Municipal Market Update: March

Municipal Market Update: March

Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.


Performance

  • The Bloomberg Barclays Municipal Bond Index posted a negative total return of +0.37% in March and trailed the Bloomberg Barclays U.S. Aggregate Bond Index (the benchmark for the taxable market), which returned +0.64%.
  • However, for the year-to-date period, the muni index was down -1.11%, less than the -1.46% for its taxable counterpart.
  • Meanwhile, high yield municipal bonds outperformed investment grade bonds as the Bloomberg Barclays High Yield Municipal Index posted a return of +1.46% in March and was up +0.58% for the year.
  • Revenue sectors in the index generally outperformed general obligation bonds.
  • Some of the better performing sectors included hospital, education and housing; the laggards included transportation and utilities.

Revenue bonds outformed G.O. bonds in all periods shown below

Revenue bonds outperformed G.O. bonds for the YTD and 12 month periods

Source: Bloomberg Barclays, as of 3/31/18. 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.

 

Technicals

  • Municipal investors continued to escape challenges that can stem from overwhelming new issue supply.
  • New issue supply came in at $25 billion, which was higher than the prior month’s supply, but 23% below the pace of the previous year. 
  • We continue to expect supply to normalize during the second quarter as early year calendar effects moderate and tax reform distortions subside. 
  • We believe a modest increase in supply might actually prove beneficial for the market, as supply sometimes generates demand and improves price discovery.
  • Last month we pointed out that municipal bond yield volatilities entered the New Year at elevated levels. You can make the case that elevated volatility is not unique to municipal bonds as it was seen broadly in financial markets and with it came investor anxiety.
  • However, rolling 30-day yield volatilities in municipal bond market dropped significantly during the month of March and they now sit at the lowest end of recent ranges, and that is true across 2-, 5- and 10-year maturities. 
  • An environment with lower volatility may lead to less investor nervousness which may then lead to steady cash flow into open end mutual funds. 
  • Open end mutual funds experienced positive flows during March which is surprising considering flows are usually challenged during tax season when clients sell assets to raise cash for their taxes.
  • If UST rates remain stable, fund flows may also likely remain stable, especially as we move past tax season.

Muni issuance: 2018 vs. 2017

Muni issuance: 2017 YTD vs. 2016 YTD

Source: Bloomberg Barclays, as of 3/31/18.

 

Monthly net new cash flows into long-term muni funds and ETFs

 

Monthly net new cash flows into long-term muni funds and ETFs

Source: Source: Investment Company Institute, Washington DC, as of 4/04/18. February flows are estimated as of the week ending 3/28/18. 

 

Valuation

  • We believe another positive factor for municipal investors is that yield ratios relative to U.S. Treasuries improved during March, making municipals cheaper from a relative value perspective. 
  • At the end of February we noted that the muni market looked like it may have turned a corner with higher yields and attractive yield ratios acting as catalysts to attract renewed investor interest.
  • During March, demand for longer-term securities picked up as evidenced by a flattening in the municipal curve.
  • The 10-year AAA muni to US Treasury ratio is 90%, and on the long end is 101%.

Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury

 

Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury

Source: Bloomberg Barclays, as of 3/31/18. 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 

 

 Muni YieldUST yieldsMuni/Treasury RatioTaxable Equivalent Yield
AAA    
1 year1.55%2.08%74.20%2.45%
3 year1.81%2.38%75.95%2.87%
5 year2.07%2.56%80.68%3.28%
10 year2.48%2.74%90.55%3.94%
30 year3.01%2.97%101.25%4.78%
BBB Revenue    
1 year2.01%2.08%96.46%3.19%
3 year2.39%2.38%100.13%3.79%
5 year2.59%2.56%101.20%4.12%
10 year3.21%2.74%117.38%5.10%
30 year4.03%2.97%135.38%6.39%

Source: Bloomberg Barclays, as of 3/31/18. 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.

Outlook

  • Looking ahead, an important element to consider in the outlook for the muni market is valuation.  
  • Given weak results during the early months of 2018, muni valuations are compelling, in our view.  
  • Munis continue to provide a yield in excess of equal-duration Treasuries, when taking into account their tax-advantaged status.
  • More broadly, in favor of fixed-income investing, the economy continues to expand at a modest pace and inflation remains controlled.  
  • The underwhelming performance so far this year has only improved municipal bond attractiveness.
  • Another point to contrast with valuations are fundamentals. Municipal balance sheets look better today than they have in at least the past few years, although fiscal discipline varies from region to region. 
  • We continue to favor revenue bonds over GO bonds, especially essential service revenue bonds.
  • As we stated last month, the municipal market will evolve in response to changing economic realities and while investors should expect bouts of elevated spread and rate volatility during the upcoming months, it may also be viewed as an opportunity, not an indication of calamity, in our opinion.
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Outperformance does not imply positive results.

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.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

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.