The Fed's move to extend its bond-buying to smaller municipalities and revenue-backed liens helped ease liquidity concerns in the muni market.
Last week the municipal market was spared the pain associated with the jump in Treasury rates, as it was supported by strong flows into municipal mutual funds and bolstered by the Fed extending its reach into smaller municipalities and revenue-backed liens. This alleviated liquidity concerns for many municipalities dealing with budgetary challenges related to the economic impact of COVID-19.
The Muni Market Was Relatively Unchanged Last Week, Underperforming Treasury Strength
During the week ended June 5, the Bloomberg Barclays Municipal Index was unchanged from the prior week, while the HY Muni Index returned 2.12%. AAA municipal yields moved modestly higher in intermediate and long maturities. Treasuries increased 16-26 bps and brought the Muni/Treasury ratio back to normal levels after rising to nearly 500% in some maturities in March, highlighting the volatility of this widely used metric at low levels of nominal Treasury rates.
Exhibit 1: Municipal Bond Yields
Source: Muni Yields: Thomson Reuters Money Market Directories. Treasury Yields: Bloomberg. As of 05 June 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.
Muni Technicals Were Balanced, Considering Above-Average Supply and Fund Flows
Municipal mutual fund flows were supportive of valuations as funds reported $1.2 billion of inflows, a fourth consecutive week of inflows. Long-term funds recorded $349 million of inflows, HY funds recorded $195 million of inflows, and intermediate-term funds recorded $125 million of inflows. Year-to-date (YTD) municipal fund net outflows now total $16.6 billion.
From a supply perspective, the municipal market recorded $10.4 billion of new-issue volume last week, up 21% from the prior week. YTD municipal issuance of $162 billion is 24% above last year’s pace, primarily driven by taxable supply which is over 3x last year’s levels. We anticipate another ~$10 billion calendar next week, led by $3.5 billion of DASNY Revenue Anticipation Notes and an $800 million taxable University of Michigan transaction. We believe elevated supply conditions, paired with rate volatility, could offer attractive entry points, but will likely be met with seasonally high coupon and principal reinvestment.
The Fed Expands MLF, Opening the Door for Smaller Munis and Revenue Liens
On Wednesday, the Federal Reserve expanded the eligibility of its $500 billion Municipal Liquidity Facility (MLF) to municipalities of all populations and started carving a path for certain revenue-backed liens to access the facility.
The MLF initially had strict terms for both who can access it (counties with two million residents, and cities with one million residents) as well as pricing, which was well above market rates. The facility effectively provided a ceiling on short-term borrowing rates for the largest borrowers, and inspired confidence across the muni market. The Fed later relaxed the population standards to 500,000 and 250,000 residents for counties and cities, respectively.
The State of Illinois was the first municipality to tap the facility this week, receiving a $1.2 billion, 1-year term loan at approximately 100 bps lower than the new-issue market offered a couple weeks ago.
This loosening of MLF standards is significant and highlights the Fed’s willingness to ease borrowing pressures on state and local governments during this crisis, and should extend the ceiling on short-term borrowing rates to large revenue issuers. For stressed municipalities with cash needs, the MLF can provide funding relief and extend any near-term liquidity challenges to the medium term, but it is not a forgivable loan nor will it be a cure for structural challenges for some municipal entities.
Considering currently low nominal borrowing rates, debt service costs are less critical than direct aid needed to weather budgetary challenges associated with COVID-19. From a policy perspective, we are more focused on the HEROES Act to ascertain the degree of direct aid municipalities will receive and inform the level of austerity measures that will take place.
Exhibit 2: MLF Sample Purchase Rates as of Monday, June 1, 2020
Source: Federal Reserve. As of 08 June 20. Source: Muni Yields: Thomson Reuters, Money Market Directories. Treasury Yields: Bloomberg. As of 05 June 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: Index Valuations and Returns
Source: Bloomberg. As of 05 June 20. Source: Muni Yields: Thomson Reuters Money Market Directories. Treasury Yields: Bloomberg. As of 05 June 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.
An obligor, also known as a debtor, is a person or entity who is legally or contractually obliged to provide a benefit or payment to another.
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.
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 Yield 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 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.
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.
One basis point (bps) is one one-hundredth of one percentage point.
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 Federal Reserve established the Municipal Liquidity Facility to help state and local governments better manage cash flow pressures in order to continue to serve households and businesses in their communities.
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.
The New York State Dormitory Authority (DASNY) is a public benefit corporation serving the State of New York. The Authority finances and builds facilities for higher education, health care providers, court facilities and nonprofit institutions and public agencies.
Revenue Anticipation Notes (RANs) are a form of note, or short-term loan that a government usually repays from a named revenue source within a period of one year. The revenue that the government uses to repay a RAN can come from a variety of sources depending on the project, such as sales, fees, or rate increases.
On May 15, 2020, the U.S. House of Representatives passed “The Heroes Act,” (H.R. 6800) the latest COVID-19 relief proposal. With an estimated cost of $3 trillion over 10 years, the Heroes Act targets many problems, including expanded food and unemployment assistance; assistance for struggling state and local governments; another $1,200 relief payments to individuals; hazard pay for essential front-line workers; housing assistance fund to help pay rents and mortgages; and health insurance premium payments for laid off workers.