Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- The upbeat investment atmosphere we observed in the municipal market during the first month of 2019 carried on throughout the month of February, and it stems from a few factors including a quiet new issue calendar, steady fundamental backdrop, solid demand from SMA accounts, and record setting subscriptions into open end mutual funds.
- Favorable demand undercurrents, steady economic growth coupled with reasonable inflation, and solid credit fundamentals are the standard to which 2019 began.
- The Bloomberg Barclays Municipal Bond Index posted a total return of +0.54% during the month of February, outperforming the -0.06% return in the Bloomberg Barclays U.S. Aggregate Bond Index (the benchmark for the taxable market). Over the previous twelve months, the municipal index outpaced the taxable index with a return of 4.13% compared with 2.25%.
- High yield municipal bonds performed inline with investment-grade bonds during February and significantly outperformed over the past 12 months. The Bloomberg Barclays High Yield Municipal Index posted a return of +0.54% in February and 6.96% over the trailing 12-month period.
Revenue and G.O. bond performed similarly in all periods shown below
Source: Bloomberg Barclays, as of 2/28/19. 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.
- Strong technicals are supportive of current valuations, in our opinion.
- We doubt a pickup in supply in the short term can overwhelm the current strong demand from SMA and mutual funds.
- Moreover, the muni market has distinct seasonal trends. Under most conditions, recent price action along with the general level of market volatility tend to drive muni demand.
- Demand tends to remain strong during times of good returns and low volatility while demand usually fades when investors confront negative returns or high volatility.
- We expect that current positive demand cycle will remain unchallenged until tax payment time
- Demand, as measured by long-term flows into mutual funds and ETFs, was stronger in February than January and the strongest since January 2018.
- New Issue supply totaled $49.5 billion for the first two months of the year, up about 25.6% from the first two months of 2018.
Muni issuance: Year to date
Source: Bloomberg Barclays, as of 2/28/19.
Monthly net new cash flows into long-term muni funds and ETFs
Source: Source: Investment Company Institute, Washington DC, as of 3/06/19. February flows are estimated as of the week ending 2/27/19.
- In today’s market, although we like the fundamentals, and strong technicals are supportive of current valuations, we are growing cautious on credits with prices that already reflect positive news.
- Aside from the full valuations observed in parts of the muni market, near-term risks to valuations are more likely to come from lackluster mutual fund cash flows.
- Our sensitivity to rate risk, or duration, is neutral to their benchmarks.
- Anticipating a flatter municipal curve we maintain a bias to the 10- to 20-year maturity range of the municipal curve. The steep ratio curve makes longer maturities look relatively attractive.
- Shorter maturities are showing tight quality spreads and lower yield ratios making them more vulnerable to volatility spilling over from the U.S. Treasury market
- In maturities shorter than 5 years, we are tactically cautious rather than a following a blanket defensive strategy.
- Credit wise, we are continuing with the income bias we’ve had all year, favoring securities rated single-A and triple-B, and some below investment grade exposure, which may have income carry benefits. However, security selection in below investment grade bonds is key because we consider below investment grade to be rich to fair value.
- Restructured Puerto Rico COFINA bonds came back to the market without causing any indigestion.
- The 10-year AAA muni to US Treasury ratio was 78.7% at the end of February, and on the long end was 99.3%. 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 2/28/19. 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
Source: Bloomberg Barclays, as of 2/28/19. 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.
- Glancing ahead, we remain convinced that steady fundamentals in the muni market will remain unchallenged in the short term owing to a number of factors, including low unemployment, and stable tax revenues, among others.
- Frankly, investors continue to benefit from the safe haven qualities of municipal bonds and are not seeing fundamental justifications for avoiding them.
- The environment is consistent with a viewpoint we offered recently regarding municipal income becoming more valuable since the Tax Cuts and Jobs Act provides investors with fewer options to avoid paying income taxes.
- Recent proposals for increased income tax rates in states such as New Jersey and Illinois make tax exemption more attractive to investors, too.
- These are some of the dynamics supporting investor decisions to deposit proceeds into municipal bonds when rebalancing their investments. Demand from SMA and mutual funds looks steady and that positive trend is likely to stay in place, at least until tax payment time.
- We anticipate near-term favorable conditions may allow munis to continue to offer good tax adjusted returns. With flexibility for adjustments, our approach is cultured from the perspective that modest domestic economic growth remains intact along with reasonable inflation.
Our thoughts on a few sectors
- Transportation. A broad category offering good valuation, in our opinion, across its subcategories including airports, bridges, mass transit systems, toll roads.
- Industrial Development Revenue (IDR’s). Potential income carry benefits and possible further credit tightening, as a stable macro backdrop remains supportive.
- Healthcare. Healthcare credits are in good shape yet valuations offer limited upside, in our opinion. We still favor national, geographically diverse credits but are looking for opportunities to add to well managed regional organizations. Healthcare is an important sector because it provides an abundant number of investment opportunities. However, this sector is undergoing considerable change, and elevated competition pressuring operating margins, already in low single digits. Another challenge comes from the three primary sources of reimbursement, private insurers, Medicare, and Medicaid. All three continually look for ways to compare payments to value for services delivered, or look to reduce coverage for services, pressuring provider’s income statement. Looking ahead, delivering high quality services through talented physicians, and nurses will remain a challenge and could exacerbate cost pressures. Use of advanced technology in healthcare is welcomed but also creates vulnerabilities. Use of advanced technology adds costs associated with combating cyber threats, especially protecting patient privacy. While Healthcare bonds may offer great investment opportunities, they also come with credit challenges requiring professional credit surveillance.
- Utilities. We see value in the sector despite negative talk around a couple of utilities, along with south east credits
- State & Local GO’s. Spreads are tight for most of this sector, but some credits down the credit spectrum look cheap to us.