Municipal Fixed Income Weekly

October 12, 2018


Municipal Fixed Income Weekly

October 12, 2018


Key Themes for the Upcoming Week

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  • The conflation of US Treasury Secretary Steven Mnuchin’s comments last week at the IMF annual meeting, in an effort to assuage concerns over foreign demand for US Treasury (UST) securities, and the latest equity market thrashing appeared to give investors respite after an almost uninterrupted 29-day rise in domestic interest rates. The benchmark 10-year UST began September drawing a 2.860% yield and peaked this past Tuesday at 3.259% before rallying to close Friday at 3.161%. While the near-term strength in the UST market was a welcome break for taxable bond investors, the tax-exempt municipal market seemed to flout the good news. Despite the applauded exceptions of a moderately firm tone on Thursday and an outright flat Friday, high-grade municipal bond investors still felt the sting of the erstwhile 6-day rout.
  • With the advent of a pronounced rise in short-term benchmark interest rates and market yields over the past twenty-one months, both taxable and tax-exempt, we added Figures 8 and 9 in order to afford a more robust evaluation of those relationships. Moreover, with the phasing out of LIBOR by 2021, our tables contain the Secured Overnight Financing Rate (SOFR), which will likely become the US substitute for LIBOR. We include the definitions of the additional index and representative security yields in the Disclosures at the end of this report.
  • The tax-exempt municipal market routinely ignores or is slow to respond to directional shifts in taxable benchmark interest rates. The UST’s firmness last week did not transmit into the municipal bond market, at least not until perhaps Thursday. By Friday’s close, the reversal and calming was entirely insufficient to generate positive returns on the week. While the surge in the impending new issue calendar should be dispatched with ease, any acceleration in fund outflows could put pressure on prices, aggravating any latent weakness in an already delicate market.
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.

US Markets:
CPI data continues to suggest a moderate pace of hikes from the Fed. Core CPI in September held steady at +2.2% year-over-year (y/y), while Headline CPI pulled back on moderating Energy Price gains to +2.3% y/y, from+2.7% y/y. The underlying trend in Core Inflation has been moderating in recent months with the 3-month and 6-momth annualized rate now both at +1.8%, down from highs of +3.1% and +2.6%, respectively. This month’s softer reading was driven in part by an outsized dip in Used Car Prices, -3.0% month-over-month (m/m), which is unlikely to be sustained. Core PPI held steady at +2.9% y/y. Meanwhile, Import Prices moderated, up 3.5% y/y, but down from its high in July of +4.8% y/y, even as the stronger dollar begins to feed through.

Small Business and Consumer Confidence remain at lofty levels, despite a tick down in the latest readings. NFIB Small Business Optimism ticked down in September from a 45-year record high last month, but still remains at its third highest reading in its history. The Index for Actual Compensation Increases rose to a record level in September, in line with the uptrend we have been seeing in recent Wage Data. The University of Michigan Consumer Sentiment Index nudged lower as well, as perceptions of growth in Household Incomes softened while Inflation Expectations for the year head edged higher, likely due to higher Energy Prices. Given the timing of the survey, it may not have fully reflected the impact of the recent equity sell-off.

The Atlanta Fed’s GDPNow Forecast for 3Q sits at +4.2 % quarter-over-quarter (q/q) saar (seasonally adjusted annual rate), from +4.1% at the end of last week.

International Developed:
The Eurozone’s Industrial Production rebounded in August, +0.9% y/y, after falling by 0.1% y/y in July due to Auto Sector output being subdued before EU emissions tests. The details in August were solid, with Capital Goods and Consumer Goods both up, along with Energy and Intermediate Goods; however, the trend still points to slowing momentum.

Emerging Markets:
China’s Trade data held up in September, despite ongoing Trade Tensions. Exports rose by 14.5% y/y, from +9.1% y/y in August. Imports moderated, suggesting some softening of domestic demand, to +14.3% y/y, from +18.7% y/y, with the Trade Surplus increasing to $31.7 billion. Exports to the US edged up slightly +14.0% y/y, from +13.2% y/y in August. The rest of the improvement came from a rebound in Exports to the EU and Japan after a sharp drop in the previous month. Trade tensions are expected to feed through and are likely to weigh on China’s export growth going forward, though the PBoC appears ready to continue to offset the impact with easing measures as it did earlier this week with its 100 basis point (bp) cut to the reserve requirement ratio.

Yield Curve
The conflation of US Treasury Secretary Steven Mnuchin’s comments last week at the IMF annual meeting, in an effort to assuage concerns over foreign demand for US Treasury (UST) securities, and the latest equity market thrashing appeared to give investors respite after an almost uninterrupted 29-day rise in domestic interest rates. The benchmark 10-year UST began September drawing a 2.860% yield and peaked this past Tuesday at 3.259% before rallying to close Friday at 3.161%.

While the near-term strength in the UST market was a welcome break for taxable bond investors, the tax-exempt municipal market seemed to flout the good news. Despite the applauded exceptions of a moderately firm tone on Thursday and an outright flat Friday, high-grade municipal bond investors still felt the sting of the erstwhile 6-day rout. The ICE AAA Municipal Yield Curve ended the week with the 6-month and 1- and 2-year spots each rising by 2 bps, even as the 3-year was up 4bps (Figs. 1 & 2). The 5-year point moved higher by 3bps, while the 7-year was softer by 5bps. The 10-, 15-, and 30-year yields were each up by 5bps, leaving the long bond to draw a 3.410% yield at Friday’s close. For added perspective, we note that the AAA ICE 10-year yield is higher by 16bps on the month and by 75bps year-to-date. The 30-year yield is greater by 89bps since 31 December 2017.

With the advent of a pronounced rise in short-term benchmark interest rates and market yields over the past twenty-one months, both taxable and tax-exempt, we added Figures 8 and 9 in order to afford a more robust evaluation of those relationships. Moreover, with the phasing out of LIBOR by 2021, our tables contain the Secured Overnight Financing Rate (SOFR), which will likely become the US substitute for LIBOR. We include the definitions of the additional index and representative security yields in the Disclosures at the end of this report.

The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield remained unchanged at 1.530%, after a 3bp decline a fortnight ago. The current level is 7bps above its 1.460% 12-week moving average (Fig. 10).

In our opinion that weekly tax-exempt benchmark interest rate has reached an ostensible equilibrium range of approximately 70% of a compendium of taxable short-term rates and yields (Figs. 8 & 9). As a reminder, the SIMFA Municipal Swap Index peaked at 1.810% on 15 April, probably due to money market share redemptions for income tax payments. As of Wednesday, the tax-exempt weekly variable rate stood at 67.012% of the overnight LIBOR Fix, 69.467% of the 1-week LIBOR Fix, and 71.163% of SOFER.

Looking beyond the 6-month point, last week’s move steepened the slope of the ICE AAA Municipal Yield Curve by 3bps, top to bottom. As of Friday’s close, the difference between the 1- and 30-year yields stood at 150bps, up from 147bps the prior week (Fig. 1). The ICE AAA Municipal Yield Curve has steepened 39bps thus far in 2018. The curve is 0.36 standard deviations above its 144.23bp 1-year trailing daily average (Figs. 13 & 14).

Municipal-to-US Treasury (M/UST) Yield Ratios
High-grade municipals were markedly weaker vis-à-vis USTs across essentially the entire term structure, with the only exceptions occurring at very short maturities. As a result of a softer AAA municipal curve, and the coincident brawn in the UST market, tax-exempt yields became comparatively more eye-catching moving out the curve (Fig. 12). The 6-month M/UST fell by a pocket-sized 0.155 ratios, to finish the week at 76.545%, compared with the prior print of 76.700% (Figure 27). The 1-year M/UST edged higher to 71.886%, a 0.213 ratio increase from the previous week’s 71.672%. The 2-year M/UST picked up1.507 ratios, to complete the last four trading sessions at 71.379%. The 5-year M/UST was higher by 2.745 ratios to finish the week at 76.590%, up from the prior Friday’s 73.845%. Over the same holiday-shortened week, the 10-year M/UST spiked to 86.749%, an increase of 3.854 ratios from the earlier print of 82.895% on the 5th of October. Lastly, the 30-year M/UST ended with a full 4.007 ratio increase from the prior week’s 98.765%, to close at 102.773%. We present a more complete view of the one-year historical AAA Municipal-to-US Treasury yield ratios in Figures 28-34 on pages 23-25.

AA Municipal-to-AA Corporate (AAM/AAC) Yield Ratios
In similar fashion, over the past four trading days municipal bonds in the Aa/AA ratings class became more appealing relative to their senior unsecured corporate counterparts throughout the term structure, increasingly so moving from shorter to longer maturities.

Friday’s close saw the 6-month AAM/AAC finish the week at 72.468%, higher by 0.972 ratios from 71.496% on the 5th of October (Fig. 35). The 1-year AAM/AAC increased by 0.990 ratios, closing the week at 71.968%, up from the preceding Friday’s 70.978%. The 2-year AAM/AAC relocated higher by 1.030 ratios, to conclude the last four sessions at 72.467%. The 5-year rose to 70.402%, a 1.432 ratio rise from the prior week’s 68.970% on the 5th of October. The 10-year printed a 2.062 ratio increase to end the week at 70.065%. Finally, the 30-year AAM/AAC glided higher by 2.473 ratios from the prior week’s 82.048%, to finish Friday at 84.522%. We present a more complete view of the one-year historical AA Municipal-to-AA Corporate yield ratios in Figures 36-42 on pages 26-28.

Market Performance
Regular readers will note that we added Figure 44, which depicts our selected S&P Municipal Indices’ characteristics as percentages the Municipal Bond Index, and of the entire municipal bond market as reported by the Federal Reserve System. We provide those ratios for a variety of features, including number of holdings, market value, and effective duration. At over $2.212 trillion, the S&P Municipal Bond Index represents roughly 57.446% of the $3.8653 trillion municipal bond market (Figs. 43, 44, & 72). Including its 189,944 individual constituent bonds, in our view it is one of the most robust and broad examples of the broad municipal market.

The S&P Municipal Bond Index has an effective duration of 6.618 years, and saw its yield increase to 3.017%, up from 2.968% on the previous Friday. Importantly, Friday marked the first time that broad-market benchmark’s yield exceeded 3.000% in almost five years. The last time it logged in excess of that watermark was fifty-six months ago on 3 February 2014, when it printed 3.006%. As interesting, the nadir occurred at the end of July 2016, when that benchmark fell to an all-time record low yield of 1.744%; S&P Dow Jones began their family of municipal bond indices in January 1999.

With the 5bps rise in yield, the S&P Municipal Bond Index delivered a -0.204% total return over the past our trading days (Fig. 45). Friday marked the second consecutive week of negative total returns, ranking it 41st in the past year (Fig. 51). Moreover, six of the seven most recent weeks supplied down performance. The latest four-day total return kept its year-to-date figure firmly in the red at -0.931%.

The Intermediate, Short Intermediate, and Short indices also concluded the week in negative territory, distributing total returns of -0.148%, -0.034%, and -0.003%, respectively. The High Yield Index generated -0.461% last week, underperforming the High Yield Excluding Puerto Rico Index, which finished the past four trading days with a total return of -0.372%. The S&P Municipal Bond California Index printed -0.262%, 5bps worse than the New York Index’s -0.212%. Puerto Rico turned in a horrid -1.275% last week, yet that yardstick still wears a +24.707% year-to-date total return.

Supply and demand
The upcoming week’s tax-exempt new issue calendar totals $9.696 billion, a welcome $5.554 billion jump from last week’s $4.143 billion (Fig. 63). Next week’s tab is about $4.002 billion above the $5.695 billion 12-week moving average. As of Friday’s close, total year-to-date issuance stood at $263.862 billion. That number compares with $304.556 billion for the same period for 2017, a 13.362% shortfall.

In June we adjusted our initial $350 billion supply estimate for all of 2018 down to $315 billion, a 28% decline from 2017’s $436.345 billion. With eleven weeks remaining in 2018, issuers will need to bring a total of about $51.138 billion in new deals in order to reach our revised forecast; that equates to $4.649 billion every week. Market activity, however, typically becomes sluggish during the weeks of Thanksgiving, Christmas and Chanukah. If we discount the number of remaining weeks in 2018 by three in order to account for the holiday season, then supply during weeks when the market is open, well-attended, and active will need to average $6.392 billion for the remainder of the year to get to our $315 billion volume estimate. As we underscored several weeks ago, we think that is certainly achievable but market conditions could quickly thwart our prediction.

Turning to demand, the Investment Company Institute (ICI) reported a negative $202 million of municipal bond fund flows for the mid-week period ending 03 October (Fig. 64). As of that date, the S&P Municipal Bond Index’s mid-week 4-day performance was -0.025%. Once again, we refer to Figure 63 which, apart from the most recent two weeks, plainly illustrates the hand hot weekly inflows since mid-May; the exception being the five-day period ending Wednesday, the 18th of July, when investors added a net $1.677 billion to municipal bond funds. Otherwise, inflows have been decidedly soft.

The most recent report serves to further galvanize our apprehensions. Anecdotally, we think there is a reasonably forcible and direct relationship between market performance and retail investors’ willingness to add or withdraw capital in light of changes in net asset values of open-end municipal bond funds.

We have long held that prolonged market weakness could spark a non-virtuous cycle where fund share redemptions beget forced selling by mutual fund managers, which, in turn, moves bond valuations lower and returns negative, thereby perpetuating outflows. The S&P Municipal Bond Index delivered negative returns in nine of the past eleven weeks since the 25th of July. Again, the $1.677 billion weekly spike in inflows was reported the prior Wednesday, 18 July, when the S&P Municipal Bond Index returned +0.132%. In fact, five of the six weeks ending on the 18th of July produced positive returns, with each Wednesday’s fund flows report delivering net capital influxes for a total of $3.632 billion over that period.

Looking forward to the forty-first ICI Municipal Bond Mutual Fund Flows report for 2018, the next one on the 17th of October will cover the four trading days ending on 10 October, when the S&P Municipal Bond Index generated an awful -0.635% return. At least over the past fortnight, investors seem to have moved in a somewhat predictable fashion by reallocating capital out of municipal bond funds. We continue to expect that if the recent trend persists, next week’s account should once again be negative. Even in light of the current softness, investors have reallocated a net total of $16.014 billion into municipal bond funds thus far in 2018.

Market Sentiment
Printing 25% bearish, ThomsonReuters Municipal Market Data (MMD) reported that dealers’ near-term market views were as negative as on 21 September, when that same group registered the same 25% (Fig. 67). In the intervening two weeks, the bearish category fetched 67% of participants. The neutral group closed Friday with 75% of respondents, versus 33% in the prior week’s report. Dealers registered no response in the bullish category. Dealers apportioned their collective views for the 1-2 month outlook at 60% in the bearish category, with the remaining 40% describing themselves as neutral (Fig. 68). Please see Figures 69 through 71 for additional survey information pertaining to buyside sentiment and dealer inventories.

Core Narrative
The tax-exempt municipal market routinely ignores or is slow to respond to directional shifts in taxable benchmark interest rates. The UST’s firmness last week did not transmit into the municipal bond market, at least not until perhaps Thursday. By Friday’s close, the reversal and calming was entirely insufficient to generate positive returns on the week. While the surge in the impending new issue calendar should be dispatched with ease, any acceleration in fund outflows could put pressure on prices, aggravating any latent weakness in an already delicate market.





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