While some may feel like August’s “dog days” may already be descriptive of the next few weeks, I sense an undertone of market uneasiness which seems to me to want to push interest rates even higher (see yield curve graph below).

A few observations:

  • According to Lipper, municipal bond fund outflows have continued from the retail sector for 10 consecutive weeks. I believe cash selling from municipal bond funds may have contributed to the higher rates and tested liquidity.
  • The new issue market is challenging participants with more than $11 billion coming to market in the next 30 days. (1)
  • This week, Puerto Rico Electric Power Authority (PREPA) tested demand as it brought $600 million BBB rated long maturity bonds to market.

Detroit hovers like a gray mist over the marketplace. I believe market participants have been alerted to an important consequence which, even if it does not come to pass, I think is worthy of attention. As highlighted in his report of August 6, 2013, Michael Zezas of Morgan Stanley warns of how close the municipal bond market is creeping to “extension risk” and its potential impact on portfolios:

“Our analysis suggests 73% of munis carry calls, and 85% of the callable market is trading at a premium, suggesting the market is pricing in the likelihood that most bonds will be called. As rates rise, many of these bonds will “extend” in duration [interest rate risk], making the market more rates sensitive.”

Mr. Zezas believes we are at, or approaching, a near-term high for rates, but he goes on to note that in his opinion, if rates do push higher by about 60 basis points, some 20% of premium bonds may turn to a discount, pushing duration significantly longer. I believe the challenge now, is to prepare our portfolios and our clients for this type of event.

James Colby is a portfolio manager and senior municipal strategist at Market Vectors ETFs.

(1) Bond Buyer as of 8/2/2013.