Municipal Fixed Income Weekly

April 20, 2018


Municipal Fixed Income Weekly

April 20, 2018


Key Themes for the Upcoming Week

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  • On Wednesday, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield leapt higher by 9bps to print a multi-year high of 1.810% (Fig. 8). That number followed the prior week's jump of 12bps on the 11th of April. From mid-2016 to present, several factors influencing short-term rates include money market reform, Federal Reserve tightening and balance sheet paring, repatriation, and burgeoning T-bill issuance. In fact, since the 28th of February, the 7-day Variable Rate Demand Note (VRDN) rate has moved higher in each of those weekly cycles for a total increase of 72bps.
  • Both US Treasuries (USTs) and high-grade municipal yields moved higher across the entire term structure over the past five trading days, with USTs outpacing their tax-exempt counterparts to the upside at each point on the curve (Fig. 10). The UST curve bulged in the 5- and 20-year segment, but displayed an otherwise routine shift higher. On the other hand, while all points on the ICE AAA Municipal Yield Curve moved higher, Figure 10 reveals a rather exaggerated saucer effect in the upward shift in the 3- to 15-year section, with interest rates at those spots increasing less than those in the short and long portions.
  • Core narrative: anxieties over inflation and rising interest rates overtook the municipal bond market in the final two days of trading last week. While the dearth of supply remains a support structure, the year-over-year deficit seems to be consistently narrowing, and as such, the supply-demand imbalance may moderate. In light of performance of late, mutual fund investors' collective concern seemed to manifest itself in the form of the largest weekly net outflows in over a year. We believe that the possibility of a follow-through of this bearish sentiment could persist into the early part of next week.
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.

Central Banks
  • The European Central Bank (ECB) will meet Thursday, but we expect no change to policy. Policymakers are reportedly considering waiting until their July meeting to announce how the bond-buying program will end; a change in interest-rate guidance may follow thereafter. Expectations for a change in policy have been reduced following a disappointing quarter of European economic data.
  • The Bank of Japan (BoJ) meets Friday, when markets will be listening for hints as to the timing of QE exit. The inflation trend has picked up, but a stronger yen remains a headwind to the BoJ's inflation target, as well as Japanese exporters.
  • Bottom line: Global central banks remain extremely accommodative, and after disappointing first-quarter economic data, any tightening announcements may be pushed out further.
International Developed Markets
  • Euro Area growth data momentum has been slowing in 1Q, after surprising significantly to the upside in the latter part of 2017. Last week economic sentiment fell by more than expected, possibly because of continued trade tensions. Core inflation held steady at 0.9% year-over-year (y/y) as expected, though it is expected to firm gradually through the course of the year. Markets expect the ECB to keep its monetary policy stance unchanged at this week's meeting, but possibly give signals about potential reductions to its accommodative stance in the second half of the year.
  • The UK employment report confirmed a still tight labor market, with the unemployment rate ticking down to 4.2% in February, a 40-year low. Inflation data fell unexpectedly though to 2.5%y/y. Market expectations of a May rate hike from the Bank of England (BoE) were pared back as BoE governor Carney's comments on the 19th of April were more dovish than expected.
  • In Japan, recent data have been volatile due to weather and Lunar New Year effects, so far suggesting softer growth for 1Q, compared to strong 4Q2017 GDP. Manufacturing business sentiment fell for the third month, dented by yen and oil strength, as well as continuing trade tensions. In contrast, the non-manufacturing sentiment matched an all-time high set in June 2015, with retail and other service sectors improving against the backdrop of a tight labor market. Core inflation was unchanged at +0.5%y/y for March, in line with expectations, while headline inflation ticked down to +1.1%y/y. Inflation is expected to continue its gradual uptrend but not enough for the BoJ to decrease its accommodative stance.
This week's data includes:
  • Monday, 23 April: US Existing Home Sales, Euro Area Composite PMI.
  • Tuesday, 24 April: US New Home Sales.
  • Wednesday, 25 April: No major data.
  • Thursday, 26 April: US Durable Goods Orders, ECB policy decision, Japan Industrial Production.
  • Friday, 27 April: US 1Q GDP, US Employment Cost Index, US PCE Inflation, UK 1Q GDP, BOJ policy decision.


Yield Curve
The US Treasury (UST) market was relatively calm on Monday and Tuesday, as yields throughout the term structure alternated up and down by 1 or 2 basis points (bps), with mostly offsetting changes. Municipal bonds were weaker by 1 to 2bps on Monday, but were largely unchanged to a basis point stronger on Tuesday. On Wednesday, economic releases showed Industrial Production rose by more than expected in March, and Housing Starts and Building Permits were both stronger than expected. The potency in these economic releases softened bids by about 5bps at most points on the UST curve, while the municipal market seemed to shrug off concerns. The atmosphere quickly changed on Thursday, as the Leading Economic Index demonstrated a continued rise in March, indicating still solid growth. That, combined with a rise in the Thomson Reuters CRB Commodity Index to a two-year high, kindled inflation fears in both the UST and municipal market. UST yields jumped by 4 to 5bps across much of the curve on each of the final two days of the week, while high-grade tax-exempt interest rates changes varied but were higher by as much as 3bps in the short and intermediate segments of the curve and by 8bps on the long end.

By Friday's close, the ICE Municipal Yield Curve had moved up by 4 bps at the 6-month spot and by 5bps at both the 1-year maturity (Figs. 1 & 2). Repeating that same pattern, rates at the 2- and 3-year points also went higher by 4 and 5bps, respectively. The 5-, 7-, and 10-year spots were all up by 2bps and the 15-year by 6bps. In the largest shift of the week, all points along the curve beyond the 18-year gapped higher by a full 10bps, with the 30-year maturity finishing the week drawing a 3.010% yield.

On Wednesday, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield leapt higher by 9bps to print a multi-year high of 1.810% (Fig. 8). That number followed the prior week's jump of 12bps on the 11th of April. From mid-2016 to present, several factors influencing short-term rates include money market reform, Federal Reserve tightening and balance sheet paring, repatriation, and burgeoning T-bill issuance. In fact, since the 28th of February, the 7-day Variable Rate Demand Note (VRDN) rate has moved higher in each of those weekly cycles for a total increase of 72bps.

Looking beyond the 6-month point, last week's activity steepened the ICE AAA Municipal Yield Curve by 5bps, top to bottom, completely offsetting the prior week's 5bps flattening. The gap between the 1- and 30-year yields rose to 132bps, compared to 127 bps the preceding week (Fig. 1). The current slope is 1.26 standard deviations below its 168.85bp 1-year trailing daily average (Figs. 11 and 12). Moreover, it is a full 86bps lower than its 1-year maximum of 218bps.

Looking at the ICE AAA Municipal Yield Curve from a different standpoint, at 2.440%, the 10-year maturity provides 81% of the interest rate at the 30-year point, whereas on 06 April 2017, that same spot provided only 71% of the long high-grade rate. The 15-year spot currently delivers 90% of the 30-year's yield, the same as the previous Friday's close; that number is down from 91% on the 16th of April.

Municipal-to-US Treasury (M/UST) Yield Ratios
Both UST and high-grade municipal yields moved higher across the entire term structure over the past five trading days, with USTs outpacing their tax-exempt counterparts to the upside at each point on the curve (Fig. 10). The UST curve bulged in the 5- and 20-year segment, but displayed an otherwise routine shift higher. On the other hand, while all points on the ICE AAA Municipal Yield Curve moved higher, Figure 10 reveals a rather exaggerated saucer effect of the shift in the 3- to 15-year section, with interest rates in that range increasing less than those in the short and long portions.

Thus, we note that high-grade municipal bond yields moved in similar direction at all points throughout the curve, but because of the difference in relative changes, they became richer vis-à-vis USTs at all points on the curve. In other words, all M/UST ratios dropped with high-grade municipal bond yields becoming comparatively less attractive. The 6-month M/UST fell by a slight 0.122 ratios, to close at 81.511%, compared with the prior print of 81.633% (Figure 25). In like manner, the 1-year M/UST completed the week lower at 78.168%, a 0.151 ratio drop from the previous week's 78.319%. Meanwhile, the 2-year M/UST decreased 1.399 ratios, to close the last five trading sessions at 72.299%. The 5-year M/UST shifted lower by 2.949 ratios to finish the week at 75.357%, down from the earlier recording of 78.306%. Over the same 1-week period, the 10-year M/UST decreased to 82.432%, a drop of 3.292 ratios from the earlier print of 85.724% on the 13th of April. Lastly, the 30-year M/UST ended with a 0.427 ratio dip from last week's 96.135%, to finish at 95.707%. 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
Similar to their AAA-rated tax-exempt and UST cousins, municipal bonds in the Aa/AA ratings category became less attractive relative to senior unsecured Aa/AA corporate bonds. Friday's close saw the 6-month AAM/AAC finished the previous five trading days at 71.407%, lower by 0.809 ratios from 72.216% on the 13th of April (Fig. 33). The 1-year AAM/AAC decreased by 0.850 ratios, closing the week at 70.203%, down from the preceding Friday's 71.053%. The 2-year AAM/AAC measure drifted lower by 0.963 ratios, to complete the last five sessions at 69.190%. The 5-year fell to 70.632%, a decrease of 1.988 ratios from the prior week's 72.619% on the 13th of April. The 10-year printed a 2.134 ratio fall to close the week at 67.559%. Finally, the 30-year AAM/AAC edged lower by an almost flat 0.032 ratios from the past week's 78.676%, to finish Friday at 78.644%. 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
Higher municipal bond yields delivered negative returns for most of the indices on which we report; the only exceptions were the S&P Municipal Bond High Yield, the High Yield Ex-Puerto Rico, and the Puerto Rico indices. The S&P Municipal Bond Index served up a -0.186% total return for the week, bringing its year-to-date number to -1.039% (Fig. 42).

The Intermediate and Short Intermediate indices also ended the week in the red, generating total returns of -0.149% and -0.094%, in that order. The S&P Municipal Bond Short Index printed a -0.053% performance for the week. The High Yield Index finished the week barely on dry ground, delivering performance of +0.035% and the High Yield Excluding Puerto Rico finished at +0.016%. The S&P Municipal Bond California Index turned in a -0.197% return, while the New York Index generated -0.175% performance for the week. Bringing the seventh consecutive week of positive performance, the S&P Municipal Bond Puerto Rico Index turned in a +0.199% total return. As of this past Friday's close, the Commonwealth's year-to-date figure of +11.188%, is a 61% retracement of 2017's dismal -18.435%.

Consistent with the S&P High Yield and High Yield Ex-Puerto Rico indices ending the week in the black, we note that of all the ratings categories, the Speculative Grade group - read, high yield – was the only one to deliver positive results (Fig. 44). Moreover, the Tobacco Settlement sector was only one of two to generate positive performance marks (Fig. 45). Weighted by market value plus accrued interest, Tobacco Settlement is the second largest sector in both the High Yield and High Yield Ex-Puerto Rico indices.

Supply and demand
Municipal market participants are expecting about $7.520 billion in new tax-exempt deals to come in the upcoming week (Fig. 57). That figure is about $2.666 billion higher than last week's $4.860 billion. The current slate is $2.574 above the $4.946 billion 12-week moving average. As of Friday's close, approximately $84.672 billion in new deals have come to market thus far in 2018. That figure compares with $113.721 billion for the same period in 2017, a $29.049 billion shortfall.

As of Friday, supply stood at 74.456% of where it was on the 07 April 2017. That figure is up from 71.462% a fortnight ago, and we are encouraged that the year-to-date deficit seems to be gradually and consistently narrowing. At the outset of 2018, we estimated total new issuance for all of this year to come in at $350 billion, a 20% decline from 2017. We stand by that appraisal, and believe supply will approach that figure by year-end.

Turning to demand, the Investment Company Institute (ICI) recorded negative net withdrawals from municipal bond funds for the second week in a row, with the most current outflow of $830 million being the most pronounced reallocation since investors withdrew $2.218 billion over the four business days ending on 4 January 2017 (Fig. 58).

The S&P Municipal Bond Index provided a paltry +0.105% for that Wednesday-to-Wednesday period. We have repeatedly underscored on these pages that, while we haven't conducted a scientific study, we believe the evidence suggests retail investors tend to react to recent market performance by adding or withdrawing capital from municipal bond funds. Thus far in 2017, the S&P Municipal Bond Index has served up a-0.065% average weekly return, and last week's -0.186% figure ranked forty-second of the past fifty-two weeks. Further, we have continued to assert that the extent to which fund flows had been positive over the past six weeks, they were nonetheless tepid. We chalk that up to negative year-to-date performance, and in light of this weakness, we will not be the least bit startled to see flows continue negative until there is a decidedly positive shift in the broad municipal bond market.

Looking forward to the sixteenth ICI Municipal Bond Mutual Fund Flows report for 2018, the next one on the 25th of April will cover the five trading days ending on 18th April, when the S&P Municipal Bond Index distributed an almost flat +0.005% return. Once again, although unadulterated conjecture, we think it is reasonable to suppose next week's ICI flows report could remain negative, albeit perhaps not as severely so as the most recent report. As of the latest print, investors have ploughed a net total of $9.750 billion into municipal bond funds thus far this year, with four of the sixteen weeks so far in 2018 producing negative net flows.

Last week, the New York Federal Reserve reported that primary dealer firms cut their collective municipal bond positions by $599 million versus the previous report. The balance totaling $26.443 billion for the five trading days ending the 11th of April was down from the $27.042 billion reported for the 4th of April (Fig. 60).

Market Sentiment
As a result of concerns about rising commodity prices, an upswing in inflationary pressures, and consequent rising interest rates, municipal bond dealers were the most negative in their near-term outlook since the week ending 23 February 2018. On Friday, Thomson Reuters Municipal Market Data reported that 78% of dealer firms in their survey were bearish for their 1-week outlook, a jump from the 30% recorded on 13 April (Fig. 61). The neutral group dropped to 22%, compared to the erstwhile report's 70% in that category. No dealers landed in the bullish group, for the second consecutive week. Dealers were not quite as downbeat in their 1-2 month outlook. As of Friday, 56% of the survey participants described themselves as bearish, that number was up from the 30% in the previous study (Fig. 62). The neutral group drew 44%, compared to 40% in the preceding enquiry. Bullish survey members fell to 0% from 30% in the erstwhile assessment. Please see Figures 63 through 65 for additional survey information pertaining to the buyside sentiment and dealer inventories.

Core Narrative
Anxieties over inflation and rising interest rates overtook the municipal bond market in the final two days of trading last week. While the dearth of supply remains a support structure, the year-over-year deficit seems to be consistently narrowing, and as such, the supply-demand imbalance may moderate. In light of performance of late, mutual fund investors' collective concern seemed to manifest itself in the form of the largest weekly net outflows in over a year. We believe that the possibility of a follow-through of this bearish sentiment could persist into the early part of next week.





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