Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- There were modest price declines across maturities during September, marking only the second month during 2017 where municipals posted negative returns.
- The Bloomberg Barclays Municipal Bond Index retreated -0.51% in September compared with a -0.48% decline in the Bloomberg Barclays U.S. Aggregate Bond Index.
- However, for the first 9 months of 2017, the Bloomberg Barclays Municipal Bond Index generated a 4.66% total return compared with 3.14% for the Bloomberg Barclays U.S. Aggregate Bond Index.
- During September, BBB and A securities outperformed AA and AAA bonds and investment grade outperformed below-investment grade.
- Yield ratios on long maturity bonds were stable while ratios on bonds with maturities short of 10 years bounced higher from tighter levels.
- Despite the modest pullback in municipal bond prices during September, a stable domestic economic backdrop, coupled with modest inflation, is fostering a climate where credit spreads remain tight and spread dispersions within and across various sectors remains low.
Revenue bonds outperformed G.O. bonds for the YTD and 12 month periods
Source: Bloomberg Barclays, as of 9/30/17. 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.
- New issue supply has been manageable for the market and mutual fund cash flows have been positive.
- New issue supply continued to run at a slower pace this year versus last year’s supply. Total supply so far in 2017 is running about 16.7% below the pace of 2016.
- Investors’ appetite for munis remained steady as evidenced by positive cash flows into mutual funds each month so far in 2017, totaling more than $27 billion.
Muni issuance: 2017 YTD vs. 2016 YTD
Source: Bloomberg Barclays, as of 9/30/17.
Monthly net new cash flows into long-term muni funds and ETFs
Source: Source: Investment Company Institute, Washington DC, as of 10/04/17. July flows are estimated as of the week ending 9/27/17.
- A handful of factors are contributing to current valuations:
- Manageable new issue supply
- Positive mutual fund cash flows
- Steady fundamentals across both general obligation and revenue bond sectors
- Attractive yield ratios versus their taxable counterparts
- Credit dramas unfolding in the headlines, including Chicago, Illinois, NJ faded to the background, while the Virgin Islands and Puerto Rico are not acting as agents of contagion
- During September, the muni yield curve steepened from 2 to 10 years, but flattened from 2 to 30 years, as intermediate-term yields rose more than long-term yields.
- The 10-year AAA muni to US Treasury ratio is currently at 86%, and on the long end is slightly above 100%.
- Although rates are low, we remain neutral duration based on our modest inflation outlook.
- The most attractive maturity range is ten to twenty years, in our opinion.
- In terms of credit quality, we will continue to look for opportunities in lower investment-grade securities and below-investment-grade markets, but the current low credit spread dispersions and tight credit spreads more broadly are leading us to an “up-in-quality” bias.
Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury
Source: Bloomberg Barclays, as of 9/30/17. 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 9/30/17. 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 43.4% top tax bracket.
- We continue to favor mid-investment grade revenue bond sectors where we feel confident about our assessment of credit stability, but significant outperformance of revenue bonds during the past few years is presenting an opportunity to strategically shift between revenue and general obligation bonds.
- Should healthcare or IDR valuations weaken, or our outlook for them improve, these sectors may present opportunity.
- Individual and corporate tax reform is back in the headlines as the current administration released their Tax reform proposal at the end of September, which was more of an outline and will require specifics to be negotiated during future congressional legislative sessions.
- We believe tax reform will prove mostly positive for munis because tax-exemption does not appear to be in jeopardy and tax reform itself will take a good amount of time.
- The territory was already hammered by a severe fiscal storm before the natural disaster caused by Hurricane Maria hit the island.
- On top of all that, another squall erupted in the bond market when some investors began to speculate that potential recovery rates may turn out to be far below market expectations, as indicated by bond prices.
- It is clear to us that island officials must first attend to the humanitarian crisis that is building, then look to repair and rebuild their infrastructure before they can even begin to think about addressing bondholder recovery rates.
- This situation will take time before it settles.
- Western Asset muni strategies have zero exposure to PR debt.