Municipal Fixed Income Weekly

February 17, 2017


Municipal Fixed Income Weekly

February 17, 2017


Key Themes for the Upcoming Week

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  • We will not publish the MFI Weekly on the 27th of February. The next issue will come on the 5th of March for the week ending 3 March 2017.
  • Wilmington Trust's Chief Economist, Luke Tilley remarked on Friday that, "Investors are understandably focused on the pace of those [sic] possible rate hikes in 2017, which are now inextricably linked to the outlook for fiscal policy. Fed officials have explicitly linked the uncertain outlook for monetary policy to the uncertain outlook for fiscal policy." In our view, this, along with the innumerable global and domestic market trends and the peculiarities of tax-exempt market supply and demand, seems to be manifest in the ever-shifting winds of the municipal bond market. Still, by Friday, the municipal market gave the impression that investors should have reason to be optimistic this upcoming week.
  • We believe the aforementioned uncertainty of monetary and fiscal policies, President Trump's infrastructure and tax reform plans, and the future of the tax-exemption of municipal bonds, could all continue to affect the volatility of municipal bond yields relative to their taxable counterparts in an unusual way. While ambiguity has always been present in the capital markets, the confluence of political policies and financial fundamentals seems to have made investors more sensitive to municipal-related market issues. For this reason, we think it reasonable to expect outsized swings in M/UST ratios across the term structure for the foreseeable future.
  • We are concerned that whereas flows have been positive throughout the past five weeks, the last three reports have each been under $1 billion. These flows seem to us to be somewhat lukewarm, and with the ostensible lack of market conviction, we are concerned that it won't take much in the way of negative performance or news for them to turn to net outflows. Should weekly total return performance persist below zero for the remainder of February, then we would expect fund flows to revert to net withdrawals by early March.
Yield curve
On Saturday, 11 February, we wrote that the final two trading days of that week set the stage for potential follow-through in the first days of the upcoming week. In fact, that is exactly what happened. For the first three trading days of last week the S&P Municipal Yield Curve moved higher, with the only exceptions being the 6-month and 1-year points, which remained unchanged. As a few reference points, the 2-year maturity rose by 3 basis points (bps) through Wednesday, while both the 7- and 10-year tenors moved up by 13bps over the same period. In similar fashion, the 20- and 30-year maturities drifted upward by 10bps each.

As has often been the case, municipal bonds mostly moved in sympathy with US Treasuries (USTs). For example, the benchmark10-year UST closed on 10 February drawing a yield of 2.407%. By the following Wednesday, 15 February, the yield on that same security reached 2.522%, a 12bp increase. Then a reversal took hold, with that same security's yield falling about 12bps to close the week at 2.399%. The high-grade municipal curve followed suit, as tax-exempt interest rates declined by between 1 and 7bps across the curve.

By this past Friday, high-grade tax-exempt interest rates largely went up on the week. While the S&P AAA Municipal Yield Curve drifted lower by 1bp at the 6-month and 2-year points, and by 3bps at the 1-year maturity, it remained unchanged at the 3-year spot (Figs. 1 & 2). The rest of the term structure wandered higher by the end of the week, with the yield on the 5-year closing at 1.590%, a 5bps increase. Both the 7- and 10-year points moved up by 7bps, whereas the 15- and 30-year maturities were higher by 5 and 4bps, respectively.

For the third week in a row, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index's yield remained unchanged at 0.65% (Fig. 3). On this day last year, that same index stood at 0.01%. We remind readers that beginning 14 October 2016, SEC-registered institutional tax-exempt municipal money market funds converted to floating rate net asset values (NAVs) and retail tax-exempt municipal money market funds became subject to the potential for gates and redemption fees. Prior to the rule changes, the SIFMA Index's yield had been under 0.20% for almost five years. But the knock-on effects of a change in supply versus demand sent the index soaring to a recent high of 0.87% on 5 October 2016. Since then the yield on that benchmark bottomed at 0.55% on 9 November, and appears to have found a near-term equilibrium in the 0.60% - 0.70% range over the past ten weeks.

Sans the 6-month spot, last week's shift in high-grade rates steepened the S&P AAA Municipal Yield Curve by 7bps, front to back, raising the difference between the 1-year and 30-year to 226bps, from 219bps the previous week (Fig. 6). At the same time, the spread between 2-year and 10-year edged up 8bps to 135bps on Friday (Fig. 7).

Wilmington Trust's Chief Economist, Luke Tilley remarked on Friday that, "Investors are understandably focused on the pace of those [sic] possible rate hikes in 2017, which are now inextricably linked to the outlook for fiscal policy. Fed officials have explicitly linked the uncertain outlook for monetary policy to the uncertain outlook for fiscal policy." In our view, this, along with the innumerable global and domestic market trends and the peculiarities of tax-exempt market supply and demand, seems to be manifest in the ever-shifting winds of the municipal bond market. Still, by Friday, the municipal market gave the impression that investors should have reason to be optimistic this upcoming week.

Municipal-to-US Treasury (M/UST) Yield Ratios
Looking at Figure 5, we see that high-grade municipal bonds underperformed US Treasuries (USTs) across most of the term structure. Challenging that drift were spots along the curve at 3-years and shorter. The S&P AAA Municipal Curve was stronger than the US Treasury Curve by 3bps at the 6-month tenor, and by 4bps at the 1-year spot. Meanwhile, the high-grade rate remained unchanged at the 3-year maturity, while the equivalent US Treasury was weaker by 1bp. Municipals' most pronounced underperformance took place in the intermediate portion of the term structure, where their yields outpaced their corresponding US Treasury counterparts to the upside by 4 to 5bps. At points longer than 15-years, high-grade municipal bonds underperformed USTs by about 2bps.

Consequently, the 1-year M/UST printed 99.881%, down from the previous Friday's 104.946%, and a 9.626 ratio drop from the 109.507% print on the 31st of January (Fig. 14). The 2-year M/UST ended the last five trading days at 86.265%, 0.838 ratios lower than the last week's 87.102%. The 5-year closed Friday at 83.377%, rising 1.679 ratios from the previous week's 81.698%, and the 10-year M/UST finished at 98.266%, up a full 2.296 ratios from 95.970% on the 10th of February. Finally, the 30-year M/UST rose by 0.615 ratios to end the week at 102.412%.

Considering the week ahead, the aforementioned uncertainty of monetary and fiscal policies, President Trump's infrastructure and tax reform plans, and the future of the tax-exemption of municipal bonds could all continue to affect the volatility of municipal bond yields relative to their taxable counterparts in an unusual way. While ambiguity has always been present in the capital markets, the confluence of political policies and financial fundamentals seems to have made investors more sensitive to municipal-related market issues. For this reason, we think it reasonable to expect outsized swings in M/UST ratios across the term structure for the foreseeable future.

Market performance
Last Thursday's and Friday's market strength wasn't enough to offset the rise in tax-exempt yields during the first three trading sessions, and after three consecutive weeks of positive performance, the S&P Municipal Bond Index took a breather and generated a -0.078% total return last week, only the second week that benchmark generated negative results thus far in 2017 (Fig. 17). In similar fashion, the Intermediate and Short Intermediate indices ended the week underwater, producing -0.173% and -0.057%, in that order. Because of the strength at the short end of the curve, the Short index managed to eke out +0.032%. Meanwhile, the S&P Municipal Bond High Yield Index delivered +0.444% total return. Following the inclination of the broad market, the California and New York indices closed in the red with -0.049% and -0.106%, correspondingly. Until last week, the S&P Municipal Bond Puerto Rico Index had strung together seven consecutive weeks of positive performance. Last week ended that streak, as that index ended with a total return of -0.385%. Despite Puerto Rico's misstep last week, as of Friday evening that benchmark's year-to-date performance stood at +2.848%.

Supply and demand
The upcoming holiday-shortened week should bring investors only about $3.455 billion in new municipal bond deals, which is about $2.380 billion less than last week's $5.826 billion, a 46.73% decline. As of Friday evening, the 12-week moving average was $4.855 billion (Fig 31). Moreover, total year-to-date new issuance through 17 February stood at about $50.568 billion, which was 8.118% ahead of last year for the same period. Looking at demand, the Investment Company Institute (ICI) reported municipal bond fund net inflows of $961 million for the trailing five business days ending 17 February (Fig. 32). Last Wednesday marked the fifth consecutive week that the ICI reported positive net flows. The most recent account brings the five-week total to +5.195 billion and the year-to-date number to +$2.977 billion, while the 12-week moving average is still firmly in negative territory at -$1.530 billion.

We are concerned that whereas flows have been positive throughout the past five weeks, the last three reports have each been under $1 billion. These flows seem to us to be somewhat lukewarm, and with the ostensible lack of market conviction, we are concerned that it won't take much in the way of negative performance or news for them to turn to net outflows. Should weekly total return performance persist below zero for the remainder of February, then we would expect fund flows to revert to net withdrawals by early March.

Market Sentiment
Due to the President's Day holiday weekend, Thomson Reuters Municipal Market Data did not conduct their market sentiment survey last week. Therefore, we have no data on which to report.







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