Municipal Fixed Income Weekly

November 9, 2018


Municipal Fixed Income Weekly

November 9, 2018


Key Themes for the Upcoming Week

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  • Bye Bye Brady. On page 7 of this issue we recap the midterm elections and highlight a few outcomes that will likely affect the tax-exempt municipal market. The focus for practitioners and investors, alike is that Republicans will turn over the House to Democrats in the 116th Congress, and Kevin Brady (R-TX) will no longer chair the House Committee on Ways and Means. Instead, he will play second fiddle to Richard Neal (D-MA), who is slated to fill that seat. Brady will stay on the committee as ranking member but he will no longer set the agenda. We remind readers that Brady was a force behind the elimination of the tax-exemption of advance refundings in the 2017 Tax Cuts and Jobs Act. He also had, and will likely keep private activity bonds (PABs) in his crosshairs. But while the Texas congressman carries on as the municipal market's bête noire, the House's inbound Democrat majority should lessen the threat of losing the tax-exemption, at least for a time.
  • All in, the tax-exempt municipal bond market won the battle, but the war endures. With Brady leaving the chair position in Ways and Means, and with Neal set to take the lead and fix the agenda, the tax-exemption of PABs, and the municipal market as a whole, may have breathing room. Though the reinstatement of the tax-exemption of advance refundings is not guaranteed with Neal's ascent, it also isn't without life, as would have likely been the case had the Republicans retained the House.
  • With seven weeks remaining in 2018, issuers will need to bring about $21.587 billion in new deals in order to reach our supply forecast; that equates to $3.084 billion every week.
  • The municipal bond market scored a positive return last week, both in terms of market performance and the midterm elections. Supply should pick up for the coming five trading sessions, helping to bring the year-end figure close to our $315 billion estimate. Meanwhile the economy remains healthy and rates appear to be relatively well-behaved.
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:
Indicators of US economic activity remain positive, with the October ISM Non-Manufacturing Index demonstrating continued solid expansion in the services sector, in line with last week's ISM Manufacturing Index reading. That watermark ticked down slightly from its 21-year high in September, but remains at elevated levels. While concerns on tariffs were frequently mentioned in the comments section of the report, there is little evidence of a direct hit to activity in the sector yet, with new orders, the most forward looking component of the survey, down only marginally. New export orders held steady for the month, as well.

Both the ISM Manufacturing and Non-Manufacturing indices indicate solid economic activity in the US, and though tariffs remain a concern, both show little direct impact as of yet. Tariffs remain a risk for business confidence though, and there have been indications of a moderation in capital expenditures by businesses in the recent 3Q GDP data as well as in the September core capital goods orders data, a leading indicator for capital expenditures. It is difficult to tell whether tariffs have impacted these measures directly, but it is something we will be monitoring closely. Other measures of economic activity stay solid.

The labor market remains vigorous according to the September Job Openings and Labor Turnover Survey (JOLTS), in line with still elevated consumer confidence data. JOLTS data is less timely because it is released with a 1-month lag relative to the Employment report, which we received last week for the month of October, and also highlighted a very healthy labor market. However, this release provides a wealth of in-depth information which is not provided in the Employment report. The JOLTS data suggests that employers continue to have difficulty filling open positions, as the ratio of new hires in the private sector relative to the number of jobs still open at the end of the month remains below 1. While the number of job openings inched down from a record high in August to a still elevated level (7.009 million jobs available), job openings also still exceed the number of unemployed (5.964 million individuals). The quits rate was stable at a 17-year high, suggesting that workers are confident in their ability to find a new job. This also bodes well for wage growth. Confidence in the labor market, along with positive views of potential income growth, has kept the University of Michigan's Consumer Sentiment Index near cycle highs, despite a small tick down in November.

The JOLTS data along with last week's Employment report both confirm that the labor market remains strong, and augur well for continued gradual wage growth. The strong labor market should continue to support consumer sentiment.

Week ahead:
After two months of softer readings, with last month weighed down by an outsized drop in auto prices, core CPI is expected to normalize, and rise by 0.2% month-over-month (m/m) from 0.1% m/m in September, which would keep the year-over-year (y/y) rate steady at 2.2%. This would allow the Fed to stay on track for a continued gradual pace of rate hikes in our view.
  • Monday: No major data
  • Tuesday: US NFIB small business optimism, UK employment.
  • Wednesday: US CPI, Eurozone GDP, Eurozone industrial production.
  • Thursday: US Philadelphia Fed manufacturing survey, US retail sales, US import prices, UK retail sales, Eurozone trade balance.
  • Friday: US industrial production, Eurozone CPI.


  • Yield Curve
    On Wednesday, the Federal Open Market Committee announced its decision to keep the federal funds target rate unchanged in the 2.00% - 2.25% range. Although domestic fixed income markets had a rather soft tone in the beginning of the week, US Treasuries (USTs) made a strong showing on Friday with the benchmark10-year note closing the week at 3.203%. High-grade tax-exempt bonds had a reasonably constructive five trading sessions, even though the ICE AAA Municipal Yield Curve ended the week as both the 6-month and 1-year marks coasted up by 1 basis point (bp) and the 2-year remained unmoved (Figs. 1 & 2). The 3-year was down 1bp, and the 5- and 7-year spots were lower by 2 and 3bps, respectively. The 10- and 15-year yields decreased by 4 and 6bps, correspondingly. Last but not least, the 30-year dropped by 4bps, to close the week drawing a 3.420% yield, just off last week's 3.460%, the highest that long-dated point had been since 30 April 2014.

    The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index interest rate increased another basis point this past Wednesday, putting it at 1.620% (Fig. 10). Wednesday marked the fourth consecutive week that short-term benchmark moved higher, as it currently represents 69.969% of the 1-month LIBOR Fix, 74.312% of SOFER (Figs. 8 & 9).

    Looking beyond the 6-month point, last week's swing flattened the slope of the ICE AAA Municipal Yield Curve by 5bps, top to bottom. As of Friday's close, the difference between the 1- and 30-year yields stood at 146bps, down from 151bps the prior week (Fig. 1). The ICE AAA Municipal Yield Curve has steepened 35bps thus far in 2018. The curve is 0.31 standard deviations above its 141.97bp 1-year trailing daily average (Figs. 13 & 14).

    Municipal-to-US Treasury (M/UST)Yield Ratios
    High-grade yields shifted slightly higher in the front of the curve, but were stronger than their UST counterparts. In fact the ICE AAA Municipal Yield Curve was sturdier than the corresponding UST term structure, with exceptions occurring at the 25-year mark and longer, where UST interest rates outdistanced municipals' to the downside (Fig. 12). As a result of last week's variegated behavior, the 6-month M/UST decreased by 0.366 ratios, to finish the week at 76.557%, compared with the prior print of 76.923% (Figure 27). The 1-year M/UST edged lower to 71.664%, a 0.585 ratio decrease from the previous week's 72.249%. The 2-year M/UST subtracted 0.784 ratios, to complete the last five trading sessions at 71.332%. The 5-year M/UST was lower by 0.960 ratios to finish the week at 76.418%, down from the prior Friday's 77.379%. Over the same period, the 10-year M/UST moved to 85.233%, a decrease of 0.819 ratios from the earlier print of 86.052% on the 2nd of November. Lastly, the 30-year M/UST ended with a 0.500 ratio increase from the prior week's 100.029%, to close at 100.529%. We present a more complete view of the one-year historical AAA Municipal-to-US Treasury yield ratios in Figures 28-34 on pages 24-26.

    AA Municipal-to-AA Corporate (AAM/AAC) Yield Ratios
    Last week, municipal bonds in the Aa/AA ratings class became more attractive relative to their senior unsecured corporate counterparts at the front of the yield curve, while richening at points beyond the 1-year maturity. Friday's close saw the 6-month AAM/AAC finish the week at 71.569%, higher by an almost flat 0.050 ratios from 71.518% on the 2nd of November (Fig. 35). The 1-year AAM/AAC grew by 0.065 ratios, closing the week at 70.892%, up from the prior Friday's 70.828%. The 2-year AAM/AAC repositioned lower by 0.251 ratios, to conclude the last five sessions at 72.340%. The 5-year dropped to 69.728%, a 0.683 ratio decline from the prior week's 70.412% on the 2nd of November. The 10-year printed a 0.774 ratio decrease to end the week at 69.451%. Finally, the 30-year AAM/AAC edged lower by 0.076 ratios from the prior week's 83.653%, to finish Friday at 83.577%. We present a more complete view of the one-year historical AA Municipal-to-AA Corporate yield ratios in Figures 36-42 on pages 27-29.

    Market Performance
    Last week's reversal from the five days ending on 02 November saw the S&P Municipal Bond Index's yield fall 2bps to finish Friday drawing a 3.050% yield. That slender drop was enough to generate a +0.230% total return, retracing much of the erstwhile week's -0.421% downturn. In fact, three of the last four weeks have generated positive performance in that broad-market benchmark (Fig. 51). While the combined five trading sessions ending 02 November represented the third worst week in the past fifty-two, Friday evidenced the seventh best in the past year. In the meantime, the Intermediate, Short Intermediate, and Short indices also concluded the week underwater, dispensing total returns of +0.211%, +0.111%, and +0.048%, respectively.

    We note that short term interest rates have risen precipitously over the current cycle, and the S&P Short Index has produced negative weekly returns in 39% of observations since 06 January 2017. With 61% producing positive weekly performance, the average positive value stands at +0.076%, while the negative one is -0.066%. More interesting though, is that since the S&P Municipal Bond Indices inception in January 1999 that same Short Index has never generated a negative rolling 1-year return. The worst one printed +0.056% on 30 April 2018, when the yield on the S&P Short Index went from 1.224% to 2.033%, a rise of 81bps over that same trailing 12-month period.

    The S&P Municipal Bond High Yield Index produced +0.201% last week, underperforming the High Yield Excluding Puerto Rico Index, which finished the past five trading days with a total return of +0.241%. The S&P Municipal Bond California Index printed +0.231%, slightly above the New York Index's +0.204%. Puerto Rico turned in a -0.163% last week, but that index still sports a +24.947% year-to-date total return.

    Supply and demand
    At $6.381 billion, the upcoming week's tax-exempt new issue calendar is a titanic-size increase over the previous week's $2.564 billion (Fig. 63). Next week's slate is $988 million over the $5.394 billion 12-week moving average, and this should help put the market on target to reach our $315 billion 2018 supply estimate. As of Friday's close, total year-to-date issuance stood at $293.413 billion. That number compares with $348.434 billion for the same period for 2017, a 15.791% shortfall.

    With seven weeks remaining in 2018, issuers will need to bring about $21.587 billion in new deals in order to reach our supply forecast; that equates to $3.084 billion every week. As we have written on these pages, market activity becomes characteristically sluggish toward the middle of 4Q and into year-end. If we discount the number of remaining weeks in 2018 by three in order to account for the holiday season, then we will need to average $5.397 billion for the remaining four weeks of the year to get to our $315 billion volume estimation. Next week should help get the market closer to that figure

    Turning to demand, on Wednesday, the Investment Company Institute (ICI) reported $1.328 billion of municipal bond fund net outflows for the mid-week period ending 31 October (Fig. 64). As of that date, the S&P Municipal Bond Index's mid-week 5-day performance was -0.155%. Although the previous week's $182 million outflow was dramatically less than the -$1.415 billion a fortnight ago, that modest recovery proved ethereal and a return to negative market performance only took the current six-week trend deeper into negative territory.

    Looking forward to the forty-fifth ICI Municipal Bond Mutual Fund Flows report for 2018, the next one on the 14th of November will cover the four trading days ending on 07 November, when the S&P Municipal Bond Index generated -0.142% return. Municipal bond funds have lost a total of $4.807 billion over the past six weeks, reducing the amount that investors have reallocated thus far in 2018 to a net total of $11.677 billion. Should market weakness persist, that number could move markedly lower before year-end. Midterm elections and the Municipal Market
    Bye Bye Brady. It's not a typo and we're not referring to the 1964 musical starring Janet Leigh, Ann-Margret, and Dick Van Dyke. But just the same, it may be a melody to the municipal bond market's ears. This is about Republican Congressman Kevin Brady (R-TX). No, he didn't get ousted in last week's midterm election. In fact, Brady handily throttled Democrat candidate and adversary, Steven David, garnering over 73% of the vote. This is the 8th Congressional district - Houston's red suburbs in the heart of the Lone Star state where David only captured 67,748 votes to Brady's 200,376. Giant Stadium in the New Jersey Meadowlands can accommodate 14,752 more fans than David could marshal last Tuesday.

    But that's not the big story. The focus for municipal market practitioners and investors, alike is that Republicans will turn over the House to Democrats in the 116th Congress, and Brady will no longer chair the House Committee on Ways and Means. Instead, he will play second fiddle to Richard Neal (D-MA), who is slated to fill that seat. Brady will remain as ranking member on the committee but he will no longer set the agenda.

    Why is that so important? We remind readers that Brady was a force behind the elimination of the tax-exemption of advance refundings in the 2017 Tax Cuts and Jobs Act. He also had, and will likely keep private activity bonds (PABs) in his crosshairs. But while the Texas congressman carries on as the municipal market's bête noire, the House's inbound Democrat majority should lessen the threat of losing the tax-exemption, at least for a time.

    Justin Underwood, director of Federal policy and fixed income research at the Bond Dealers of America, also serves as director for the Municipal Bonds for America coalition. He relates that Richard Neal has long been an outspoken champion of tax-exempt financing. We remain hopeful that Neal will continue that tradition. Further, Underwood believes incoming chairman Neal will support an effort to back advance refundings. We share his view and remain hopeful this indispensable financing mechanism regains its tax-exempt status.

    On the other hand, the municipal fixed income market suffered several unsung defeats – some deep – in last week's election, as incumbent Representative Randy Hultgren (R-IL) lost the bid to retain his seat in Illinois' 14th Congressional district. Along with Dutch Ruppersberger (D-MD), Hultgren is the co-founder and co-leader of the Municipal Finance Caucus, and with over forty-two House members, that group has worked diligently to ensure that Congress continues to protect the tax-exemption of municipal bonds. Both the House of Representatives and the municipal bond market will lose one of their most fervent advocates in January. If the Municipal Finance Caucus is to remain bipartisan, then Republicans will need to find a representative with Hultgren's political heft to replace him in that conclave. His shoes will be difficult to fill, to be sure. There are twelve remaining Republican representatives in the caucus and it would be beneficial to have a member of Ways and Means or someone in another leadership position to fill the vacancy that Hultgren is leaving.

    Staying in Illinois, Congressman Peter Roskam (R-IL) sought to retain his seat in the 6th district, but lost to Democrat Sean Casten, who secured 52.8% of the vote. Mr Underwood points out that while Roskam, who is a member of Ways and Means, was a traditional defender of tax-exempt financing he sided with Brady on the elimination of the tax-exemption for advance refundings.

    Finally, Bill Shuster (R-PA) is retiring effective at the end of this term. As chairman of the House Transportation and Infrastructure Committee, the Pennsylvania representative has long been a devout backer of municipal financing and played a key role in the effort to preserve the tax-exemption. Municipal market allies will feel his absence as Congress attempts to take up a new infrastructure package in the upcoming year.

    All in, the tax-exempt municipal bond market won the battle, but the war endures. With Brady leaving the chair position in House Ways and Means, and with Neal taking the lead and setting the agenda, the tax-exemption of PABs, and the municipal market as a whole, may have breathing room. While the return of the tax-exemption of advance refundings is not guaranteed with Neal's ascension, it also isn't without life, as would have likely been the case had the Republicans retained the House.

    Core Narrative
    The municipal bond market scored a positive return last week both in terms of market performance and the midterm elections. Supply should pick up for the coming week, helping to bring the year-end figure close to our $315 billion estimate. Meanwhile the economy remains healthy and rates appear to be relatively well-behaved.





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