Municipal Fixed Income Weekly

October 13, 2017


Municipal Fixed Income Weekly

October 13, 2017


Key Themes for the Upcoming Week

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  • We reference the S&P Municipal Bond Indices as a proxy for municipal market characteristics, including risk metrics, total return, and performance attribution. We highlight a few changes to those indices' rules that occurred immediately prior to the market open on Monday, 2 October 2017. S&P Dow Jones Indices made modifications to the Dated Date Criterion, Mutual Fund Holding Criterion, and the rule regarding Defaulted Bonds. Some of these adjustments and their effects are covered under the Market Performance section on page 6.
  • Hurricane Maria dealt such devastation to Puerto Rico, that during our absence, the S&P Municipal Bond Puerto Rico Index suffered a -4.376% five-day return. In fact, beginning at the close of 15 September, the Puerto Rico Index lived through three successive weeks of shattering returns, printing -4.026%, -4.334%, and -4.376%, in that order. As of Friday evening, the year-to-date performance for the S&P Municipal Bond Puerto Rico Index was a miserable -15.553%.
  • We are reducing our estimate for all of 2017 to a 15% shortfall from last year's $444.800 billion and targeting total supply for this year to come in at roughly $380 billion. October has thus far provided only $9.527 billion in supply. On this date last October, the first two weeks delivered $23.573 billion and finished the month at $53.447 billion. Nevertheless, for the time being we will remain hopeful that the balance of October and November will surprise to the upside and the 4Q2017 will deliver.
  • Core Narrative: unthinkable human suffering continues in Puerto Rico, as political jawboning seems to have contributed nothing to actual relief on the island. As Maria left a wake of ruin, on Wednesday, 11 October, Moody's downgraded the Commonwealth's general obligation debt to Ca, from Caa3. Still, despite Puerto Rico's and the U.S. Virgin Islands' travails, the broader market ended with sound returns and should start the upcoming week with positive momentum. A dearth of supply continues to be a tailwind.
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.

Crude oil fell 4.5% on the week, as concerns about the effect of Tropical Storm Nate outweighed reductions in active oil rigs and crude inventories. Volatility remains low, and implied volatility (VIX) touched a new all-time low mid-week.

Federal Reserve composition is increasingly in focus as suggested favorites include Kevin Warsh, Janet Yellen, Gary Cohn, Jerome Powell, and John Taylor. Quarles received Senate approval on Thursday; he will be a voting member on the Board, as well as Vice Chair of Supervision. The bottom line: there is a great deal of uncertainty around the future makeup of the Fed, with four vacant seats on a seven-member board, assuming Yellen is not re-nominated.

In global politics, the situation in Catalonia remains fluid but fairly isolated to Spanish markets. Meanwhile, U.K. Prime Minister May continues to struggle for support, and some are speculating she could resign. Last week saw this uncertainty weigh on the British pound sterling; and the last five trading days were the worst for the pound in a year.

The NFIB Small Business Optimism Index fell by 2.3 points to 103.0 in September, with six of the eleven components posting a decline. This month's report took a slightly softer tone than previous months, though it was not entirely due to hurricane impacts, as the dip in sentiment was not limited to Florida and Texas and was spread across the country. The decline in the index was led by a drop in Sales Expectations (-12pts), Business Conditions (-6pts), and Capex Expectations (-5pts). Job Creation softened, not just in hurricane impacted areas as six of the nine census regions saw a decline in average employment change per firm. The net percent of owners raising average selling prices declined 3 points to a net 6 percent. Despite the softer tone, sentiment still remains near cycle highs.

The August JOLTS (job openings and labor turnover survey) data continued to underscore health in the labor market. Job Openings edged down very slightly in August to 6,082k from its cycle high in July (revised down by 30k to 6140k). The Job Openings rate was unchanged at 4.0%, at its cycle high. The Quits Rate also ticked down a tenth to 2.1%, but remained near recent highs.

Initial Jobless Claims fell by 15k to 243k in the week ending 7 October, from the previous week (revised down by 2k to 258k), continuing to move back toward pre-hurricane levels, as the 4-week moving average declined by 10k, to 258k.

Headline CPI was +2.2% year-over-year (y/y) in September and 0.5% month-over-month (m/m), largely driven by a 6.1% gain in energy prices on the month. Gasoline prices were +13.1%, the largest monthly increase since June 2009. Core CPI held steady, +1.7% y/y (+0.1% m/m), as gains and declines were spread across a number of categories in the month of September. The gains that were seen were more moderate compared to very strong readings last month. Looking at the trend over the past three months however, many of the categories that had been weighing on inflation since the start of the year have begun to moderate, and on a 3-month annualized basis, Core CPI is now running at 2.0% y/y.

Given the Fed's recent willingness to look past recent weakness in inflation data, September data is still likely strong enough to keep the Fed on track for a December rate hike, but the next two months of data will need to be watched closely.

Retail Sales rebounded in September, +1.6% m/m, with an upward revision of one tenth to -0.1% m/m in August. Some of this rebound may be related to hurricanes, with strong bounces in auto sales (+3.6% m/m), gasoline (+5.6% m/m), and building materials (+2.1% m/m). Overall this was a strong report, as Control Retail Sales (ex-autos, gasoline, and building materials), also remained robust, up 0.4% m/m (and revised up in August to 0.0% m/m from -0.2% m/m). Retail sales ex autos and gas was up 0.5% m/m.

University of Michigan Consumer Sentiment jumped up to 101.1 (+6pts) in the preliminary reading for October, its highest level since 2004, with a jump in both the Current Economic Conditions (+4.7pts), and Expectations (+6.9pts). Inflation Expectations for the next year however, dipped to 2.3% (from 2.7%), and for the next 5 years to 2.4% (from 2.5%).

The Atlanta Fed's GDPNow forecast edged higher to 2.7% for 3Q2017, up from 2.5% at the end of last week, on the backs of Retail Sales and CPI data this week.

Yield Curve
High-grade tax-exempt interest rates fell across most of the term structure last week, with the only exceptions being at the 6-month and the 1- and 2-year maturities, where yields remained unchanged. By the conclusion of trading on Friday, the ICE AAA Municipal Yield Curve was lower by 1 basis point (bp) at the 3-year term and by 4bps at the 5-year maturity (Figs. 1 and 2). The 7- and 10-year spots relocated down by 5 and 6bps, respectively, while the yield at the 15-year contracted by 8bps. The 30-year moved lower by 9bps to finish the week drawing a 2.730% yield.

The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield declined for the second successive week, printing 0.910% this past Wednesday (Fig. 8). The current level is only 3bps off the 27 September 2017 record of 0.940%, which was the highest since 24 December 2008, when it stood at 1.25%. Weekly variable rate demand notes (VRDNs) spent most of the last five years hovering between 0.010% and 0.200%. For a more detailed explanation of the SIFMA Municipal Swap Index and VRDNs, please refer to the notes and disclosures at the end of this report.

Considering the term structure beyond the 6-month point, last week's changes in tax-exempt rates flattened the slope of the ICE AAA Municipal Yield Curve by 9bps, with the disparity between the 1- and 30-year yields lessening to 179bps, down from 188bps the preceding week (Fig. 11). At 179bps, the slope of the high-grade municipal yield curve is the flattest it has been over the past 180-days and only 7bps off of its 360-day low of 172bps, which occurred precisely one year ago on 13 October 2016. Additionally, at its current level, the slope is 2.60 standard deviations (a z-score of -2.60) below its trailing 90-day average of 191.33 bps (Fig. 12). Over the past year, the ICE AAA Municipal 1yr-30yr slope has averaged 203.97bps. The spread between the 2- and 10-year tapered by 6bps last week, and is the flattest it has been over the past 90 days.

Furthermore, it is only 5bps higher than its trailing 180-day nadir of 89bps, which was reached on 26 June (Figs. 13 and 14).

Having a look at the ICE AAA Municipal Yield Curve from a different vantage point, at 1.960%, the 10-year maturity gives a full 72% of the interest rate at the 30-year point, whereas one month ago, that same point provided 68% of the long high-grade rate. The 15-year spot currently delivers a full 84% of the 30-year's yield.

The past four trading days saw an uninterrupted decline in yields across most of the tax-exempt municipal bond term structure, with the strength in the rally building successively throughout the week. It seems reasonable to expect next week to begin on firm footing.

Municipal-to-US Treasury (M/UST) Yield Ratios
With the notable exception of the short maturities, both U.S. Treasury (UST) and high-grade municipal interest rates shifted lower across the term structure over the past five trading days. We mentioned above that 6-month and 1- and 2-year high quality municipal yields finished the week untouched, while the 6-month and 1-year USTs were higher by 1 and 2bps, respectively. Otherwise, USTs outpaced the ICE AAA Municipal Yield Curve to the downside at all other points across the term structure (Fig. 10).

With USTs moving up in differing measures on the short end of the yield curve, the 6-month M/UST fell by 1.230 ratios, to close at 72.000%, compared with the prior print of 73.230% (Figure 25). The 1-year M/UST also finished the week lower at 70.571%, a 0.480 ratio drop from the previous week's 71.051%. In a contrary trend, the 2-year M/UST drifted higher by 0.676 ratios to finish the last five trading sessions at 68.136%. The 5-year M/UST moved higher 0.279 ratios to finish the week at 71.053%, up from the earlier recording of 70.774%. The 10-year M/UST ended the week scoring 86.154%, a change of +0.850 ratios from the earlier version of 85.304% on the 6th of October. Lastly, the 30-year M/UST ended with a 0.184 ratio rise from last week's figure, to finish at 97.292%. 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
Yield ratio changes for AA municipal bonds and senior unsecured AA corporate bonds were mixed but chiefly muted last week making municipals in that ratings category generally less attractive than their taxable corporate equivalents were the previous Friday. The 6-month AAM/AAC finished the past five trading days at 59.666%, lower by 0.106 ratios from 59.772% on the 6th of October (Fig. 33). The 1-year AAM/AAC was the only ratio that moved higher, but only by a smidgeon, concluding the week at 60.077%, 0.011 ratios greater than the preceding Friday's 60.066%. The 2-year measure moved down by 0.352 ratios to end the last five trading days at 58.602%. The 5-year shuffled lower and came to rest at 61.006%, a decline of 0.155 ratios from the prior week's 61.161% on the 6th of October. Similarly, the 10-year printed a 0.252 ratio drop at 65.114%. On the other hand, the 30-year AAM/AAC edged up 0.182 ratios from the prior week's 81.133%, to close on Friday at 81.315%.

Market Performance
As frequent readers of this publication know, we reference the S&P Municipal Bond Indices as a proxy for municipal market characteristics, including risk metrics, total return, and performance attribution. Before we review returns, we highlight a few changes to those indices' rules that occurred immediately prior to the market open on Monday, 2 October 2017.

Firstly, there was a change to the Dated Date Criterion (the date that interest begins accruing on a newly issued bond). Previously, bonds had to have a Dated Date within three months of the monthly index rebalancing in order to be eligible for inclusion. Effective on the 2nd of October, bonds must have a Dated Date subsequent to 31 December 2010 in order to be eligible for index inclusion.

Secondly, effective in conjunction with the October 2017 indices rebalance, S&P Dow Jones decided to eliminate the Mutual Fund Holding Criterion. Previously, municipal bonds must have been held by mutual funds in order to be eligible for index inclusion.

Thirdly, and finally, S&P Dow Jones altered the rule regarding Defaulted Bonds. Prior to October's rebalancing, defaulted bonds were included in the S&P Municipal Bond Index and related sub-indices. Effective on the 2nd of October, defaulted bonds are excluded from the S&P Municipal Bond Index and related sub-indices. S&P does, however, maintain and publish several separate Municipal Bond Defaulted Indices, but these are no longer a subgroup of the broad market benchmark.

The aforementioned had some profound changes to the S&P Municipal Bond Indices' characteristics. Most notably, the number of bonds in the index in September stood at 99,465 for a total market value of $1.747 trillion. As of this writing, there are 178,012 bonds in that same index totaling $2.167 trillion, an increase of about $420 billion in market value, or about a 24.041% upsurge. Looking on page 40 at Figure 66, we note that the municipal bond market in total is $3.837 trillion (the most recent report of the Federal Reserve System on 30 June 2017). Put another way, in September, the S&P Municipal Bond Index was approximately 46% of the entire municipal bond market. Today, that same benchmark represents about 56% of the market, a 10% increase. As far as we know, the S&P Municipal Bond Index is the broadest market barometer available.

There are other implications as a result of the abovementioned modifications. With the addition of 78,547 holdings, the Municipal Bond Index's effective duration increased to 6.500 years, from 6.346 years in the prior month. Likewise, the Intermediate Index's effective duration went to 5.823 years, up from 5.580 years. In point of fact, both the Short Intermediate and the Short indices saw increases, too. This signals a slight increase in interest rate sensitivity to these watermarks, as yields shift – both to the upside and to the downside.

Turning to performance, domestic fixed income markets were closed on Monday in observance of Columbus Day and with a decline in tax-exempt interest rates during the holiday-shortened week, the S&P Municipal Bond Index delivered a +0.349% performance, the eleventh best performing week of the forty-one thus far in 2017 (Fig. 42). The Intermediate and Short Intermediate, and Short indices printed total returns of +0.305%, +0.145%, and +0.045%, in that order. The High Yield Index ended the week on dry land, serving up performance of +0.240%, while the High Yield Excluding Puerto Rico finished the week at +0.263%.

The S&P Municipal Bond California Index produced a healthy +0.402%, bringing that state's year-to-date performance to +5.376%. As of Friday's close, the New York Index landed with a 1-week return of +0.346%. Readers will recall that we did not produce this publication last Monday, for the week ending on the 6th of October. Hurricane Maria dealt such devastation to Puerto Rico, that during our absence, the S&P Municipal Bond Puerto Rico Index suffered a -4.376% five-day return. In fact, beginning at the close of 15 September, the Puerto Rico Index lived through three successive weeks of shattering returns, printing -4.026%, -4.334%, and -4.376%, in that order. As of Friday evening, the year-to-date performance for the S&P Municipal Bond Puerto Rico Index was a miserable -15.553%.

Please refer to page 29, figures 43, 44, and 45 for a look at the performance of the top ten weighted states, ratings categories and municipal sectors.

Supply and demand
The approaching week should provide roughly $9.232 billion in new deals, which is a 36.333% jump from the prior week's $6.772 billion (Fig. 57). The likely roster is about $2.949 billion greater than the trailing $6.283 billion 12-week moving average. As of Friday's close, year-to-date municipal bond issuance stood at $298.294 billion. That number compares with $366.832 billion for the same year-to-date period in 2016, an 18.684% year-over-year shortfall. At the beginning of the year, we estimated that 2017 would fall about 10% short of 2016's record $444.800 billion in supply, and conclude this year with about $400 billion in supply. In recent weeks we mentioned that if new issuance does not pick up, we would adjust our number lower to a 15% shortfall in 2017, expecting the final number to print close to $380 billion. Frankly, this year's deficit seems to continually widen, and we appear to have missed the mark by being exceedingly hopeful.

More specifically, we are halfway through October as of this writing, and the month has thus far provided only $9.527 billion. On this date last October, the first two weeks delivered $23.573 billion and finished the month at $53.447 billion. Over the past five years, October has averaged $37.756 billion for the month. Even to get to $380 billion, a 15% decline from 2016, we would need to average $7.428 billion in weekly new issuance for the balance of the year. In the forty-one weeks thus far in 2017 weekly supply has averaged $7.276 billion. While we may see spurts of new deals the holiday season fast approaching.

We are reducing our estimate for all of 2017 to a 15% shortfall from last year's $444.800 billion and targeting total supply for this year to come in at roughly $380 billion. For the time being we will remain hopeful that the balance of October and November will surprise to the upside and the 4Q2017 will deliver.

Examining demand, the Investment Company Institute (ICI) reported $120 million in positive flows into municipal bond funds for the week ending 04 October (Fig. 58). The S&P Municipal Bond Index produced an almost even +0.015% for that week, and manufactured negative returns for the prior three. The past three prints have been sequentially lower, with the most recent report coming in well below the $731 million 12-week moving average. Still, Wednesday's report marks the thirteenth consecutive report of positive net flows. So far this year, investors have ploughed a net total of $22.597 billion into municipal bond funds, averaging approximately $565 million per week.

Looking forward to Wednesday, the 18th of October, the ICI Municipal Bond Mutual Fund Flows report on that date will cover the five trading days ending on the 11th of October. The S&P Municipal Bond Index generated a total return of +0.109% over that period, which is the second consecutive week that it produced positive performance, albeit rather lukewarm. As such, we are disposed to think fund flows should continue to subside, and possibly move into negative territory in the next report.

Last week, the New York Federal Reserve reported that primary dealer firms decreased their collective municipal bond positions by $1.191 billion versus the previous report. The balance totaling $18.317 billion for the five trading days ending the 4th of October was a lower than the previous report's $19.508 billion reported for the 27th of September (Fig. 60). Securities beyond 10 years in maturity represent 52% of their collective municipal bond holdings, followed by variable rate demand notes (VRDNs), which constitute about 17%.

Market Sentiment
This past Friday, Thomson Reuters Municipal Market Data reported that 33% of dealer firms were bearish for their 1-week outlook, an increase from last week's 13%. The neutral group fetched 67% of participants, which was measurably lower than the prior report of 80%. In the bullish category, dealers came up nil for the fifth week in seven. Last week printed 9% in that class. The same survey group recorded 17% in the bearish camp for the 1-2 months outlook. The neutral category came in at 83%, up substantially from the prior week's 53%. Like the 1-week look ahead, dealers recorded no bullish responses for the fifth time in seven weeks, with the prior report registering 14%.

For the 1-week outlook, the buy-side once again seemed slightly less cynical than the dealer community as it scored 29% in the bearish category. The neutral group was lower at 71%, down from 80% in the previous survey, and the bullish category printed nil for the second week in a row. Looking out 1-2 months, 57% of portfolio managers were bearish, while those who were neutral recorded 14 %. Bullish respondents weighed in at 29%.

For the third consecutive week in fifteen, traders described their municipal bond inventories as heavy, coming in at 17%. The other twelve weeks printed nil in that group. No participants landed in the medium cluster, and the balance of 83% of contributors labeled their inventories light.

Core Narrative
Unthinkable human suffering continues in Puerto Rico, as political jawboning seems to have contributed nothing to actual relief on the island. As Maria left a wake of ruin, on Wednesday, 11 October, Moody's downgraded the Commonwealth's general obligation debt to Ca, from Caa3. Still, despite Puerto Rico's and the U.S. Virgin Islands' travails, the broader market ended with sound returns and should start the upcoming week with positive momentum. A dearth of supply continues to be a tailwind.





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