Municipal Fixed Income Weekly

May 12, 2017


Municipal Fixed Income Weekly

May 12, 2017


Key Themes for the Upcoming Week

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  • By Friday's close, the ICE AAA Municipal Yield Curve was lower by 1bp at the 2-year spot (Figs. 1 and 2). The 3- and 5-year tenors each fell by 3bps, and the 7-year's yield was lower by 6bps. The 10-, 15-, and 30-year maturities each dropped by 5bps. We expect the strength that began last Wednesday to continue gathering momentum into the early part of the upcoming week.
  • As we reported last week, the Puerto Rico Oversight, Management and Economic Stability Act's board put the Commonwealth into Title III. Irrespective of stakeholders' view of this watershed moment in the island's saga, we think an in-court resolution is likely to take longer than one that might have been negotiated among interested parties. One thing is for sure, the municipal bond market is in uncharted waters and the uncertainty of the outcome will likely infuse volatility into Puerto Rico's bond prices and returns.
  • On Thursday, the New York Federal Reserve reported that primary dealer firms' municipal bond positions were a significant $2.477 billion lighter than the previous week. The most recent report of $17.100 billion for the five trading days ending 3 May was the lowest number reported in sixty-three weeks. The new issue calendar over the past month has averaged $7.349 billion per week, which is 14.435% over the $6.422 billion 12-week moving average. The decrease in municipal bond inventories may indicate the desire of dealers to make room on their balance sheets for positioning upcoming deals in light of the recent pick-up in supply.
  • Core Narrative - The municipal market may have benefited from several distractions last week, including news related to the 7 May presidential election and Emmanuel Macron's victory over the National Front's candidate, Marine Le Pen. Additionally, President Trump's firing FBI Director James Comey provided enough commotion that municipal bond investors apparently put concerns over the president's tax reform proposal aside for the moment. A dearth of new issuance has continued to serve as a price support. Despite the noise, municipal market fundamentals remain firmly in place. We continue to be constructive on the market.
Yield curve
Last Monday, high-grade municipal yields were all but stationary, with the only movement occurring in the 2-, 5-, and 6-year maturities, and that was only a 1 basis point (bp) drift higher. On Tuesday, a little action occurred at the 10-year point and beyond, with yields inching up by 1 to 2bps. But by Wednesday, the market reversed direction, with interest rates falling by 1 to 3bps from the 2-year maturity and longer. Thursday, was relatively quiet, with yields drifting lower by a basis point or two in the 5- to 15-year range. Then, on Friday, weaker than expected Core CPI and Retail Sales sent both US Treasury and municipal rates lower, as high-grade yields fell by 1 to 3bps in the 2- to 7-year segment of the curve, and by 4 to 5bps out to the 20-year tenor. Beyond the 20-year point, tax-exempts rallied by 3bps.

By Friday's close, the ICE AAA Municipal Yield Curve was unchanged at the 6-month and 1-year maturities, while the 2-year spot was lower by 1bp (Figs. 1 and 2). The 3- and 5-year tenors each fell by 3bps, and the 7-year's yield was lower by 6bps. The 10-, 15-, and 30-year maturities each dropped by 5bps, leaving the long point on the curve drawing a 2.970% yield. We expect the strength that began last Wednesday to continue gathering momentum into the early part of the upcoming week. Last Wednesday, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield fell for the third consecutive week, dropping 6bps to print 0.790% (Fig. 3).

Sans the 6-month spot, last week's change in tax-exempt rates flattened the ICE AAA Municipal Yield Curve by 5bps, front to back, shrinking the difference between the 1-year and 30-year yields to 210bps, from 215bps for the previous week (Fig. 6). The spread between 2-year and 10-year contracted by 4bps, and closed at 114bps on Friday (Fig. 7).

Municipal-to-US Treasury (M/UST) Yield Ratios
Last week, UST yields fell across the term structure with the only exceptions being the 6-month point, which rose by 1bp, and the 1-year maturity, which remained unchanged. High-grade municipal yields were unchanged at both the 6-month and 1-year maturities, and outpaced UST interest rates lower at most points along the curve (Fig. 5). The 1-year M/UST ratio stayed untouched on the week, at 78.027%, while the 2-year M/UST yield ratio edged higher by 0.612 ratios to close Friday at 75.194%, up from the prior print of 74.581 (Fig. 16). With municipals stronger than USTs farther out the curve, the 5-year M/UST finished at 74.716%, falling by 0.284 ratios from the previous week's 75.000%. The 10-year M/UST closed the past five trading days at 90.714% versus the previous print of 91.876% on the 5th of May. Finally, the 30-year M/UST was 1.572 ratios below the previous week's figure, to finish at 99.431%.

AA Municipal-to-AA Corporate (AAM/AAC) Yield Ratios
The 1-year AAM/AAC closed the week at 57.997%, 1.563 ratios higher than the previous Friday's 56.434% (Fig. 23). The 2-year measure dropped 0.244 ratios to end the last five trading days at 56.793%. The 5-year printed 61.729%, a decrease of 0.846 ratios from the prior week's 62.575% on the 5th of May, and the 10-year printed down 1.151 ratios at 68.010%. The 30-year AAM/AAC slid 0.789 ratios to end the week at 83.664%.

Market performance
For the second week in a row, the municipal bond market generated positive returns for most of the indices we include in this publication. As of Friday's close, the S&P Municipal Bond Index manufactured a +0.228% performance for the week, which was stronger than last week's almost-flat +0.019%, bringing that benchmark's year-to-date performance to +2.398% (Fig. 30). Similarly, the Intermediate, Short-Intermediate, and Short indices closed the past five trading days firmly on dry ground, with total returns of +0.280%, +0.147%, and +0.063%, in that order.

Puerto Rico represents the largest exposure of any state or territory in the High Yield Index, weighing in at 20.87%, as measured by market value. In point of fact, last week Puerto Rico contributed a -0.788% drag on the High Yield Index's -0.496% return. On the other hand, the High Yield Ex-Puerto Rico Index generated +0.372%. As we reported last week, the Puerto Rico Oversight, Management and Economic Stability Act's (PROMESA's) board put the Commonwealth into Title III, which is shaped after chapter 9 bankruptcy. Irrespective of stakeholders' view of this watershed moment in the island's saga, we think an in-court resolution will likely take longer than one that might have been negotiated among interested parties. One thing is for sure, Puerto Rico is in uncharted waters and the uncertainty of the outcome may infuse a large measure of volatility into the Commonwealth's bond prices and returns. We also stick with our view that while the island's financial difficulties are, in part, reflective of debt levels, broader socioeconomic issues are the root cause of Puerto Rico's problems. Unless these issues are addressed, the Commonwealth will continue to struggle and the board's well-intentioned remedies are apt to be temporary in nature. The S&P Municipal Bond Puerto Rico Index fell sharply last week, producing a total return of -3.170%, bringing that benchmark's year-to-date performance to a dismal -3.770%

The California and New York indices closed up with +0.315% and +0.283% performances, correspondingly.

Supply and demand
The upcoming five trading sessions should bring investors a robust $7.245 billion in new municipal bond deals, about $1.093 billion lower than last week's $8.339 billion (Fig. 44). The most recent weekly estimate is $823 million above the $6.422 billion 12-week moving average. As of last Friday, year-to-date municipal bond issuance stood at $136.206 billion, an 11.898% shortfall from 13 May 2016, when year-to-date supply stood at $154.600 billion. We remind readers that in the beginning of the year we forecasted a 10% decline in supply for 2017. We still believe new issuance will come in at roughly $400 billion.

Turning to demand, on Wednesday the Investment Company Institute (ICI) reported $204 million of net flows into municipal bond funds for the preceding five trading days ending 03 May (Fig. 45). Over the past fifteen weeks, reported fund inflows exceeded $1 billion only once, and that was on the 12th of April. In fact, year-to-date, weekly flows have averaged $420 million, compared to an average of $1.159 billion for the same period last year. Flows remain shaky in our view, and could be subject to a reversal if market tenor deteriorates. Nevertheless, sixteen of the eighteen weeks so far in 2017 have seen positive flows, with investors ploughing $7.558 billion of capital into municipal bond mutual funds year-to-date.

On Thursday, the New York Federal Reserve reported that primary dealer firms' municipal bond positions were a significant $2.477 billion lighter than the previous week. The most recent report of $17.100 billion for the five trading days ending 3 May was the lowest number reported in sixty-three weeks, when the 24 February 2016 account printed $16.999 billion (Fig. 47). Primary dealers' largest positions still reside in maturities beyond 10-years, with that category representing 63% of their collective municipal bond holdings. The new issue calendar over the past month has averaged $7.349 billion per week, which is 14.435% over the $6.422 billion 12-week moving average. The decrease in municipal bond inventories may indicate the desire for dealers to make room on their balance sheets for positioning upcoming deals in light of the recent pick-up in supply.

Market Sentiment
On Friday, Thomson Reuters Municipal Market Data reported that traders became slightly more optimistic for the five trading days ahead. The bearish category registered 29%, down from 44% the prior week, and neutral respondents came in at 57%, up from 44% on the 5th of May (Fig. 48). Bullish survey participants registered 14%, the second positive response in five weeks, and up from the prior print of 12%. Looking out 1-2 months, traders continued to shift to a more neutral stance, as 12% recorded a bearish view, down from 22% in the prior survey (Fig. 49). Neutral participants scored 88%, up from 78% the previous week. Bullish traders printed nil for the third consecutive week.

The buy-side swung to an emphatically drearier outlook. Portfolio managers printed 67% in the bearish category for the 1-week slot, up significantly from 40% the prior week (Fig. 50). For the same 1-week horizon, they weighed in at 33% neutral, almost cut in half from the 60% recording on the 5th of May. No buy-side managers scored in the bullish set. Shifting to the 1-2 months outlook, portfolio managers were equally as pessimistic. Exactly identical to their 1-week outlook, two-thirds were bearish, an increase from 40% in the preceding survey, and one-third of the respondents landed in the neutral zone (Fig. 51). Remarkably, 40% of buy-side participants were bullish for the next 1-2 months in the previous survey a fortnight ago, but that figure fell to 0% on Friday.

Once again, on 12 May, no dealers who contributed to last week's survey scored their municipal bond inventories in the heavy category. The medium and light groups printed exactly as they did on 5 May, coming in at 12% and 88%, in that order (Fig. 52).

Core Narrative
The municipal market may have benefited from several distractions last week, including news related to the 7 May presidential election and Emmanuel Macron's victory over the National Front's candidate, Marine Le Pen. Additionally, President Trump's firing FBI Director James Comey apparently provided enough commotion that municipal bond investors put concerns over the president's tax reform proposal aside for the moment. The broad market produced positive total return last week and had an air of conviction. The year-to-date supply shortfall narrowed to 11.898%, down from the prior week's 13.533% for the same period. Nevertheless, a dearth of new issuance has continued to serve as a price support. We repeat the theme that positive fund flows are unimpressive and could deteriorate with any market weakness. Despite the noise, municipal market fundamentals remain firmly in place. We continue to be constructive on the market.





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