Municipal Fixed Income Weekly

January 12, 2017


Municipal Fixed Income Weekly

January 12, 2017


Key Themes for the Upcoming Week

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  • Should the upward shift in US government and corporate bond interest rates persist, we think it entirely reasonable to expect tax-exempt municipal yields to respond in similar fashion. We note, however, supply and demand, along with other factors indigenous to the municipal market can trigger contrary trends, which makes forecasting market movements extraordinarily hard. In Figures 49-54 on pages 32 and 33, we investigate the potential returns of the S&P Municipal Bond Intermediate, Short Intermediate, and Short indices in a variety of changing interest rate scenarios over two distinct horizons. While this exercise does not uncover the future path of municipal bond interest rates, it may help readers to gauge the potential range of performance outcomes under various conditions and over different time periods.
  • As of Friday's close, approximately $3.880 billion in new deals have come to market thus far in January. That figure compares with $15.872 billion for the same interval in 2017, an $11.992 billion or 75.553% shortfall. Issuers, underwriters and broker-dealers, and buyers are all likely experiencing a bit of fatigue from the year-end onslaught - the market is probably catching its collective breath. A few weeks do not constitute a trend, and we expect supply to quicken to a somewhat ordinary tempo. Still, we believe the elimination of tax-exempt advance refundings will quell issuance in 2018. As we wrote last week, our municipal supply appraisal for 2018 stands at roughly $350 billion, a 20% decline from 2017.
  • Core narrative: the tax-exempt municipal bond market has taken on a distinctly tepid, if not downright negative tone over the past several weeks. Some of the fragility can be attributed to the rise in UST interest rates, and some over concerns about the future effects of recent tax reform. All the same, the dearth of supply should offer a support mechanism over the next several weeks. While positive, fund flows remain unconvincing, and we will keep close watch on retail demand.
The Economy and the Fed
We thank chief economist Luke Tilley, economist Rhea Thomas, and the rest of Wilmington Trust's economics team for lending perspective and weighing in on a few selected highlights from the past week.

Monday, 08 January
  • Monday's benchmark 10-year US Treasury (UST) closing yield: 2.480%; 10-year ICE AAA Municipal closing yield: 2.040%.
Tuesday, 09 January
  • The JOLTS (Job Openings and Labor Market Turnover Survey) for November showed a slight decline in the Job Openings Rate by 0.1 percentage points (pp) to 3.8%. The Hiring Rate dipped by 0.1pp to 3.7%. The Quits Rate however, remained unchanged, while the Layoffs Rate edged down to 1.1%, suggesting a still solid labor market.
  • The NFIB Small Business Optimism Index came in at 104.9, -2.6 points from a near record high in November, indicating still strong sentiment. Indicators on the lack of qualified applicants for jobs suggest tight labor market conditions.
  • Tuesday's benchmark 10-year UST closing yield: 2.553%; 10-year ICE AAA Municipal closing yield: 2.080%.
Wednesday, 10 January
  • Import Prices ticked up by 0.1% month-over-month (m/m) and by +3.0% year-over-year (y/y), though November was revised up by one tenth to 0.8% m/m. Non-Fuel Import Prices rose 1.4% in 2017, compared to a 0.2% increase in 2016, the largest calendar year upturn since 2011 when it was up by 3.4%.
  • Wednesday's benchmark 10-year UST closing yield: 2.557%; 10-year ICE AAA Municipal closing yield: 2.150%.
Thursday, 11 January
  • PPI came in on the slightly softer side for December, in contrast to CPI. PPI printed 2.6% y/y (-0.1% m/m), as a result of a decline in Food Prices, while Energy Prices were unchanged. Core PPI (Ex-Food, Energy, and Trade Services) rose by a muted 0.1% m/m (+2.3% y/y).
  • Initial Jobless Claims edged up 11k to 261k, a 3-month high in the week ending 06 January; the 4-week moving average climbed by 9k to 250,750. Continuing Claims, however, fell by 35k to 1,867k.
  • Thursday's benchmark 10-year UST closing yield: 2.537%; 10-year ICE AAA Municipal closing yield: 2.150%.
Friday, 12 January
  • CPI rose by 2.1% y/y in December, with Energy Prices down by 1.2% m/m. Core CPI jumped by a solid 0.3% m/m, and by1.8% y/y on the back of firm gains in Shelter and Medical Care Prices. Used Vehicle Prices continued to show gains, likely boosted by post hurricane related replacement demand. On a 3-month annualized basis, CPI is now 2.5%. page 4 of 44 ©2018 Wilmington Trust Corporation and its affiliates. All rights reserved. Municipal Fixed Income WEEKLY MARKET REVIEW 12 January 2018 Investing involves risks and you may incur a profit or a loss. Past performance is no guarantee of future results.
  • Retail Sales jumped by a robust 0.4% m/m in December (+5.4% y/y), the fourth straight monthly rise. The Control Retail Sales measure (Ex-Autos, Gas, and Building Materials) increased by 0.3% m/m, with upward revisions to the prior two months as well. Gains in the Building Materials and Furniture and Home Stores categories may suggest lingering post hurricane demand. Internet Retailers and Food Services and Drinking Places also saw advances in December, showing broader consumer strength. On a year-over-year basis, nearly all categories of retail sales showed increases, with Internet Retailers enjoying the largest gains (+12.7%y/y).
  • The Atlanta Fed's GDPNow Forecast for 4Q grew to 3.3%, from 2.7% at the end of last week.
  • Friday's benchmark 10-year UST closing yield: 2.546%; 10-year ICE AAA Municipal closing yield: 2.150%.


Yield Curve
Although the high-grade tax-exempt yield curve did not twist as it did in the previous week, by Friday's close rates had dropped at the front end, then increased in progression from the 5-year point and beyond. The ICE AAA Municipal Yield Curve was lower by 3 basis points (bps) at the 6-month maturity, and remained still at the 1- through 4-year points (Figs. 1 and 2). The 5- and 7-year spots rose by 4 and 8bps in that order, while 10-year was weaker by 11bps. Both the 15- and 30-year maturities' yields moved higher by 13bps, as the long-term point on the curve closed the week drawing a 2.680% yield.

On Wednesday, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield followed-through with the second decline since the end of 2017, falling by 16bps to print 1.310% (Fig. 8).

As we mentioned in the prior issue of this publication, it is not unusual for dealers to set floating rate securities at above-market rates at the close of the year. Now that year-end window dressing is behind us, we see that benchmark's yield approaching a more market-like level; the 12-week moving average stood at 1.140% on Wednesday. Absent a startling event that could affect short-term interest rates, or unanticipated text in the Federal Reserve's Beige Book release on Wednesday, we suppose the SIFMA Municipal Swap Rate Index could inch closer to mid-December 2017 levels.

Looking beyond the 6-month point, last week's changes in tax-exempt rates steepened the slope of the ICE AAA Municipal Yield Curve by 13bps. The gap between the 1- and 30-year yields grew to 118bps, up from 105bps the preceding week (Fig. 1). Despite the recent increase, the current curve slope remains relatively level. It is only 18bps off its flattest point in the past year, which occurred on 02 January (Figures 11 and 12). In contrast, on 13 March 2017, the ICE AAA Municipal Yield Curve 1yr-30yr slope stood at 243bps, its steepest point over the past twelve months.

Viewing the ICE AAA Municipal Yield Curve from a different perspective, at 2.150%, the 10-year maturity still provides 80% of the interest rate at the 30-year point, whereas on 12 January 2017, that same spot provided 75% of the long high-grade rate. The 15-year spot currently delivers a full 91% of the 30-year's yield, the same as the previous Friday's close.

Municipal-to-US Treasury (M/UST) Yield Ratios
As last week's high-grade municipal yield steepened, with the 6-month point dropping and longer maturities mostly rising at an increasing rate, the yield relationships of AAA tax-exempts and their corresponding USTs vacillated. However, the variations were entirely intuitive given that USTs were weaker than their municipal brethren inside of the 7-year maturity and considerably stronger at that point and all spots further out the curve (Fig. 10).

The 6-month M/UST declined by 2.604 ratios, to close at 86.929%, compared with the prior print of 89.533% (Figure 25). The most recent report was less than the 91.028% reading reached on 27 December, the highest the 6-month M/UST has been in the past 180 days, with that ratio averaging 74.581% over that same period (Fig. 27). In similar fashion, the 1-year M/UST concluded the week lower at 86.555%, a 1.113 ratio drop from the previous week's 87.668%. The 2-year M/UST dropped 1.648 ratios, to close the last five trading sessions at 76.923%, whilst the 5-year M/UST edged lower by a mere 0.235 ratios to complete the week at 72.007%, down from the earlier recording of 72.242%. The 10-year M/UST wrapped up the week moving up to 84.314%, a hike of 1.823 ratios from the earlier print of 82.491% on the 5th of January. Lastly, the 30-year M/UST ended with a full 3.125 ratio rise from last week's 90.844% figure, to finish at 93.969%. We present a more complete view of the one-year historical AAA Municipal-to-US Treasury yield ratios in Figures 26-32 on pages 22-24.

AA Municipal-to-AA Corporate (AAM/AAC) Yield Ratios
With a like inclination to their Aaa/AAA equivalents, municipal bonds in the Aa/AA ratings category became less appealing relative to senior unsecured Aa/AA corporate bonds inside of the 5-year spot, while turning out to be more desirable beyond the 5-year maturity. Friday's close saw the 6-month AAM/AAC finished the previous five trading days at 73.619%, lower by 3.395 ratios from 77.014% on the 5th of January (Fig. 33). The 1-year AAM/AAC was 1.379 ratios lower, closing the week at 77.206%, down from the preceding Friday's 78.585%. The 2-year AAM/AAC measure fell by 1.333 ratios, to complete the last five sessions at 73.055%. The 5-year drifted a bit higher to 68.081%, an increase of 0.261 ratios from the prior week's 67.820% on the 5th of January. The 10-year printed a 2.155 ratio hike to close the week at 67.846%. Finally, the 30-year AAM/AAC rose by a round 3.000 ratios from the past week's 75.316%, to finish Friday at 78.316%. We present a more complete view of the one-year historical AA Municipal-to-AA Corporate yield ratios in Figures 34-40 on pages 25-27.

Market Performance
The tax-exempt municipal market had a rough go of it during the second week of the New Year, as yields mostly increased across the term structure, with the notable aforementioned exceptions. The S&P Municipal Bond Index closed Friday's trading drawing a 2.420% yield-to-worst, a 5.3bps rise from the previous week's 2.367% (Fig. 41). As a result of that upturn, that broad-market benchmark served up a disappointing -0.347% total return for that period, bringing its year-to-date figure to an almost identical -0.348% (Fig. 42). Likewise, the Intermediate and Short Intermediate indices generated performances of -0.309% and -0.051%, in that order.

The manifest exclusion of the interest rate climb across the curve occurred in the short segment. As such, with an effective duration of only 1.929 years, the S&P Municipal Bond Short Index saw an ever so slight -0.009% change in its yield-to-worst, setting the stage for a +0.039% total return on the week.

The High Yield Index finished the past five trading days in the red, delivering -0.391%, while the High Yield Excluding Puerto Rico concluded the week at -0.356%. Sporting a 6.631-year effective duration, the S&P Municipal Bond California Index turned in a -0.369% return. As of Friday's close, the New York Index generated -0.321% performance for the week. The S&P Municipal Bond Puerto Rico Index manufactured an unfortunate -0.568%. Still, at +0.429%, the Commonwealth's year-to-date performance bests all other indices on which we report.

As tax-exempt yields progressed higher in sympathy with USTs over the past fortnight, the municipal bond market took on a somewhat softer tone. Should the upward shift in US government and corporate bond interest rates persist, we think it entirely reasonable to expect tax-exempt municipal yields to respond in similar fashion. We note, however, that the effects of supply and demand, along with other influences indigenous to the municipal market can trigger contrary trends, which makes foretelling market movements extraordinarily hard.

With this in mind, we encourage readers to look at the 1-Month and 12-Month Horizon & Scenario Analyses in Figures 49-54 on pages 32 and 33. In that section, we investigate the potential returns of the S&P Municipal Bond Intermediate, Short Intermediate, and Short indices in a variety of changing interest rate scenarios over two distinct horizons. While this exercise does not uncover the future path of municipal bond interest rates, it may help readers to gauge the potential range of performance outcomes under various conditions and over different time periods.

Supply and demand
After December's $62.502 billion deluge, supply was off to a slow start in 2018. The third week of the year will be short due to the observance of Martin Luther King, Jr. Day, and should bring us $3.116 billion in supply, $553 million more than the prior slate of $2.583 billion (Fig. 57). The total tab for the upcoming four trading sessions is still $4.544 billion below the $7.660 billion 12-week moving average. In point of fact, weekly new issue schedules have been below their corresponding 12-week moving averages in each of the past four weeks. Institutional investors are undoubtedly hoping that next week will signal the acceleration of new deals coming to market.

As of Friday's close, approximately $3.880 billion in new deals have come to market thus far in January. That figure compares with $15.872 billion for the same period in 2017, an $11.992 billion or 75.553% shortfall. Issuers, underwriters and broker-dealers, and institutional buyers are almost certainly experiencing a bit of fatigue from the year-end onslaught - the market is probably catching its collective breath. A few weeks do not constitute a trend, and we expect supply to quicken to a somewhat ordinary tempo. Still, we believe the elimination of tax-exempt advance refundings will quell issuance in 2018. As we wrote last week, our municipal supply appraisal for 2018 stands at roughly $350 billion, a 20% decline from 2017.

Turning to demand, the Investment Company Institute (ICI) recorded $253 million of net flows into municipal bond funds for the week ending 03 January, the first positive account in the six since the 29 November print (Fig. 58). The S&P Municipal Bond Index produced a +0.248% return for the most recent mid-week interval.

Looking forward to the second ICI Municipal Bond Mutual Fund Flows report for 2018, the next account on the 17th of January will cover the four trading days ending on 10 January, when the S&P Municipal Bond Index generated a -0.439% return. Since the market return for the latest Wednesday-to-Wednesday period landed in decidedly negative territory, we believe flows will likely slow from the prior week's pace.

We think it noteworthy to point out that it has generally been a practical guidepost to use concurrent market performance as a standard against which retail investors make municipal bond fund purchase and sell decisions. Still, we have gotten our preceding two forecasts wrong. Last week we went counter to our practice and made an adjustment for our view of investor's shared mindset. We wrote that although the S&P Municipal Bond Index delivered a +0.248% return for the prior week, attitudes as gauged by mutual fund flows appeared to have taken on a bearish sentiment, and we expected outflows to continue for the most recent report regardless of the positive performance. Of course, that did not occur. Perhaps retail investors were a tad slow to respond to the recent upturn in market performance.

Last week, the New York Federal Reserve reported that primary dealer firms shrunk their collective municipal bond positions by $3.445 billion versus the previous report. The balance totaling $25.253 billion for the five trading days ending the 3rd of January was the second consecutive week of decline. The previous report showed $28.698 billion reported for the 27th of December (Fig. 60).

Market Sentiment
Municipal bond dealers grew rather dispassionate in their near-term view. On Friday, Thomson Reuters Municipal Market Data reported that 12% of dealer firms in their survey were bearish for their 1-week outlook, a drop from the 33% recorded on the 5th of January (Fig. 61). The neutral group drew a score of 75%, compared to the former report's 40% in that category. Dealers in the bullish set recorded 13%, as measured up against 27% in the prior survey. An unquestionably more negative response unfolded for dealers' 1-2 month outlook. As of Friday, 67% of survey participants described themselves as bearish, that number was up from the 40% in the previous study (Fig. 62). The neutral group chalked up 22% of the contributors, compared to 33% in the preceding enquiry. Bullish survey members shrank to 11%. Please see Figures 63 through 65 for additional survey information pertaining to the buyside sentiment and dealer inventories.

Core Narrative
The tax-exempt municipal bond market has taken on a distinctly tepid, if not downright negative tone over the past several weeks. Some of the fragility can be attributed to the rise in UST interest rates, and some over concerns about the future effects of recent tax reform. All the same, the dearth of supply should offer a support mechanism over the next several weeks. While positive, fund flows remain unconvincing, and we will keep close watch on retail demand.





Investing involves risks and you may incur a profit or a loss. Past performance is no guarantee of future results.