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The municipal market took a welcome turn in September, notching its first positive month since April. It was sweet vindication for those of us who knew the summer selloff was overdone. The fundamentals underlying the market just didn’t warrant the type of pounding that the market was taking.

I’ve talked in prior posts about what’s been driving the recent volatility. At the risk of sounding like a broken record, it’s not Detroit … or Puerto Rico … or any other idiosyncratic credit event. It’s been interest rates … the Fed … and how Fed action might influence interest rates.

What I haven’t talked about is supply, which happens to be a big deal in the municipal space and (no surprise) has been impacted by interest rates this year. Here’s what investors should know:

Supply is down. New issuance is 13% lower in 2013 than it was this time last year, according to data from Thomson Reuters. Why? Because interest rates (and, therefore, borrowing costs) are up. Municipal market issuers took advantage of last year’s historically low rates to refinance existing bonds and to issue new debt on favorable terms. Higher rates this year, and the 2012 rush to take advantage of low rates, means less incentive (and perhaps less need) in 2013.

’Tis the season. We are entering a seasonal period when municipal bond issuance is typically very low and may not ramp up until the end of first quarter 2014. That phenomenon may be exaggerated this year when you factor in the effect of a Yellen-led Fed and D.C.-induced uncertainty in the broader economy. Issuers may be more inclined to “wait and see” before bringing any big deals.

A shrinking market. Longer-term, supply could continue to shrink as municipalities are less likely to embark on large infrastructure projects, particularly in a higher-rate environment.

Putting it all together, good bonds may be harder to find. Limited supply in the market could make it harder to source attractive opportunities. For the most part, we’ve been seeing new issues priced at a concession to the secondary market — but price isn’t everything. Diligent credit research is critical to separating the wheat from the chaff, particularly when the field is smaller and it can be tempting to pluck the first opportunity.

A discussion of supply would not be complete without looking at the other side of the equation: demand.

Given the performance challenges this year, demand for municipal bonds has been muted. In fact, most of the buying has been done by non-traditional investors who have come to recognize the compelling risk/reward available in munis. Going forward, a pick-up in demand could create supply, as issuers are more apt to come to market when they think there might be a captive audience for their bonds.

For now, the market remains in a pattern of net negative supply (more bonds leaving the market than coming in), which could be a price tailwind in the months ahead given the factors I cited above. With the summer selloff having created greater income opportunities (and an attractive entry point) for investors, now may be the time to jump back in before the new year rush creates demand — and munis’ price tag goes up.

 

Peter Hayes, Managing Director, is head of BlackRock’s Municipal Bonds Group and a regular contributor to The Blog. You can find more of his posts here.

 

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Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.