of November. Newmoney issuance finished lower by approximately 2.2% YTD YOY, though this reading may change upon the receipt of December s data. As bond insurance penetration of the newissue market currently resides at approximately 3.5% of all new-issue supply (in comparison to as much as 57% in 25), we continue to advocate that investors look primarily at the underlying ratings of each municipal security when evaluating creditworthiness. As we put pen to paper, activity throughout the primary market appears to be declining for the holiday season and year end, as 3-Day Visible Supply has declined significantly to $5.36 billion (nearly 4% lower than this year s $8.9 billion average). This comes after the second week of December brought one of the largest calendar weeks of the year, as issuers made their final efforts to rush to the market before market activity declined. Figure 6. 3-Day Visible Supply Timeline (212 YTD) Visible Supply - Billions (B) Day Visible Supply that new-issue bond supply will increase only modestly, at approximately 5% to 1% in the coming year. However, myriad fiscal policy and tax code changes may substantially alter the contours of the municipal bond market in the coming year. Depending upon the form and timing of potential tax reform, supply forecasts throughout the Street (including our own) could substantially miss the mark Market Performance As alluded to in the title of our last Municipal Bond Monthly publication Rapid Reversal Will it Last?, the municipal marketplace experienced a sudden and powerful rally following the 212 Presidential Election. This strength was predicated upon the anticipation of higher marginal income tax rates during the Obama Administration s second term, and was further intensified by the market s expectation for lower levels of issuance and heavier bond redemptions during the holiday season and into the new year. How quickly a market can change November s postelection rally was indeed substantial; however, this strength reversed suddenly at the beginning of December, as the market encountered a string of bearish technicals. First, primary market activity intensified as issuers committed their final efforts to rush to the market before the holiday season began (as discussed, the second week of December brought one of the largest new-issue calendars of 212). Second, some selling was prevalent amid expectations of a rise in capital gains tax rates, while dealer support began to wane as some participants were reluctant to take on substantial positions before closing their books for the end of the year. Third, market focus shifted yet again, away from the possibility of higher marginal income tax rates and toward the possibilities of changes to the federal tax exemption (for more discussion on the aforementioned thoughts please review our R&O report. Consequently, yields on the 5-yr, 1-yr, and 3-yr AAA benchmarks have risen by 19, 32 and 32 basis points, respectively, since the release of our last publication. Please see the accompanying table for yield changes across the credit spectrum and throughout the yield curve since November 16, /3/212 2/7/212 3/13/212 4/17/212 5/22/212 6/26/212 7/31/212 9/4/212 1/9/212 11/13/212 12/18/212 Source: Thomson Reuters Municipal Market Data as of 12/18/12 As discussed in our R&O, Given our expectation for rangebound or only mildly elevated yields during 213, we anticipate Please refer to important information, disclosures and qualifications at the end of this material. 5

6 FIXED INCOME STRATEGY / DECEMBER 19, 212 Figure 7. Market Performance Table AAA 11/16/212 12/18/212 Change (bps) 11/16/212-12/18/212 5 Year Year Year Year AA 5 Year Year Year Year A 5 Year Year Year Year BBB 5 Year Year Year Year Source: Thomson Reuters Municipal Market Data as of 12/18/12 As the weakness throughout the municipal bond market intensified, municipals underperformed US Treasuries, which drove municipal relative-value ratios (the municipal yield as a percentage of the corresponding US Treasury yield) higher. As of the release of this publication, relative-value ratios have risen to approximately 11% of corresponding USTs, from 94.5% on November 16. Figure 8. 1-Yr Relative-Value Ratio Timeline (212 YTD) % Of Corresponding USTs /3/212 2/7/212 3/13/212 4/17/212 5/22/212 6/26/212 7/31/212 1-Yr Ratios 9/4/212 1/9/212 Source: Thomson Reuters Municipal Market Data as of 12/18/12 11/13/212 12/18/212 Relative-value ratios on prerefunded municipal securities, on the other hand, remain at attractive levels, as 5-yr ratios rose during December s sell-off and currently reside at approximately 18% of USTs. We continue to view these levels as opportunistic entry points for investors looking to redeploy assets out of cash and into high-quality, shorterduration investments. These securities may also function as an attractive alternative for those investors looking to position assets after cleaning up portfolios from a credit and interest rate perspective, as we discussed in our R&O. Figure 9. 5-Yr Pre-Refunded Relative-Value Ratio Timeline % Of Corresponding USTs /3/212 2/7/212 3/13/212 4/17/212 5/22/212 Pre-Re Ratios 6/26/212 7/31/212 9/4/212 1/9/212 Source: Thomson Reuters Municipal Market Data as of 12/18/12 11/13/212 12/18/212 Credit spreads remained mostly unchanged since the release of our last publication. As detailed in our R&O, we continue to advocate exposure to mid-tier A or higher-rated essential service revenue bonds and general obligation paper. BBB rated securities only make our shopping list for mid-level BBB or higher essential service revenue bonds such as water, sewer, and electric. Targeting Value and Investment Strategy The slope of the municipal bond yield curve steepened during the market s most recent period of weakness, to 259 basis points from 234 on November 16. When analyzed within the broader context of this year, this move mitigates the magnitude of municipal bond yield-curve flattening, which now stands at an impressive 71 basis points YTD. As covered in our R&O, we recently changed our target maturity range for yield-curve positioning, to 5-11 years from the 6-14 year range. As a result of 212 s curve flattening the marginal yield available on longer maturities has declined, which greatly impacts investors risk/reward dynamic. Consequently, an investor can earn approximately 67% of the entire yield curve by year 11. Please see the accompanying visual, which exhibits the progression of this year s yieldcurve flattening throughout 212. Of course, every investor will want to structure their portfolio maturities to reflect their individual liquidity needs and risk tolerances; however, the 5-11 year range, in our opinion, currently provides an Please refer to important information, disclosures and qualifications at the end of this material. 6

7 FIXED INCOME STRATEGY / DECEMBER 19, 212 optimal balance between the risk/reward dynamic. Also, we continue to advocate investing in above-market coupon securities (preferably 5%) as such securities are, in most cases, more defensive in nature, and will likely hold their value more effectively in a rising interest rate environment. Figure 1. Yield-Curve Flattening Yield (%) Maturity January 3, 212 March 1, 212 May 1, 212 July 2, 212 September 4, 212 November 1, 212 December 3, 212 Source: Thomson Reuters Municipal Market Data as of 12/17/12 As local governments continue to confront significant fiscal headwinds, our strategy recommends mid-tier A or higher rated general obligation bonds, and we have recently expanded our focus for essential service (water, sewer, electric) revenue bonds to include the mid-level BBB rated and higher category. Credit quality selection remains paramount in the current environment; routine portfolio credit analysis and maintenance should be conducted on a quarterly basis. Happy Holidays, JD MG Please refer to important information, disclosures and qualifications at the end of this material. 7

8 FIXED INCOME STRATEGY / DECEMBER 19, 212 Figure 11. State Ratings STATE MOODY S RATING MOODY S OUTLOOK S&P RATING S&P OUTLOOK ALABAMA Aa1 Stable AA Stable ALASKA Aaa Stable AAA Stable ARIZONA Aa3* Stable AA-** Stable ARKANSAS Aa1 Stable AA Stable CALIFORNIA A1 Stable A- Positive COLORADO Aa1* Stable AA** Stable CONNECTICUT Aa3 Stable AA Stable DELAWARE Aaa Stable AAA Stable DISTRICT OF COLUMBIA Aa2 Negative A+ Stable FLORIDA Aa1 Stable AAA Stable GEORGIA Aaa Stable AAA Stable HAWAII Aa2 Stable AA Stable IDAHO Aa1* Stable AA+** Stable ILLINOIS A2 Negative A Negative INDIANA Aaa* Stable AAA** Stable IOWA Aaa* Stable AAA** Stable KANSAS Aa1* Negative AA+** Stable KENTUCKY Aa2* Negative AA-** Stable LOUISIANA Aa2 Stable AA Stable MAINE Aa2 Negative AA Stable MARYLAND Aaa Negative AAA Stable MASSACHUSETTS Aa1 Stable AA+ Stable MICHIGAN Aa2 Stable AA- Stable MINNESOTA Aa1 Negative AA+ Stable MISSISSIPPI Aa2 Stable AA Stable MISSOURI Aaa Stable AAA Stable MONTANA Aa1 Stable AA Stable NEBRASKA No G.O. Rating Stable AAA** Stable NEVADA Aa2 Stable AA Stable NEW HAMPSHIRE Aa1 Stable AA Stable NEW JERSEY Aa3 Stable AA- Negative NEW MEXICO Aaa Negative AA+ Stable NEW YORK Aa2 Stable AA Positive NORTH CAROLINA Aaa Stable AAA Stable NORTH DAKOTA Aa1* Stable AA+** Positive OHIO Aa1 Stable AA+ Stable OKLAHOMA Aa2 Stable AA+ Stable OREGON Aa1 Stable AA+ Stable (continued on next page) Please refer to important information, disclosures and qualifications at the end of this material. 8

9 FIXED INCOME STRATEGY / DECEMBER 19, 212 STATE MOODY S RATING MOODY S OUTLOOK S&P RATING S&P OUTLOOK PENNSYLVANIA Aa2 Stable AA Negative RHODE ISLAND Aa2 Negative AA Stable SOUTH CAROLINA Aaa Stable AA+ Stable SOUTH DAKOTA No G.O. Rating Stable AA+** Stable TENNESSEE Aaa Stable AA+ Positive TEXAS Aaa Stable AA+ Stable UTAH Aaa Stable AAA Stable VERMONT Aaa Stable AA+ Positive VIRGINIA Aaa Negative AAA Stable WASHINGTON Aa1 Negative AA+ Stable WEST VIRGINIA Aa1 Stable AA Stable WISCONSIN Aa2 Stable AA Stable WYOMING No G.O. Rating No Outlook AAA** Stable PUERTO RICO Baa3 Negative BBB Negative *Issuer Rating **ICR -- Issuer Credit Rating Data Source : Moody s.com Data Source: Rating Changes for the 5 States from Moody's October 3, 212 & Moody s.com Data Source : U.S. State Ratings And Outlooks: Current List -- S&P - - September 18, 212 & S&P.com Data Source : Bloomberg December 19, 212 Please refer to important information, disclosures and qualifications at the end of this material. 9

10 FIXED INCOME STRATEGY / DECEMBER 19, 212 Figure Year Munis as a Percentage of 5-Year Treasuries, January 1996-December 212 % of Corresponding USTs 5-Year Relative Value Ratio Averag e Jan-96 Nov-97 Oct-99 Aug -1 Jul-3 Jun-5 Apr-7 Mar-9 Jan-11 Dec-12 Source: Thomson Reuters Municipal Market Data as of Figure Year Munis as a Percentage of 1-Year Treasuries, January 1996-December Year Relative Value Ratio Averag e % of Corresponding USTs Jan-96 Nov-97 Oct-99 Aug -1 Jul-3 Jun-5 Apr-7 Mar-9 Jan-11 Dec-12 Source: Thomson Reuters Municipal Market Data as of Figure Year Munis as a Percentage of 3-Year Treasuries, January 1996-December 212 % of Corresponding USTs 3-Year Relative Value Ratio Averag e Jan-96 Nov-97 Oct-99 Aug -1 Jul-3 Jun-5 Apr-7 Mar-9 Jan-11 Dec-12 Source: Thomson Reuters Municipal Market Data as of Please refer to important information, disclosures and qualifications at the end of this material. 1

11 FIXED INCOME STRATEGY / DECEMBER 19, 212 Disclosures The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Smith Barney is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. 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12 FIXED INCOME STRATEGY / DECEMBER 19, 212 Morgan Stanley Private Wealth Management Ltd, which is authorized and regulated by the Financial Services Authority, approves for the purpose of section 21 of the Financial Services and Markets Act 2, content for distribution in the United Kingdom. Morgan Stanley Smith Barney is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. Morgan Stanley Smith Barney research, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney. 212 Morgan Stanley Smith Barney LLC. Member SIPC. Please refer to important information, disclosures and qualifications at the end of this material. 12