Municipal bond investors have watched credit spreads in the market narrow considerably over the past three years.

They aren’t expected to reverse course anytime soon.

Spreads between triple-A general obligation bonds and single-A GOs in the 10-year range have contracted by 50 basis points from highs over that span. For spreads between equivalent triple-A GOs and triple-B GOs over the same three-year period, the differential has narrowed almost 75 basis points.

“It’s the kind of market where investors are looking for as much yield as they can get,” said Hugh McGuirk, head of municipal investments at T. Rowe Price. “And for probably most of the last couple of years investors have favored bonds with spread to them, and that extra demand for spread has naturally tightened spreads up pretty steadily over the last couple of years.”

Several factors lie behind the tightening. For one, persistent, extremely low interest rates have made the search for yield particularly challenging, leading investors to venture down the credit scale.

What’s more, the substantial decrease in new-money issuance in 2011 hampered muni investors in their need to put money to work. New-money issuance levels haven’t been as low as the $147.6 billion in 2012 and the $150.9 billion in 2011 since 1997, Thomson Reuters numbers show.

Also, the rise in credit analysis among investors following the collapse of the monoline bond insurance business — and subsequent increased comfort with lower-rated credits — boosted demand for single-A and triple-B bonds.

And many buyers see this environment lasting for at least another 12 months, or until sometime after a change in policy at the Federal Reserve prompts a move in interest rates.

So how have investors reacted? Predictably, different firms have adopted different strategies, which vary among their different funds. But their interests converge around the need to shorten their funds’ general duration, or the measure of a bond’s sensitivity to changing interest rates.

“In general, across the firm, our idea is to be a little bit higher-grade and a little bit shorter in duration than we would have been a year ago,” said Joe Deane, executive vice president and head of munis at PIMCO.

Muni funds at BMO Global Asset Management U.S. are overweight A-rated credits and looking to add more if they can, according to Duane McAllister, co-manager of the BMO intermediate tax-free fund. The firm’s strategies revolve around the belief that 2013 is year of transition, and of managing risk.

“So, we’ve pulled our duration back in,” he said. “We’re running neutral to slightly short duration postures across all of our strategies. We’re bringing down our yield-curve exposures from the longer end to the intermediate and short. And we’re looking to add single-As, but we’re not really adding much in the way of triple-B securities right now.”

Though there’s been a better bid for A-rated GOs relative to triple-As than there was three years ago, McGuirk said, T. Rowe Price generally invests up and down the credit spectrum.

“We do have more A-rated bonds today than we did five years ago, but the demise of insurance has a lot to do with that,” he said. “But we’ve been buying a lot more A-rated bonds. There’s no investment that we turn down strictly based on a rating. We’ll look at anything.”

The spreads between triple-A GOs and single-A GOs at the 10-year part of the yield curve show marked compression since the start of 2010, according to Municipal Market Data numbers. They’ve shrunk from a high during the period of 113 basis points to 64 basis points on Feb. 20, and have averaged almost 87 basis points.

For spreads between triple-A GOs and triple-B GOs at the 10-year part of the yield curve, the compression is even more dramatic. They’ve shrunk from a high of 214 basis points over the period to 140 basis points. They’ve averaged a spread of almost 188 basis points over the span.

There was more uncertainty about the actual underlying credits in the market when spreads were at their widest back in late 2008 and early 2009, according to Burton Mulford, CFA, a portfolio manager and trader at Eagle Asset Management. At that time, the market was much more dislocated as the monoline insurance companies all capsized, upending their triple-A ratings.

In 2005, about 85% of the Barclay’s municipal bond index — at the time, the Lehman Municipal Bond Index — was either triple- or double-A, McGuirk noted. Since January 2009, credit spreads started to tighten. And over the period, the emphasis on credit research, and digging into individual credits, in particular, has grown, Mulford said.

Beyond a growing comfort with lower-rated credits, a diminished supply of new-money issuance has been instrumental to tighter spreads, investors say. For starters, the tremendous amount of current refundings volume has taken out of the market many of the higher-coupon, very short-call bonds — most of which were issued back in 2002 and 2003 with 10-year calls.

Investors want to replace that income, according to Deane. So the preponderance of the cash flows coming into the mutual fund business over the last year have been in high-yield and very long funds.

“And it’s going to go on for at least a majority of this year, too,” he said, “because 2002 and 2003 were two relatively large years for issuance.”

When new issues come to market, spreads tighten, Mulford added. The original price of weak double-As, single-As or triple-Bs might be one level. Then because of over-subscription, often at up to 15 times, you see further tightening before the actual deal is priced, he added.

“And what happens in a low-interest-rate environment, every basis point counts,” Mulford said. “So investors are willing to take some smaller incremental spreads just to add some yield.”

The trend should continue until Treasuries back off significantly, he said, and the muni market should be relatively range-bound over the next 12 months. But 18 months and out, investors could see some widening as the market sells off, Mulford said.

As far as credits go, health care has seen lots of compression and has fared well, McAllister said, as have airport bonds, transportation and toll road credits. But over the course of 2013 performance will become more specific to the credit, he added.

“There will be some health care names that, instead of tightening, they’ll widen out,” McAllister said, “because of the changes that are occurring with the implementation of Obamacare.”

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