Municipal Market Update: September

Municipal Market Update: September

Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.


Performance

  • Municipal bond performance struggled during September, but it was in line with the broad taxable market.
  • The Bloomberg Barclays Municipal Bond Index posted a total return of -0.65% during the month, about the same as the -0.64% retreat in the Bloomberg Barclays U.S. Aggregate Bond Index (the benchmark for the taxable market).
  • For the year-to-date period, the muni index returned -0.40%, outperforming its taxable counterpart, which returned -1.60%.
  • High yield municipal bonds again outperformed investment grade bonds as the Bloomberg Barclays High Yield Municipal Index posted a return of -0.40% in September, bringing the year-to-date return to +4.45%.
  • A catalyst for negative muni price action was the weakness in the U.S. Treasury market, which impacted municipal bond relative valuations.
  • Yet, consistent with our past comments, near-term risks to valuations will likely come from a less favorable technical backdrop as we just don’t see any fundamental justification for shunning munis.

 

Revenue bonds outperformed G.O. bonds in three of the four periods shown below

Revenue bonds outperformed G.O. bonds for the YTD and 12 month periods

Source: Bloomberg Barclays, as of 9/30/18. Past performance is no guarantee of future results.  An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. For illustrative purposes only and does not represent the performance of any specific investment product.

 

Technicals

  • Demand, as measured by long-term flows into mutual funds and ETFs, was modestly negative in September, but remained positive for the year-to-date period.
  • New Issue supply totaled at $24 billion for the month, down about 27% when compared to the amount of issuance hitting the market during August.
  • Year-to-date, new issuance was approximately $247 billion, representing a 15.8% decline versus last year’s pace.

 

Muni issuance: 2018 vs. 2017

Muni issuance: 2017 YTD vs. 2016 YTD

Source: Bloomberg Barclays, as of 9/30/18.

 

Monthly net new cash flows into long-term muni funds and ETFs

 

Monthly net new cash flows into long-term muni funds and ETFs

Source: Source: Investment Company Institute, Washington DC, as of 10/03/18. September flows are estimated as of the week ending 9/26/18. 

 

Valuation

  • Yields were higher across all maturities in September. However, the shape of the tax-exempt municipal curve flattened as yields for maturities inside of 5 years rose about 10 basis points (bps) more than longer maturities.
  • The 10-year AAA muni to US Treasury ratio is 85.5%, and on the long end is 101.6%. These ratios are calculated by dividing the respective muni yield by the respective US Treasury yield.

 

Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury

 

Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury

Source: Bloomberg Barclays, as of 9/30/18. Past performance is no guarantee of future results.  For illustrative purposes only and does not represent the performance of any specific investment product.

 

Muni/Treasury Ratios and Taxable Equivalent Yields 

 

 Muni YieldUST yieldsMuni/Treasury RatioTaxable Equivalent Yield
AAA    
1 year1.92%2.56%75.03%3.05%
3 year2.07%2.88%71.63%3.28%
5 year2.23%2.95%75.42%3.53%
10 year2.62%3.06%85.52%4.16%
30 year3.26%3.21%101.63%5.17%
BBB Revenue    
1 year2.23%2.56%87.00%3.54%
3 year2.59%2.88%89.67%4.10%
5 year2.80%2.95%94.83%4.44%
10 year3.46%3.06%113.07%5.49%
30 year4.24%3.21%132.16%6.73%

Source: Bloomberg Barclays, as of 9/30/18. Past performance is no guarantee of future results.  For illustrative purposes only and does not represent the performance of any specific investment product.  Taxable Equivalent Yield (TEY) is based on 37% top tax bracket. An investor may be subject to the federal Alternative Minimum Tax, and state and local taxes may apply. Capital gains, if any, are fully taxable.

Outlook

  • Looking ahead we are encouraged by the steady fundamentals in the overall muni market due to a number of factors, including low unemployment, and stable tax revenues, and modest spending proposals included in many recent state and local budgets.
  • Given this backdrop, we expect that any poor muni performance in the short-term will be modest in scale and scope and market weakness may even produce good investment opportunities in both duration and credit.
  • We will look to steeper curves, higher yields, and wider spreads as an opportunity to add duration and credit risk.
  • Yet, two areas of the market remain a small concern. First, shorter maturities, inside of 5 years, continue to show tight credit spreads and lower yield ratios making them more vulnerable to weakness versus longer maturities. Second, we see spreads as tight to fair value in high yield, making that segment of the market more vulnerable too.
  • Longer-term, our belief is that the municipal market will again offer good returns and low volatility.

Hurricane Update

  • The hurricane season kicked into gear during the month when Hurricane Florence caused significant wind and flooding related damage in the Carolinas and Virginia after making landfall as a Category 1 storm, on September 14th.
  • The destruction from Florence, although significant, is expected to be significantly less than last year’s three U.S. hurricanes.  According to Moody’s rating service, damage from Harvey totaled $134 billion, Maria cost $120 billion, and Irma’s total was $84 billion. In contrast, damage from Florence is estimated at $50 billion, or less.
  • While it will take time to assess the storm’s full impact, about 150 local governments across three states will suffer some adverse impact from Florence; and utilities could lose revenue from service interruption and infrastructure damage.
  • Nevertheless, state aid, FEMA and other insurance funds will help to stabilize municipal revenue while cleanup and recovery take place. Issuers in the affected area also have a strong track record of maintaining their credit quality after damaging storms without interruptions in debt service payments.

 

 

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Outperformance does not imply positive results.

A credit rating is a measure of an issuer’s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor’s, Moody’s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.