Proposals in two key states would change the landscape for the largest issuers and their investors.
Municipals Outperformed During the Week
AAA municipal yields moved 7-10 basis points lower during the week, outperforming Treasuries and leading the Municipal/Treasury ratios lower to 69%-103% across the yield curve. The Bloomberg Barclays Municipal Index returned 0.47%, while the HY Muni Index returned 0.75%.
Technicals: Strong Fund Flows Continue
Fund Flows: During the week ending August 5, municipal mutual funds reported a 13th consecutive week of inflows at $1.6 billion, according to Lipper. Long-term funds recorded $610 million of inflows, high-yield funds recorded $103 million of inflows and intermediate funds recorded $14 million of inflows. Municipal fund net inflows YTD now total $6.0 billion.
Supply: The muni market recorded $8.8 billion of new-issue volume last week, up 18% from the prior week. Issuance of $256 billion YTD is 30% above last year’s pace, primarily driven by taxable issuance, which is approximately 4.5x last year’s levels and comprises 30% of YTD issuance. We anticipate approximately $10 billion in new issuance this week (+17% week-over-week), led by $1.4 billion LA MTA and $561 million taxable Michigan State Building Authority transactions.
This Week in Munis: Tax Policy Makes Headlines in New York and California
More tax policy rhetoric came into focus in California and New York last week, which would have direct implications for the municipal market’s largest issuers and investors.
A proposal in California detailed a retroactive income tax hike that would raise the top rate to 16.8% from 13.3%. Proponents forecast that the proposed tax increase could raise close to $7 billion and help close an estimated $55 billion state budget deficit. Opponents argue that passage would cause wealthy taxpayers to flee California and detract from long-term growth prospects. The most recent tax-increase legislation that raised California’s top rate to 13.3% passed by a margin of 55% to 45% in 2012 and was extended in 2016.
Last Tuesday, New York Governor Andrew Cuomo pleaded with New York City’s wealthiest residents to return to the city, highlighting the top one percent of the city’s population pays 50% of the tax revenues. New York City faces a $30 billion budget deficit due to the pandemic and it will be exacerbated if those who have left the city do not return in a post-COVID world.
This week’s rhetoric highlights the sizeable budgetary challenges faced by the municipal market’s largest issuers, as well as the demand for federal aid to help cure budgetary shortfalls. Absent significant federal aid, we anticipate austerity measures that would result in downgrades across the municipal market. At the same time, the prospect of higher taxes is a tailwind for tax-exempt municipal valuations and demand prospects. For California residents, considering a 16.8% top tax rate, we anticipate the taxable-equivalent yield of a 30-year state general obligation security would increase 24 bps from 2.94% to 3.18%.
Exhibit 1: California Bonds—Nominal vs. Taxable Equivalent Yields
Source: Bloomberg. California 30-year representative yield is the 30-year California BVAL yield. As of 07 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 2: Municipal Bond Yields and Index Returns
Sources: (A) Muni yields: Thomson Reuters Money Market Directory; Treasury Yields: Bloomberg. As of 07 Aug 20. (B) Bloomberg. Taxable-equivalent yield assumes a top marginal tax rate of 40.8%. As of 07 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 07 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 07 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 Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
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.
The Bloomberg Valuation Service (BVAL) provides transparent evaluated price information for a variety of financial instruments, including GSAC sector bonds (Government, Supranational, Agency, and Corporate), mortgage backed securities, municipal bonds, and over-the-counter derivatives.
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.