Absent improving fundamentals, we believe additional spread compression will remain paused.
Municipals Posted Negative Returns as Yields Moved Higher
AAA municipal yields moved 7-9 bps higher across the curve during the week. Municipal/Treasury ratios declined below 100% across the curve for the first time since March volatility. The Bloomberg Barclays Municipal Index returned -0.31%, while the HY Muni Index returned -0.03%.
Technicals Soften with a Heavy Calendar
Fund Flows: During the week ending August 12, municipal mutual funds reported a 14th consecutive week of inflows at $2.3 billion, according to Lipper. Long-term funds recorded $1.2 billion of inflows, high-yield funds recorded $344 million of inflows and intermediate funds recorded $215 million of inflows. Municipal mutual fund net inflows YTD now total $11.4 billion.
Supply: The muni market recorded $10.4 billion of new-issue volume last week, up 25% from the prior week. Issuance of $265 billion YTD is 26% above last year’s pace, primarily driven by taxable issuance, which is up 366% from last year’s levels and comprises 26% of YTD issuance. We anticipate over $13 billion in new issuance this week (+31% week-over-week), led by $7.2 billion State of Texas TRANs and $1.6 billion NYC Transitional Finance Authority transactions.
This Week in Munis: Spread Tightening Stalled
COVID-19 has repriced municipal risk across sector and quality levels-as transportation, industrial revenue, healthcare, single A rated and BBB rated securities sharply underperformed the broader municipal market and high-grade securities in March 2020 (Exhibit 1). Since March, however, this reversion appears to have paused and we do not expect additional spread compression absent improving fundamentals.
Exhibit 1: Investment Grade Municipal Index Spread Attribution
Source: Bloomberg. As of 14 Aug 20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The reversal in market sentiment and liquidity from late March throughout the second quarter has contributed to strong demand for the asset class, as robust fund flows contributed to spread tightening and outperformance in these hard-hit sectors. Over the past couple months, this spread compression has stalled.
We believe municipal investors could continue to be rewarded with carry for choosing appropriate issuer-level risks within these segments of the market. However, we expect that at current nominal yield levels, the potential for significant outperformance associated with spread compression is limited, and will be driven by fundamental credit trends at the issuer level.
Exhibit 2: Municipal Bond Yields and Index Returns
Sources: (A) Muni yields: Thomson Reuters Money Market Directory; Treasury Yields: Bloomberg. As of 14 Aug 20. (B) Bloomberg. Taxable-equivalent yield assumes a top marginal tax rate of 40.8%. As of 14 Aug 20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Exhibit 3: Tax-Exempt and Taxable Municipal Valuations
Source: (A) Bloomberg, Western Asset. AAA, AA, A, BBB Corporate Indices. After-tax yield assumes a top effective tax rate of 40.8%. As of 14 Aug 20. (B) Bloomberg, Western Asset; Taxable Muni Index Corporate comparable used is the long corporate (ex. BBB) to better align credit quality and duration. As of 14 Aug 20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Definitions:
State of Texas TRANs refers to Texas tax and revenue anticipation notes, a municipal security.
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.
Investment-grade bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
High yield (HY) bonds, also called junk bonds, are bonds with below investment-grade ratings (BB, B, CCC for example) and are considered low credit quality and have a higher risk of default.
The Bloomberg Barclays Municipal Bond Index is a rules-based, market value-weighted index engineered for the long-term tax-exempt bond market.
The Bloomberg Barclays Municipal High Yield (HY) Index is market value-weighted and designed to measure the performance of U.S. dollar-denominated high-yield municipal bonds issued by U.S. states, the District of Columbia, U.S. territories and local governments or agencies.
The Bloomberg Barclays Investment Grade Municipal Bond Index is a rules-based, market value-weighted index engineered for the investment-grade long-term tax-exempt bond market.
One basis point (bps) is one one-hundredth of one percentage point.
Revenue bonds are supported by the revenue from a specific project, such as a toll bridge, highway, or local stadium.
General obligation (GO) bonds are issued directly by state or local governments or their agencies to meet essential government functions such as schools and highway construction. These bonds are backed by the issuer’s pledge and its full faith, credit and taxing power to meet interest and principal payments.
Yield-to-Worst (YTW) is the yield generated assuming a bond is redeemed by the issuer on the least desirable date for the investor. Yield-to-Worst for the asset class is calculated as the weighted average yield to worst of the individual constituent bonds.
A spread is the difference in yield between two different types of fixed income securities with similar maturities; usually between a Treasury or sovereign security and a non-Treasury or non-sovereign security.
The Municipal/Treasury Ratio (M/T ratio or muni-Treasury ratio) is a comparison of the current yield of municipal bonds to U.S. Treasuries. If the yield on AAA munis is 1.5% and the yield on the 10-year Treasury is 2.0%, the ratio is 0.75. The higher the muni-Treasury ratio, the more attractive munis are relative to Treasuries.
