Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- Municipals underperformed U.S. Treasuries during August as evidenced by higher ratios across the maturity spectrum.
- The Bloomberg Barclays Municipal Bond Index posted a total return of +0.26% during the month, trailing the 0.64% gain in the Bloomberg Barclays U.S. Aggregate Bond Index (the benchmark for the taxable market).
- The lackluster muni returns that transpired during August are within a market exhibiting low volatility and an abundant amount of liquidity.
- For the year-to-date period, the muni index returned 0.25%, outperforming its taxable counterpart, which returned -0.96%.
- High yield municipal bonds again outperformed investment grade bonds as the Bloomberg Barclays High Yield Municipal Index posted a return of +0.80% in August, bringing the year-to-date return to +4.86%.
Revenue bonds outperformed G.O. bonds in three of the four periods shown below
Source: Bloomberg Barclays, as of 8/31/18. 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.
- Demand, as measured by muni fund flows was positive in August and for the year-to-date period.
- From the demand side of the ledger, two factors are leading banks to shed exposure to municipal bonds.
- Tax reform steered corporate tax rates to 21% and changes to accounting rules for amortization of premium callable bonds, both combined, reduced the need for banks to hold tax-exempt municipal bonds.
- We expect banks will continue to cut their traditional municipal debt exposure in a measured style.
- August new issue supply totaled $33 billion, which was up 25% when compared to the amount of issuance hitting the market during July.
- Year-to-date, new gross supply was just shy of $224 billion, representing a 15% decline during the first eight months of 2018 versus last year’s pace of $263.8 billion.
- One of the provisions included in last year’s tax reform package was the elimination of municipal refunding activity and that provision has led to a significant drop in supply.
- Yet new financings, although overwhelmed by the drop in refunding activity, are actually 17% higher so far this year versus last year’s pace.
Muni issuance: 2018 vs. 2017
Source: Bloomberg Barclays, as of 8/31/18.
Monthly net new cash flows into long-term muni funds and ETFs
Source: Source: Investment Company Institute, Washington DC, as of 9/05/18. August flows are estimated as of the week ending 8/29/18.
- The shape of the tax-exempt municipal curve flattened in August because yields for maturities inside of 5 years were higher between 5 and 15 basis points, while yields for longer maturities were mostly unchanged.
- The 10-year AAA muni to US Treasury ratio is 86%, and on the long end is 102%. 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 8/31/18. 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
Source: Bloomberg Barclays, as of 8/31/18. 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.
- Looking ahead, September has historically produced elevated price volatility. This is due in part to the market moving out of its summertime doldrums, and September also marks the end of a quarter. Elevated volatility is not guaranteed by quarter end but warrants attention.
- Pew’s annual report of state governments’ cash reserves shows seven straight years of improvement. Cash reserves act as a rainy day fund and can help counterbalance declines in future tax revenues seen during less robust economic times. Though cash reserves are in much better shape today they remain lower than their pre-recession levels. All considered this is still a net positive when viewing the market through a fundamental lens.
- Early results from sports betting are in and they are looking good. Both New Jersey and Mississippi are indicating upbeat results and outlooks from their sports book, even though they are in the very early innings of getting them running at full throttle.