Municipal Fixed Income Weekly

August 4, 2017


Municipal Fixed Income Weekly

August 4, 2017


Key Themes for the Upcoming Week

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  • The upcoming five trading days should bring about $6.508 billion in new deals, which is a 3.690% decrease from last week's $6.757 billion (Fig. 49). We underestimated the new issue calendar by about $416 million in last week's publication, and reported it at $6.341 billion. The $6.757 billion is more accurate. As of last week's finish, year-to-date municipal bond issuance stood at $229.372 billion. That number compares with $269.493 billion for the same year-to-date period last year, a 14.888% shortfall.
  • Next week's ICI funds flows report will include the 27th and 28th of July, which saw yields unchanged to slightly higher by about 1bp, while the S&P Municipal Bond Index delivered an almost flat -0.011% return. Likewise, through last Wednesday, yields remained in a tight trading range and the broad market index served up a +0.219% return. Apart from an unforeseen negative event, we expect the upcoming ICI report to trim a few million dollars from fund flows, but remain positive and continue on a path toward the current $538 million 12-week moving average. Thus far in 2017, twenty-seven of the thirty weeks reported have seen net inflows, with investors ploughing $14.017 billion of net capital to municipal bond mutual funds.
  • Tobacco Settlement finished the week with a horrific -1.073%, placing it last in the twenty-four sectors of S&P Municipal Bond Index. Tobacco's trouncing is likely attributed to follow-through from the U.S. Food and Drug Administration's announcement two Fridays ago, that it may limit the amount of nicotine present in cigarettes. We believe the Tobacco Settlement sector will continue to come under pressure, and recommend avoiding bonds in that segment for the time being.
  • Core Narrative: while last week was busy with economic data, domestic fixed income markets were rather orderly and traded within a reasonably tight range. The municipal bond market was no exception. We expect the same type of behavior at least for the first few upcoming trading sessions. A dearth of supply continues to serve as a tailwind for municipal bond evaluations, and with the flat to up market performance over the past several weeks, we expect fund flows to remain steadily positive.
The Economy and the Fed
We thank chief economist Luke Tilley, economist Rhea Thomas, and the rest of Wilmington Trust's economics team for weighing in on a few selected highlights from the past week.

The Chicago Purchasing Manager Index dipped to 58.9 in July, still pointing to expansion, but down by 6.8 points. The reading was at its lowest in three months. However, this reading has declined in the month of July for four of the last five years, as auto manufacturers typically lower production for factory retooling in the month of July. One item of note was that the Price Pressures Index perked up in July after easing in Q2, to its highest in three months, similar to the ISM Price indices.

The Pending Home Sales Index rose 1.5% in June to 110.2, after 3 months of declines. All major regions saw a rise in contract signings, with the exception of the Midwest. Low supply of homes, particularly at lower price levels, continued to weigh on activity. Sales to investors were the lowest of the year (13%), which pushed all cash transactions down to 18% (smallest share since June 2009). The NAR noted that this may lead to less competition for homes, allowing for more purchases by first time buyers.

The Dallas Fed Texas Manufacturing Outlook showed continued expansion in July, The key Production Index rose 11 points to 22.8. The company outlook indicator rose 15.1 points, to its highest since 2010.

Core PCE stabilized at 1.5% year-over-year (y/y) and +0.1% month-over-month (m/m) in July, while headline PCE was +1.4% y/y, and flat on the month. Nominal personal income and disposable personal income were flat in June, but this was due to dividend income falling back by 3% m/m after a larger than normal increase of 4.8% m/m in May. Wages and salaries were slightly stronger in June, up 0.4% m/m (after a 0.1% rise in May). Personal saving as a percent of disposable income was +3.8% m/m. The personal consumption expenditures number rose by 0.1% m/m, but in real terms, was flat, with spending on goods -0.2% m/m, and spending on services up 0.1% m/m.

The Institute for Supply Management (ISM) Index dropped by 1.5 points to 56.3 in July, in line with the pullback in the regional manufacturing surveys for the month. The reading was still the fourth highest in the past year, and the index remains above its 12-month average of 54.7, with 15 of 18 industries reporting growth. The ISM prices Index jumped to a 3-month high as well. The Non-Manufacturing ISM Survey however, dropped by 3.5 points to 53.9 in July, an 11-month low. This was a soft reading, with seven of the ten sub-indices rising at a slower pace in July. The Price Index was one exception, rising for the second month (similar to July data for Manufacturing ISM and Chicago PMI). The composite Manufacturing and Services ISM for July does point to a slightly softer GDP reading for Q3.

Construction spending was weak, -1.3% m/m in June. Although May was revised higher to 0.3% from 0.0%, April was revised down to -1.8% from -0.7%. The weakness was driven by Public Construction, which dropped 5.4%, the largest drop in 15 years. April was also revised down to -4.7%. Private spending also dipped 0.1% m/m for the third straight month. Residential spending inched down by -0.2% m/m, and was driven by a 2.9% drop in new multifamily construction, while singly family construction rose by 0.3% m/m. This suggests a slight downward adjustment to Q2 GDP from 2.6% to 2.4%.

Non-farm payrolls saw a solid gain in July, +209k, stronger than consensus estimates of 180k, and the ADP employment reading of +178k. May and June data saw net upward revisions of +2k. Employment growth has averaged 184k per month year to date, running well above the 100k sustainable pace of job growth the Fed has mentioned in the past. The unemployment rate ticked down a tenth to 4.3%, back to the 16-year low seen earlier in May. Average hourly earnings rose by 0.3% m/m, holding steady at 2.5% year-over-year (y/y). The data point to a robust labor market, which should eventually prod wages higher and support the consumer.

The trade deficit narrowed by $2.8bn, to -$43.6bn in June. The goods deficit improved by -$2.1bn in line with last week's advance release, along with the services surplus rising by $0.6bn in this release. The Atlanta Fed GDP forecast for Q3 came in at 3.7% as of the 4th of August, after the jobs and trade data.

Yield Curve
On the 28th of July, we wrote on these pages that it was reasonable to see domestic fixed income markets commence that following Monday's trading without fanfare. The benchmark 10-year U.S. Treasury note bounced around most of the morning within about a 3basis point (bp) range between a low yield 2.271% and a high of 2.303%. Having finished the previous Friday's domestic trading at a 2.289% yield the benchmark security spent Monday afternoon sliding toward that same level to close the day all but unchanged at 2.292%. At the same time, the ICE AAA Municipal Yield Curve remained motionless except for the 7- and 9-year maturities, where yields drifted up by a measly basis point.

Early Tuesday morning trading was relatively flat, with the 10-year UST marking time around the 2.300% level. At 8:30AM EDT, June Personal Income printed flat and Real Personal Spending came in at 0.0%, down from May's +0.1%. On the other hand, both the y/y Personal Consumption Expenditure (PCE) Deflator and the PCE Core Price Index looked as if they may have sparked a mild concern over inflation for investors, as the benchmark 10-year UST edged up to a 3.319% yield until shortly after 9:00AM, but those anxieties proved transitory and one hour later, the Construction Spending number sent the 10-year yield tumbling and by late in the afternoon, its yield reached a low of 2.250% and closed U.S. trading drawing 2.251%. Adding to the soft economic tone, both Total and Domestic Vehicle Sales trickled in throughout the day, with the tally coming in below survey estimates. High-grade tax-exempt municipal bonds mimicked the UST market with yields falling by 1bp across most of the term structure, the only exception being the 6-month and 1-year maturities, where yields were up 1bp and unchanged, respectively.

Wednesday saw domestic fixed income markets trading largely sideways for most of the morning then rallying to a low intraday yield of 2.241% by about 11:00AM EDT. The afternoon was a bit weaker, with the 10-year UST edging up by about 2bps by the close. Municipal bond yields ended the day either flat or stronger by 1bp on relatively heavy volume. The MSRB reported trade volume of $13.983 billion in par value, the most active day since the $14.865 billion on the 13th of July.

On Thursday, high-grade municipal interest rates moved lower by 2 to 3bps across most of the term structure. With all the strength throughout the mid-week, Friday saw the municipal curve unchanged inside the 6-year point and softer by 1bp beyond that maturity.

By the end of trading last week, the ICE AAA Municipal Yield Curve finished with the 6-month and 1-year maturities each lower by 2bps, while the 3- and 5-year points fell by 5 and 3bps, respectively (Figs. 1and 2). The 7-, 10-, and 15-year maturities were each lower by 4bps, in that order. The 30-year point was stronger by 3bps, and closed the week drawing a 2.930% yield.

After two weeks of holding steady at 0.820%, on Wednesday, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield fell by 3bps from the prior week, to register 0.790%. On the 28th of June, that weekly watermark printed a 0.910% rate, and has spent four of the past five weeks in decline. The current level is only 13bps off of its multi-year peak of 0.920%, which occurred on 19 April 2017.

Considering past the 6-month point, last week's changes in tax-exempt rates flattened the ICE AAA Municipal Yield Curve by 2bps, front to back, diminishing the difference between the 1- and 30-year yields to 187bps, down from 189bps the previous Friday (Fig. 6). At 187bps, the slope of the high-grade municipal yield curve is 5bps off its 180-day low of 182bps, and well below its 206.13bps average for that same period (Fig. 7). The spread between the 2- and 10-year remained unmoved, and closed at 101bps on Friday, only 12bps higher than the flattest level that portion of the curve has been in the past six months (Figs. 8 and 9).

Municipal-to-US Treasury (M/UST) Yield Ratios
High-grade municipal yields varied both directionally and in amplitude against U.S. Treasury yields over the past five trading sessions, with AAA municipal bond yields mostly outpacing USTs on the short and intermediate portions of the curve, while USTs bested municipals on the long end. The 1-year M/UST moved lower by 1.052 ratios on the week, to close at 68.369%, while the 2-year M/UST was cut by 2.419 ratios to end Friday at 67.159%, down from the preceding print of 69.578% (Fig. 21). The 5-year M/UST finished at 64.978, falling by 1.616 ratios from the previous week's 66.594%. The 10-year M/UST dropped a mere 0.310 ratios to close the past five trading days at 84.806% versus the earlier print of 85.116% on the 28th of July. Lastly, the 30-year M/UST ended with a 0.802 ratio hike from last week's figure, to finish at 95.037%.

AA Municipal-to-AA Corporate (AAM/AAC) Yield Ratios
Yield ratios for AA municipal bond and senior unsecured AA corporate bonds were generally lower last week. The 1-year AAM/AAC concluded the week at 54.319%, 1.406 ratios lower than the preceding Friday's 55.725% (Fig. 28). Similarly, the 2-year measure fell 2.361 ratios to end the last five trading days at 54.691%. The 5-year skirted lower to 55.442%, a lessening of 1.155 ratios from the prior week's 56.597% on the 28th of July. The 10-year printed 0.637 ratios downward at 64.406%. On the other hand, the 30-year AAM/AAC increased 0.0.393 ratios to the prior week's 79.357%, to close on Friday at 79.749%.

Market performance
With the decline in interest rates, the tax-exempt municipal market produced mostly healthy scores last week. The S&P Municipal Bond Index, a broad-market measurement, finished the week, generating +0.219%, while the Intermediate Index produced +0.245% (Fig. 35). The Short Intermediate and Short indices landed on dry ground as well, printing +0.163% and +0.100% returns, in that order. The High Yield Index ended the week slightly in the red, turning out a total return of -0.042%. Likewise, Puerto Rico struggled over the past five trading days, with the Commonwealth's index delivering a performance of -0.303%. Thus, the S&P Municipal Bond High Yield Excluding Puerto Rico printed a slightly positive +0.037% whilst he S&P Municipal Bond California and New York Indices produced +0.268% and +0.194%, respectively, and in line with the broad market waterline.

July turned out to be relatively strong, with the S&P Municipal Bond Index generating +0.660% for the month, while the Intermediate, Short Intermediate and Short indices registered +0.738%, +0.576%, and +0.333% for July.

Looking at the top ten states of the S&P Municipal Bond Index, weighted by market value, for the third week in a row, Illinois produced the best return of the subset, finishing the week at +0.352% (Fig. 36). For the second consecutive week, Ohio made worst showing of the top ten, registering a total return of +0.035%.

The Baa/BBB category was the best returning ratings group, delivering +0.258%, while the speculative grade (high yield) securities posted the worst performance, producing -0.081% (Fig. 37). Turning to sectors, Higher Education provided was the highest return, supplying +0.305% (Fig. 38). Tobacco Settlement finished the week with an horrific -1.073%, placing it last in the twenty-four sectors of S&P Municipal Bond Index. Tobacco's trouncing is likely attributed to follow-through from the U.S. Food and Drug Administration's announcement two Fridays ago, that it may limit the amount of nicotine present in cigarettes. We believe the Tobacco Settlement sector will continue to come under pressure, and recommend avoiding bonds in that segment for the time being.

Supply and demand
The upcoming five trading days should bring about $6.508 billion in new deals, which is a 3.690% decrease from last week's $6.757 billion (Fig. 49). We underestimated the new issue calendar by about $416 million in last week's publication, and reported it at $6.341 billion. The $6.757 billion is more accurate. As of last week's finish, year-to-date municipal bond issuance stood at $229.372 billion. That number compares with $269.493 billion for the same year-to-date period last year, a 14.888% shortfall.

Pivoting to demand, on Wednesday, the Investment Company Institute (ICI) registered $582 million of net flows into municipal bond funds for the preceding five trading days ending 26 July, marking the third consecutive week of a positive tide (Fig. 50). The funds flow report prints on Wednesday, and lags by one week. For example, the most recent report dated 02 August, includes data for the five trading days ending 26th of July. The current account captured the 20th and 21st of July, when the ICE AAA Municipal Yield Curve shifted downward by a combined 3 to 5 bps across the term structure, as the S&P Municipal Bond Index generated a +0.204% return for those two days. The first three days of the following week saw benchmark high-grade municipal yields shift up by between 1 and 4 bps, while that same S&P broad market index printed performance of -0.069%. For the five trading days ending 26 July, the S&P Municipal Bond Index generated a moderate +0.134%. In the previous edition of this publication, we posited that mutual fund flows would stay positive for this week and next, but would decline from the 19 July report's $771 million of net inflows and approach the former $507 million 12-week moving average. In fact, this Wednesday's print was $582 million, slightly stronger than we anticipated, but in line with the effect we expected.

Next week's ICI funds flows report will include the 27th and 28th of July, which saw yields unchanged to slightly higher by about 1bp, while the S&P Municipal Bond Index delivered an almost flat -0.011% return. Likewise, through last Wednesday, yields remained in a tight trading range and the broad market index served up a +0.219% return. Apart from an unforeseen negative event, we expect the upcoming ICI report to trim a few million dollars from fund flows, but remain positive and continue on a path toward the current $538 million 12-week moving average. Thus far in 2017, twenty-seven of the thirty weeks reported have seen net inflows, with investors ploughing $14.017 billion of net capital to municipal bond mutual funds.

On Thursday, the New York Federal Reserve reported that primary dealer firms' municipal bond positions shrunk by $1.015 billion versus the previous report. The balance totaling $19.542 billion for the five trading days ending the 26th of July was lower than the previous report's $20.557 billion reported for the 19th of July (Fig. 52). Primary dealers' largest positions are in maturities beyond 10 years with that category representing a full 53% of their collective municipal bond holdings, followed by variable rate demand notes (VRDNs), which constitute about 22%.

Market Sentiment
Last week, Thomson Reuters Municipal Market Data (MMD) reported that 14% of dealer firms registered as bearish for the 1-week outlook (Fig. 53). That figure is down from 33% in the 28 July survey. The 86% balance of dealer respondents fell in the neutral category, with the bullish group remaining at 0% for the third uninterrupted week. Looking out 1-2 months, 67% of dealer firms expressed that they were bearish on the municipal bond market (Fig. 54). That figure is up from 17% in the last assessment. Neutral participants scored 33%, with a low-conviction view straight through September.

Likewise, the vast majority of portfolio managers landed head-on in the neutral zone for the next week. Scoring exactly the same as last week, 20% of survey participants were in the bearish category, whilst the 80% balance of contributors expressed their 1-week outlook as neutral (Fig. 55). Longer term, the buy-side came in at 25% in the bearish group and 75% in the neutral category (Fig. 56). The prior survey showed 20% of contributors in the bullish class, which was the only other positive showing in the past seven weeks.

For the fifth uninterrupted week, no traders labeled their inventories as heavy (Fig. 57). The number of members who described their inventories as medium was about halved to 17%, down from 33% on the 28th of July. A full 83% of traders who participated in the survey characterized their positions as light. That number was up from 67% in the last week's survey.

Core Narrative
While last week was busy with economic data, domestic fixed income markets were rather orderly and traded within a reasonably tight range. The municipal bond market was no exception. With high-grade tax-exempt yields falling by a few basis points on the week, we expect the same type of behavior at least for the first few upcoming trading sessions. A dearth of supply continues to serve as a tailwind for municipal bond evaluations, and with the flat to up market performance over the past several weeks, we expect fund flows to remain steadily positive.





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