Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- 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
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.
- 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
Source: Bloomberg Barclays, as of 9/30/18.
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.
- 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
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
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.
- 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.
- 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.