Municipal Market Update: March

Municipal Market Update: March

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


Performance

  • The Bloomberg Barclays Municipal Bond Index posted a total return of +1.58% during the month of March, underperforming the +1.92% return in the Bloomberg Barclays U.S. Aggregate Bond Index (the benchmark for the taxable market).
  • Year-to-date performance was similar: 2.9% for munis and 2.94% for the taxable market.
  • Over the previous twelve months, the municipal index outpaced the taxable index with a return of 5.38% compared with 4.48%.
  • High yield municipal bonds outperformed investment-grade bonds during March and over the past 12 months. The Bloomberg Barclays High Yield Municipal Index posted a return of +2.58% in March and 8.14% over the trailing 12-month period.

 

Revenue and G.O. bond performed similarly in all periods shown below

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

Source: Bloomberg Barclays, as of 3/31/19. 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

  • Solid absolute results so far this year were driven by an insatiable appetite for municipal bonds against unremarkable supply, as well as sound fundamentals.
  • Demand, as measured by long-term flows into mutual funds and ETFs, was positive for the fourth consecutive month in March.
  • New Issue supply totaled $76.5 billion for the first three months of the year, up about 17% from the first three months of 2018.
  • We believe the muni market is unlikely to offer big surprises to investors in the short term.
  • Some factors we are watching that could lead to disequilibrium, include higher yield ratios, subscriptions into mutual funds turning negative, or if sudden credit risks begin to surface in the public finance market.
  • Outflows from mutual funds are typical this time of year, but so far, subscriptions remain strong.

Muni issuance: Year to date

Muni issuance: 2017 YTD vs. 2016 YTD

Source: Bloomberg Barclays, as of 3/31/19.

 

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 4/03/19. March flows are estimated as of the week ending 3/27/19. 

 

Valuation

  • Solid absolute results so far this year resulted in lower tax-exempt yield ratios, which richened relative to US Treasuries.
  • We continue to stick with a strategy we entered the year with, looking to benefit from income carry, favoring securities rated single-A or lower.
  • Our sensitivity to rate risk, or duration, is neutral to respective benchmarks
  • We continue to have a bias to the 10-year to 20-year maturity range of the municipal curve because a steep ratio curve makes them look attractive versus other maturity ranges.
  • We don’t expect long ratios to be in a tight range. In the short term we would expect them to soften slightly before they go lower.
  • In maturities shorter than 5 years, the slope of the curve is extremely flat, and that area of the curve is a little more vulnerable to modest steepening, in our opinion.
  • Shorter-maturities are also showing tight quality spreads and lower yield ratios.
  • We see value in floating rate bonds because they offer higher yields with less rate risk than most short duration fixed coupon bonds.
  • The 10-year AAA muni to US Treasury ratio was 78.4% at the end of March, and on the long end was 96.5%. 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 3/31/19. 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 year1.51%2.39%63.42%2.40%
3 year1.53%2.20%69.40%2.43%
5 year1.59%2.23%71.34%2.53%
10 year1.89%2.41%78.38%2.99%
30 year2.72%2.81%96.54%4.31%
BBB Revenue    
1 year2.26%2.39%94.81%3.59%
3 year2.29%2.20%103.77%3.63%
5 year2.39%2.23%106.95%3.79%
10 year2.73%2.41%113.31%4.33%
30 year3.55%2.81%126.07%5.63%

Source: Bloomberg Barclays, as of 3/31/19. 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

  • Muni investors can be fickle, and they don’t always wait for data to turn from optimistic to pessimistic. That behavior could lead to weakness, but we believe that environment requires a large surprise in the macro backdrop, which is not our base case.
  • Our view is that the current macro-economic backdrop will support current fundamentals, and current valuations, including some below investment grade munis.
  • We continue to stick with a strategy we entered the year with, looking to benefit from income carry, favoring securities rated single-A or lower.

Other points of interest

  • A new subject in the market includes congestion pricing. It is employed in major cities around the globe and is finding its way into domestic public policy. The long-suffering New York City MTA, will soon enjoy a new revenue source, called congestion pricing. Vehicle traffic traveling in specific parts of Manhattan will be subject to a fee. This new revenue source will help cover MTA’s large capital improvement needs, and repay debt. We don’t expect MTA bonds to outperform the broad market in the short term. However, we may look to buy into elevated debt supply from new loans that are likely to come to the market.
  • In Puerto Rico, the US Appeals Court for the First Circuit upheld the District Court ruling that upended the protected status of special revenue debt in Chapter 9 bankruptcies. This ruling may affect the ratings for some special revenue bonds but it also is all the more reason to have professionals conduct credit surveillance of municipal credits. Some fret this ruling will impact all revenue bonds. When applied to the broader market the ruling has the potential to reduce liquidity for stressed credits within economically challenged regions but the ruling should not impact liquidity for well managed essential service revenue bonds.
  • As a sidebar, a unicorn investment generally refers to a startup company that reaches a $1 billion dollar market value as determined by private or public investment, and we generally don’t see them in the municipal bond market. However, the municipal market may have financed a unicorn. At the end of March, the Florida Development Finance Corp. was conducting a $1.75 billion debt roadshow for the first private passenger railroad in the U.S., in more than a century. At the beginning of April, muni investors ravenous for higher yields snapped up the securities. We will cover this more next month.
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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.

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

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