Municipal Fixed Income Weekly - Wilmington Trust

Municipal Fixed Income Weekly

August 3, 2018


Municipal Fixed Income Weekly

August 3, 2018


Key Themes for the Upcoming Week

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  • With all the attention institutional investors gave the 10-year US Treasury (UST) last week as it pierced the 3.000% intraday level for the first time since the 13th of June, that benchmark security ended Friday's trading at 2.949%, just about one basis point (bp) lower than it closed the previous week – a rather uneventful roundtrip. The 10-year UST's resilience failed to translate over into the tax-exempt municipal bond market, as high-grade yields edged higher across the term structure.
  • In a remarkable showing, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield vaulted 35bps skyward on Wednesday, the largest one-week move – either up or down – in almost ten years (Fig. 8). That huge leap came after a four-week 57bp decline. At its current 1.290% level, the SIFMA Index stands at 68.617% of the 4-week US Treasury bill's 1.880% bond-equivalent rate. Moreover, it is 66.154% and 67.363% of the 1-week and overnight LIBOR Fix, respectively. The most recent print seems to make sense to us and probably represents a more sustainable equilibrium given these and other short-term benchmark interest rates.
  • Consistent with the ICE AAA Municipal Yield Curve's thematic shift slightly higher, the S&P Municipal Bond Index's yield moved up by 0.040% over the past five trading days to produce a -0.102% total return. Once again, the most recent downturn wasn't enough to bring its year-to-date performance into the red. As of Friday's close, the S&P Municipal Bond Index has generated +0.130% thus far in 2018.
  • Core narrative: the municipal bond market bucked the UST market's firmness last week, as tax-exempt securities traded off by several basis points across the curve. Supply continues to serve as a support mechanism. Wednesday's fund flows print was softer than the prior week's, but positive nonetheless. Participants will likely take their lead from domestic taxable fixed income markets.
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:
Labor market indicators remain strong. The July Employment Report was solid despite the softer than expected headline reading on Payrolls. Nonfarm Payrolls rose by 157k (vs. 193k expected). Upward revisions to the last two months of 59k kept the three-month average of Job Gains at a robust 224k. The Unemployment Rate ticked down to 3.9% (from 4.0%), while the broader U-6 Unemployment Rate, including the marginally attached and discouraged workers dipped down to a cycle low of 7.5% (from 7.8%). Average Hourly Earnings held steady at 2.7% year-over-year (y/y), but on a three-month average basis continued to edge higher. The Employment Cost Index confirmed a gradual upward trend in wages with the key Private Wages and Salaries measure ticking up a tenth to +2.9% y/y. The Conference Board's Jobs Plentiful vs. Hard to Get indicator rose to its highest in seventeen years, continuing to point to positive Consumer Sentiment on the labor market.

The ISM Manufacturing and Nonmanufacturing Indices both declined notably in July. Though both remained firmly in expansionary territory, they showed softening in key components including Production, New Orders, and Export Orders. Many of the comments from respondents to the surveys noted concerns on tariffs (particularly uncertainty, higher prices, and changes of plans to account for the impact of tariffs).

Core PCE inflation was slightly softer than expected coming in at +1.9% y/y, with Headline PCE rising by 2.23% y/y. This is likely to keep the Fed on its gradual pace of hikes.

Housing market data continued to show moderating momentum. Pending Home Sales, a leading indicator of Existing Home Sales, rose by slightly more than expected on a monthly basis, but remained -4.0% y/y. The S&P Case-Shiller 20-City Home Price Index rose by 6.5% y/y in May, slowing its pace of gains 6.7% y/y in April.

International Developed:
Eurozone 2Q GDP was slightly softer and July Inflation higher than expected. Core Inflation jumped to 1.1% y/y, while Headline Inflation edged up slightly to 2.1%, driven by Energy Prices and Food, Alcohol and Tobacco. The ECB will likely continue to keep its fairly dovish stance in place with its pledge to keep rates on hold until summer 2019, as core inflation still remains muted. The labor market remained strong though, with the Unemployment Rate steady at 8.3% in June, the lowest since December 2008.

The Week Ahead:
In the US, CPI will be the main focus. Consensus forecasts look for July Headline CPI to rise by 3.0% y/y, from 2.9% y/y, and Core CPI to hold steady at 2.3% y/y. We continue to expect that Inflation will edge slightly higher due to Energy and Base Effects, before settling back by year-end as these impacts fade. This should keep the Fed on its gradual pace of hikes.

Yield Curve
With all the attention institutional investors gave the 10-year US Treasury (UST) last week as it pierced the 3.000% intraday level for the first time since the 13th of June, that benchmark security ended Friday's trading at 2.949%, just about one basis point (bp) lower than it closed the previous week – a rather uneventful roundtrip. The 10-year UST's resilience failed to translate over into the tax-exempt municipal bond market, as high-grade yields edged higher across the term structure. The ICE AAA Municipal Yield Curve drifted higher by 1bp at both the 6-month and 1-year spots (Figs. 1 & 2). The 2- and 3-year individually moved 2bps higher, while the 5-year added 4bps to its yield. At the same time, the 7-year maturity rose 2bps. The 10-, 15-, and 30-year all increased by 4bps, as the long bond ended the week drawing a 3.020% yield.

In a remarkable showing, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield vaulted 35bps skyward on Wednesday, the largest one-week move – either up or down – in almost ten years (Fig. 8). That huge leap came after a four-week 57bp decline. At its current 1.290% level, the SIFMA Index stands at 68.617% of the 4-week US Treasury bill's 1.880% bond-equivalent rate. Moreover, it is 66.154% and 67.363% of the 1-week and overnight LIBOR Fix, respectively. The most recent print seems to make sense to us and probably represents a more sustainable equilibrium given these and other short-term benchmark interest rates. To be sure, we have reiterated several times on these pages that there is typically an imbalance of supply and demand coming up to the 15th of April federal income tax return filing due date; Figure 8 illustrates this year was no different. Then, June and July saw heavy maturity and call redemptions, with cash proceeds likely flowing into Variable Rate Demand Notes (VRDNs) driving those levels lower. As investors reallocated capital out of the VRDNs and into other assets including longer-term municipal bonds, demand waned for floating rate securities, propelling yields higher. While August redemptions may temporarily drive the current level back down, we think it sensible for investors to continue to expect the long-term trend in the SIMFA Municipal Swap Index to track other benchmarks such as the federal funds rate on a tax-adjusted basis, recognizing that cyclical supply and demand often override those tendencies.

Looking beyond the 6-month point, last week's trading action 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 157bps, up from 154bps the prior week (Fig. 1). The ICE AAA Municipal Yield Curve has steepened 46bps thus far in 2018 and is 0.17 standard deviations above its 152.78bp 1-year trailing daily average (Figs. 11 & 12).

Municipal-to-US Treasury (M/UST) Yield Ratios
Excepting the 6-month spot, municipal bonds underperformed their UST counterparts across the entire term structure last week (Fig. 10). The 6-month M/UST fell by 0.352 ratios, to finish the week at 61.124%, compared with the prior print of 61.475% (Figure 25). The 1-year M/UST moved higher at 61.285%, a 0.242 ratio increase from the previous week's 61.043%. The 2-year M/UST added 1.566 ratios, to complete the last five trading sessions at 61.178%. The 5-year M/UST was higher by a full 2.195 ratios to finish the week at 70.592%, up from the prior Friday's 68.397%. Over the same 1-week period, the 10-year M/UST rose to 84.235%, an increase of 1.577 ratios from the earlier print of 82.659% on the 27th of July. Lastly, the 30-year M/UST ended with a 1.105 ratio increase from the prior week's 96.471%, to close at 97.577%. 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
Municipal bonds in the Aa/AA ratings category became more attractive relative to their senior unsecured corporate counterparts throughout the term structure. Friday's close saw the 6-month AAM/AAC finish the previous five trading days at 57.112%, higher by 0.751 ratios from 56.361% on the 27th of July (Fig. 33). The 1-year AAM/AAC increased by 0.718 ratios, closing the week at 56.841%, up from the preceding Friday's 56.124%. The 2-year AAM/AAC moved a higher by 1.432 ratios, to complete the last five sessions at 61.468%. The 5-year climbed to 65.195%, a 1.777 ratio rise from the prior week's 63.419% on the 27th of July. The 10-year printed a 1.220 ratio upturn to close the week at 67.488%. Finally, the 30-year AAM/AAC drifted higher by 0.993 ratios from the previous week's 77.489%, to finish Friday at 78.482%. 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
Consistent with the ICE AAA Municipal Yield Curve's thematic shift slightly higher, the S&P Municipal Bond Index's yield moved up by 0.040% over the past five trading days to produce a -0.102% total return (Fig. 42). Last week's showing was the second successive negative print in as many, ranking it the 37th worst in the past year (Fig. 47). Once again, the most recent downturn wasn't enough to bring its year-to-date performance into the red. As of Friday's close, the S&P Municipal Bond Index has generated +0.130% thus far in 2018.

The Intermediate, Short Intermediate, and Short indices also completed the week in the red, delivering total returns of -0.094%, -0.035%, and -0.010%, respectively. However, unlike the S&P Municipal Bond Index, the Intermediate Index's downturn was sufficient to land it underwater thus far in 2018, with that benchmark's year-to-date performance standing at -0.013% as of Friday's close. The lower duration Short Intermediate and Short indices are still firmly on solid ground, with year-to-date total returns of +0.714% and +1.074%, in that order. The High Yield Index produced +0.031% last week, just outperforming the High Yield Excluding Puerto Rico Index, which finished the past five trading days with a total return of -0.033%.

Puerto Rico returned to generating positive performance last week, as the Commonwealth's index printed +0.686% for the past five trading days. The previous week's performance was the first negative print twenty-one weeks. In fact, the S&P Puerto Rico Index has only delivered five down weeks in thirty-one, with the negative periods averaging -0.265%. It warrants saying that the S&P Municipal Bond Puerto Rico Index's +21.511% year-to-date total return doesn't reflect the health of the island's financial and economic health, but rather is merely a partial rebound from 2017's -18.435% rout.

All sectors in the S&P Municipal Bond Index produced negative results on the week, with Other Utility and Prerefunded/Escrowed-to-Maturity bonds ranking first and second at -0.008% and -0.021%, correspondingly (Fig. 45). The worst performing sector was Port, generating -0.133% over the past five trading days.

Supply and demand
The upcoming week's new issue calendar stands at $6.921 billion, $1.285 billion above the $5.636 billion 12-week moving average (Fig. 59). The schedule for the forthcoming five trading days is $2.145 billion greater than last week's $4.776 billion. As of Friday's close, total year-to-date issuance stood at $194.182 billion. That number compares with $235.189 billion for the same period for 2017, a 17.436% shortfall.

to demand, the Investment Company Institute (ICI) reported a positive $472 million of municipal bond fund flows for the week ending 25 July (Fig. 60). As of that date, the S&P Municipal Bond Index's mid-week 5-day performance was -0.128%.

Looking forward to the thirty-first ICI Municipal Bond Mutual Fund Flows report for 2018, the next one on the 8th of August will cover the five trading days ending on 01 August, when the S&P Municipal Bond Index generated a -0.153% return. All in, investors have reallocated a net total of $14.250 billion into municipal bond funds thus far in 2018.

Market Sentiment
Dealers' concerns over rising interest rates persisted over the past week. On Friday, Thomson Reuters Municipal Market Data reported that 25% of dealer firms in their survey were bearish for their 1-week outlooks, a fall from last week's 50% (Fig. 63). The neutral group closed Friday with 75%, compared to the prior report's 50% in that category. No dealers described themselves as bullish over the upcoming week. Still, with 100% landing in the bearish camp, dealers were unanimous for their 1-2 month outlook (Fig. 64). Please see Figures 65 through 67 for additional survey information pertaining to the buyside sentiment and dealer inventories.

Core Narrative
The municipal bond market bucked the UST market's firmness last week, as tax-exempt securities traded off by several basis points across the curve. Supply continues to serve as a support mechanism. Wednesday's fund flows print was softer than the prior week's, but positive nonetheless. Participants will likely take their lead from domestic taxable fixed income markets.





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