Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- In the thick of summer doldrums, secondary market trading volumes now stand at 18-month lows, and municipal yield ratios dropped to levels not seen in over a year as munis continue to outperform US Treasuries.
- With that as a backdrop, the investment grade Bloomberg Barclays Municipal Bond index posted positive returns of +81 basis points (bps) during July, bringing the year-to-date total return to 4.40%.
- The high yield municipal market gained 66 bps, slightly below IG, its year-to-date returns stand at +6.83%.
Revenue bonds underperformed G.O. bonds in July, but outperformed in the other periods shown
Source: Bloomberg Barclays, as of 7/31/17. 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.
- Muni issuance in July totaled $23.5 billion, or down 20% month-over-month and down 13% year-over-year. Year-to-date, gross issuance stands at $223 billion.
- Cash deposits into open end Muni funds remained strong. By the end of the month, ICI data showed that fund inflows totaled $1.4 billion, bringing year-to-date inflows to $15 billion.
- While primary municipal supply should remain subdued over the next few weeks, fund flows are likely to remain positive and, together with coupon payments and bond redemptions, we expect market technicals will remain supportive to munis in August.
Muni issuance: 2017 YTD vs. 2016 YTD
Source: Bloomberg Barclays, as of 7/31/17.
Monthly net new cash flows into long-term muni funds and ETFs
Source: Source: Investment Company Institute, Washington DC, as of 8/02/17. July flows are estimated as of the week ending 7/26/17.
- The muni yield curve flattened between 2 and 5 years and steepened between 10 and 30 years.
- The 10-year muni to US Treasury ratio is currently at 83%, and on the long end it’s at 95%.
Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury
Source: Bloomberg Barclays, as of 7/31/17. 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 7/31/17. 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.
- Overall, we maintain our bullish view on municipal bonds due to positive technicals, evidenced by anemic issuance, a decline in secondary trading volume, sustained inflows into mutual funds, and steady fundamentals.
Regarding other major subjects affecting the municipal market:
- The effort to repeal and replace the Affordable Care Act appears to be over, removing some near-term uncertainties overshadowing municipal healthcare credits. However, current spreads look tight to us, and Congress may revisit the healthcare bill, perhaps later this year or more likely after mid-term elections.
- Illinois GO credit spreads tightened more than 100 basis points (bps) versus the widest levels seen during June, but that issuer still trades cheap relative to most other bonds rated BBB. The City of Chicago is about 90bps lower in spread too, and the drop in spreads for both issuers was due to Illinois finally passing a budget for the first time in three years. The ongoing public battles between that state’s governor and legislature leads us to believe volatility will remain elevated in Illinois credits.
- Toward the end of July, the Food & Drug Administration (FDA) floated the idea of reducing nicotine levels in combustible cigarettes to non-addictive levels. This is a sweeping notion but there are no definitive rules or any timetable attached to this FDA proposal. They are just planning to start preliminary discussions. We expect it will take quite some time for any tobacco regulation to be finalized. Meanwhile, investors should focus more on cigarette shipment declines. Cigarette shipments declined 3.9% y/y last year, but if more states introduce large excise taxes similar to California’s substantial increase, and the shipment decline accelerates as a result, most high-beta tobacco bonds could become more vulnerable at current levels.
- The House Financial Services Committee began consideration of legislation to designate municipals as High Quality Liquid Assets.