With a year-to-date total return of 2.17% for the Barclays Municipal Bond Index, tax exempts have quietly and successfully navigated 2015’s wild market swings by consistently underperforming US Treasuries in rallies and outperforming them in sell-offs. The net result has been less volatility and a year-to-date performance that places it among the top asset classes (see chart). Can this continue?

We believe the answer is yes, but the pace of gains should moderate from here, given the bond market’s strong reaction to the “nothing done” September Federal Open Market Committee meeting and many market participants’ expectations that the Fed won’t lift rates until next year.

Meanwhile, the municipal asset class enjoys a number of supporting factors, the first of which is supply. While year-to-date issuance, up 29% through October, is notably higher than the same period in 2014, there hasn’t been an overabundance of bonds available as the majority of issuance has been for refunding older issues.

Fund Flows Split

On the demand front, the number of weeks seeing mutual fund inflows and outflows has roughly been split throughout the year, with the past few weeks garnering slightly positive flows. It is interesting to note that even the outflow weeks, which were typically mild, did not materially damage investor sentiment. Relative value—in the vicinity of 100%—remains compelling, as it has been for most of the year. In fact, it has been rather compelling for years (averaging 98% since September 2011) due to the continuing specter of tax reform. We believe tax-reform rhetoric is likely to hang over the muni market through the presidential election. The first real shot at tax reform would not come until at least 2017, in our view.

Investment grade credit spreads have been remarkably stable and essentially unchanged since the start of the year, despite a select number of ongoing negative credit stories—among them Puerto Rico, Chicago, New Jersey and Illinois. While high-profile, high yield Puerto Rico occupies center stage and is likely to remain there, the rest of the market remains unshaken by developments specific to the island commonwealth.

Paid to Wait

As the Fed ponders Europe and China and as investors ponder the Fed, we believe municipal bondholders continue to be “paid to wait” in the form of tax-exempt coupons and “curve roll,” a strategy involving buying longer-dated securities and selling them after two to three years. Our broad muni strategy remains unchanged at this time and centers around holding maturities of 15 to 25 years, adding bonds in this range during periods of market weakness. Finally, given the recent decline in forward GDP forecasts and the growing acceptance of the “lower for longer” outlook for bond yields, investors may wish to reconsider shorter positions of inside four years (many of which currently may hold gains) in favor of moving a little further out on the yield curve toward 10 years. As always, we prefer above-market coupons of 5%, and advocate higher credit quality for local general-obligation bonds and mid-range quality for essential-service revenue bonds.

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