Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- History was made in the municipal bond market recently when yields beyond ten years reached extreme lows.
- Why have munis been doing so well?
- A popular theme in the market is that tax reform and, more specifically, reduction of state and local tax write-offs for federal taxes are driving investors into municipal bonds.
- However, explanations of healthy returns in the municipal market go beyond federal tax reform.
- First, we entered 2019 in good fundamental shape, and, as expected, U.S. public finance credits continued to play out in a positive fashion.
- Second, strength in the U.S. Treasury market provided support for the rally in municipal bond prices.
- Strong performance in municipal bonds has also come from modest supply in the face of historic demand from retail investors.
- The Bloomberg Barclays Municipal Bond Index1 posted a total return of +0.81% during the month of July, outpacing the +0.22% return in the Bloomberg Barclays U.S. Aggregate Bond Index2 (the benchmark for the taxable market).
- The muni index performance for the year-to-date and previous twelve-month periods was also solid at 5.94% and 7.31% respectively, but trailed the 6.35% and 8.08% returns posted for the taxable market.
- High yield municipal bonds outperformed investment-grade bonds during July and over the past 12 months. The Bloomberg Barclays High Yield Municipal Index3 posted a return of +0.63% in July and 8.08% over the trailing 12-month period.
Revenue bonds4 outperformed G.O. bonds5 in all periods shown below
Source: Bloomberg Barclays, as of 7/31/19. 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.
- Demand remains very strong for tax-exempt bonds.
- Demand, as measured by long-term flows into mutual funds and ETFs, was positive for the eigth consecutive month in July.
- New Issue supply totaled $198.7 billion for the first seven months of the year, up 3.3% from $192.4 during the first seven months of 2018.
Muni issuance: Year to date
Source: Bloomberg Barclays, as of 7/31/19.
Monthly net new cash flows into long-term muni funds and ETFs
Source: Source: Investment Company Institute, Washington DC, as of 8/7/19. July flows are estimated as of the week ending 7/31/19.
- Municipal yield ratios look attractive. However, they should be signaling good value because we often see elevated ratios during low yield environments, and we are in a low yield environment.
- Most importantly, higher ratios today are not an indication of problems lurking in the municipal bond market such as a lack of demand.
- The slope of the muni yield curve6 is flatter but we still feel that the intermediate to longer end is attractive.
- The front area of the curve will be driven by the UST market given low yields up front, tight credit spreads, and low yield ratios.
- Credit spreads are mostly tighter, across sectors. With that, “Go up in quality” given modest credit spreads is a popular theme discussed in the marketplace but, at the moment, but we disagree because we feel lower investment grades should continue to outperform given modest growth and benign inflation.
- Our duration7 stance is neutral to long with a bias to 10+ year maturities.
- We favor the lower end of the investment grade spectrum (A- & BBB-rated securities).
- We favor high beta GO’s and are less constructive on some revenue bonds that have outperformed.
- We continue to favor bonds offering higher convexity, and reasonable credit spreads.
- Overall, history is being made in muni yield levels. The level of rates is low, but inflation is also low, and the macro backdrop is supportive of valuations, in our opinion.
- Material upside performance seems less likely from current levels at the same time it is not optimal to sit in a defensive position. Indeed, this market appears well suited for active fixed income management.
- The 10-year AAA muni to US Treasury ratio was 76.20% at the end of July, and on the long end was 92.95%. 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 7/31/19. 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 7/31/19. 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.
- Our fundamental outlook for 2019 remains upbeat for municipal debt as we estimate US growth will come in just below 2%, which a modest downgrade from our previous estimates but still supportive of credit fundamentals.
A quick glance at various sectors:
- Airports have benefitted from a good economic backdrop, and budget airlines are raising growth of smaller airports.
- Marine ports exhibit good fundamentals, in our opinion, but remain vulnerable to tariffs.
- Healthcare has good fundamentals with fair valuations, in our opinion, but is facing challenging value-based reimbursement models and upcoming campaign rhetoric.
- We believe the Water & Sewer sector has solid credits, but some facilities are facing large maintenance capital programs.
- Utilities are facing higher pressure from carbon emissions yet exhibit good fundamentals for the most part.
- Within Higher Education, some liberal arts colleges are struggling.
1 The Bloomberg Barclays Municipal Bond Index is a rules-based, market value-weighted index engineered for the long-term tax-exempt bond market.
2 The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. The index includes institutionally traded U.S. Treasury, government sponsored, mortgage and corporate securities.
3 The Bloomberg Barclays High Yield Municipal Index is the high yield component of the Bloomberg Barclays Municipal Index.
4 Revenue bonds are supported by the revenue from a specific project, such as a toll bridge, highway, or local stadium.
5 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.
6 The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
7 Duration measures the sensitivity of price (the value of principal) of a fixed-income investment to a change in interest rates. The higher the duration number, the more sensitive a fixed-income investment will be to interest rate changes.