Municipal Fixed Income Weekly

March 24, 2017


Municipal Fixed Income Weekly

March 24, 2017


Key Themes for the Upcoming Week

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  • We thank IHS Markit for supplying US corporate yield curves, as we expand our comparison of tax-exempt-to-taxable yield ratios to the US Credit categories. In this issue we broaden our analysis by adding the IHS Markit Senior Unsecured AA US Credit Yield Curve and compare it to the S&P AA Municipal Yield Curve, generating AA Municipal-to-AA Corporate (AAM/AAC) yield ratios. The AAM/AACs will become a regular component of the MFI Weekly (Figs. 21 through 26).
  • Bonds that are issued within the Commonwealth of Puerto Rico that are not rated or whose ratings are less than or equal to BB+ by Standard & Poor's, Ba1 by Moody's or BB+ by Fitch Ratings, make up a significant portion of the S&P Municipal Bond High Yield Index. As of Friday's close, Puerto Rico comprised 21.52% of that benchmark, weighted by market value plus accrued interest. Because Puerto Rico bonds represent such a substantial slice of the High Yield Index, S&P created the High Yield Ex- Puerto Rico Index in March 2016 using data back to 2010. Puerto Rico's troubles have manifested themselves in the form of outsized return volatility over the past several years (Figs. 32 & 33). Including this relatively new benchmark should supply further perspective on the high yield municipal market.
  • With Puerto Rico struggling once again last week, the S&P Municipal Bond High Yield Ex-Puerto Rico Index surpassed the High Yield Index by almost 40bps, scoring a +0.711 total return. Whilst the commonwealth continued to thrash about, the Puerto Rico Index finished in the red last week with a -0.907% total return, driving its year-to-date performance to -1.373%. Despite the potential for intermittent periods of positive returns, we expect the island's woes to persist for the foreseeable future, and recommend that investors avoid municipal bonds issued in Puerto Rico.
Yield curve
Looking back eight trading days to the 15th of March, municipal bond interest rates began an unabated decline that remained strong through this past Friday's close. Chronicling the week, on Monday, yields fell by as much as 1 to 2 basis points (bps) across much of the term structure. Tuesday was a bit firmer yet, as rates from the 9- through 12-year tenors dropped by 5bps, while most of the remaining portion of the curve declined by 2 to 3bps. Wednesday and Thursday saw declines of 2 to 3bps across the majority of the term structure each day.

On the week, high-grade tax-exempt interest rates finished unchanged at the 6-month and 1-year spots, at the same time the 2-year maturity declined by 2bps. The S&P AAA Municipal Yield Curve fell by 6bps at the 3-year point, as the 5-, 7-, and 10-year tenors declined by 9, 11, and 12, respectively (Figs. 1 & 2). Both the 15- and 30-year yields were lower by 11bps each.

Last Wednesday, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index printed 8bps higher than the previous report, to show a 0.79% yield (Fig. 3). Last week's change was on the tail of a 9bps rise from the prior reset, which appeared to be in direct response to the 15 March FOMC decision to raise the range of the federal funds rate target range 25bps to 0.75%-1.00%, from 0.50%-0.75%. The current SIFMA Municipal Swap level of 0.79% is the highest since the SEC mandated money market reform on 14 October 2016, when that rate reached 0.83%. We remind readers that until one year ago, the SIFMA Municipal Swap Index was in the single digits, where it had been for much of the period between 12 June 2013 and 9 March 2016. Then, in anticipation of the changes in money market regulation, the rate began its climb, cresting at 0.87% on 5 October 2016, just 10 days before reform took effect.

Sans the 6-month spot, last week's move in tax-exempt rates flattened the S&P AAA Municipal Yield Curve by 11bps, front to back, shrinking the difference between the 1-year and 30-year yields to 220bps, from 231bps for the previous week (Fig. 6). At 220bps, the slope of the 1yr-30yr is the flattest since 10 February, when it printed 219bps. The spread between 2-year and 10-year edged lower last week by 10bps to 123bps on Friday (Fig. 7).

Municipal-to-US Treasury (M/UST) Yield Ratios
It was a mixed bag of yield changes inside the 5-year tenor, as the 6-month UST moved higher by 2.6bps, while the high-grade municipal yield remained unchanged (Fig. 5). The 1-year spot saw the UST rate fall by less than a basis point, and the municipal yield was once again unmoved. UST yields also outpaced their corresponding AAA municipal yields at the 2-, 3-, and 4-year maturities by between 1 and 4bps. At the 5-year point and beyond, the S&P AAA Municipal Yield Curve's downward shift left most of the UST yields behind. While the 1-year M/UST remained ostensibly unaffected at 84.896%, the 2-year ended the last five trading days at 84.328%, 2.572 ratios higher than the last week's 81.756% (Fig. 14). The 5-year M/UST closed Friday at 82.559%, skirting lower by 1.021 ratios from the previous week's 83.581%, and the 10-year M/UST finished at 95.060% versus the previous print of 96.361% on the 17th of March. Finally, the 30-year M/UST was about the same as last week at 101.627%.

AA Municipal-to-AA Corporate (AAM/AAC) Yield Ratios
As of this writing, we have added a new table (Fig. 21) and several charts (Figs. 22 through 26) depicting the relationship between representative AA-rated municipal bond yields and AA-rated corporate bond yields. In the numerator of the AAM/AAC yield ratios we use selected interest rates from the S&P AA Municipal Yield Curve. In the denominator, we use the IHS Markit AA Senior Unsecured US Corporate yields.

On Friday, the 1-year AAM/AAC closed at 56.432%, 3.007 ratios higher than the previous week's 53.425% (Fig. 21). Likewise, the 2-year quotient moved higher by 3.020 ratios to end the last five trading days at 61.519% The 5-year printed 68.354%, 1.596 ratios higher than the 66.758% number on the 17th of March.. Finally, the 10- and 30-year AAM/AACs were both greater to end the week at 71.699% and 84.902%, respectively.

Market performance
The municipal bond market enjoyed a sturdy week of dwindling tax-exempt interest rates and robust performance. The S&P Municipal Bond Index turned in a return of +0.506%, the second strongest 1-week performance of the year, only outdone by the period ending 13 January (Fig. 28). The Intermediate, Short Intermediate, and Short indices finished the past five trading days in positive territory, as well with performances of +0.575%, +0.294%, and +0.110%, in that order. Meanwhile, the S&P Municipal Bond High Yield Index delivered a +0.315%. With Puerto Rico struggling once again last week, the S&P Municipal Bond High Yield Ex-Puerto Rico Index surpassed the High Yield Index by almost 40bps, scoring a +0.711 total return for the past five trading days.

The California and New York indices closed up with +0.556% and +0.523% performances, correspondingly. As the commonwealth continued to thrash about, the Puerto Rico Index finished in the red last week with a -0.907% total return, trimming its year-to-date performance to -1.373%. Despite the potential for intermittent periods of positive returns, we expect the island's woes to persist for the foreseeable future, and recommend that investors avoid municipal bonds issued in Puerto Rico.

Supply and demand
The next five trading days should bring investors about $5.800 billion in new municipal bond deals, which is a $1.198 billion increase over last week's $4.602 billion (Fig. 42). The most recent report is slightly below the $5.976 billion 12-week moving average. While January was an extremely strong month for supply, delivering a record $34.725 billion, February new issuance was a paltry $20.678 billion, down 35% from the same month last year. As of this past Friday evening, the first three and a half weeks of March served up just $23.740 billion, which is on track to be the lightest issuance for that month since 2011. Year-to-date supply stood at $81.004 billion at the week's close, which was about 1% shortfall vis-à-vis the $94.477 billion in new issuance for the same period in 2016. We continue to hold that total municipal issuance for calendar year 2017 should come in at about $400 billion, roughly 10% less than the $445 billion that came to market last year.

Turning to demand, on Wednesday, the Investment Company Institute (ICI) conveyed $249 million of net outflows from municipal bond funds for the preceding five trading day ending 15 March (Fig. 43). The most recent report marked the first negative record in ten weeks and only the second thus far in 2017. The November-December 2016 municipal market pounding delivered a chain of ten uninterrupted 1-week negative flows, beginning on 2 November and ending on 4 January 2017, totaling $28.213billion in net withdrawals. The latest series of positive streams amounting to a mere $6.378 billion began on 11 January, and lasted nine weeks through 8 March. Interestingly, the most recent report drove the barely positive $79 million 12-week moving average into positive territory for the first time in seventeen weeks.

On Thursday, the New York Federal Reserve reported that primary dealer firms increased their net municipal bond positions to $21.870 billion for the five trading days ending 15 March 2016 (Fig. 45). That figure is up $1.328 billion from the previous report's $20.542 billion. As a point of reference, the twenty-three primary dealers are trading counterparties of the New York Fed in its implementation of monetary policy and are among the largest broker-dealers operating in the United States. Registering $11.969 billion, the overwhelming majority of primary dealers' municipal bond inventory was greater than 10-years in maturity, and that category was higher by $318 million from last week's $11.651billion.

The heftiest increase in primary dealer positions occurred in the variable rate demand note (VRDN) category, where they added a considerable $1.054 billion to the prior week's $3.720 billion, to print $4.774 billion. The statistics in the report include both taxable and tax-exempt municipal positions. A main driver for such a jump could be that leading up to the Federal Reserve's announcement on the 15th of March, short-term taxable securities such as commercial paper and repurchase agreements became cheaper than taxable municipal VRDNs, and institutional investors may have exercised their put options, selling these floating-rate municipal securities back to dealers and rolling the proceeds into alternate instruments.

As an illustration, a 7-day VRDN due in 2038, subject to Federal income tax and accompanied by a letter of credit from FNMA, stood with a floating rate coupon at 0.460% on 30 November 2016, and by 08 March it was 0.560%. Then, on 15 March, coincident with the FOMC's announcement, its weekly rate reset up 20bps to 0.760%.

Meanwhile on 30 November, Bloomberg's US Commercial Paper Placed Top 15-Day Discount Index (DCPB015D), which is a composite of offered levels for highly rated US Commercial Paper programs, was yielding 0.480%. By 15 March, it printed 0.850%, increasing 37bps.

In this example, rotating out of the VRDN at 0.760% and reinvesting in 15-day commercial paper could have allowed investors to pick up 9bps in yield. In today's low interest rate environment, money market mutual funds that are yield-starved may be eager to transact for such incremental returns, leaving a greater proportion of VRDNs in the hands of dealers.

Market Sentiment
On Friday, Thomson Reuters Municipal Market Data reported that traders became more optimistic for the five trading days ahead. For the 1-week outlook, the bearish category registered 0% for the second consecutive week. Two weeks ago it stood at 62% (Fig. 46). The neutral respondents slid to 75% on Friday, versus 83% in the last report. Bullish survey participants registered 25%, up from 17% the previous week.

Looking out 1-2 months, 20% of traders recorded a bearish stance, compared with just 9% in the prior report. The neutral category rose to 80%, up from 73% on the 17th of March. The bullish group came in at nil for the 1-2 month horizon, down from 18% (Fig. 47).

The buy-side was slightly less sanguine than the sell-side, at least for the nearterm. In point of fact, while no portfolio managers registered bearish for 1-week outlook – the first incidence since 10 February – 80% weighed in as neutral. The preceding week, neutral respondents were a bit higher at 86% (Fig. 48). The bullish category jumped to 20%, up from 0% in the previous report.

Longer term, portfolio managers were slightly less enthusiastic for the 1-2 month horizon than they were for the near-term (Fig. 49). Bearish managers rose to 33%, whereas they registered 11% on 17 March. The neutral group weighed in at a 67%, down from 78%, and no buy-side observers had a bullish response, the fourth such comeback in five weeks.

All dealers who contributed to last week's survey scored their municipal bond inventories in the light category (Fig. 50).





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