Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- After a weak end to 2016, the municipal market posted positive results during each of the first three months of the year.
- This turnaround was triggered by a number of factors, including generally positive underlying fundamentals, declining long-term yields, moderating supply and overall solid investor demand.
- All told, the Bloomberg Barclays Municipal Bond Index gained 1.58% during the first quarter.
- In contrast, the overall taxable bond market, as measured by the Bloomberg Barclays U.S. Aggregate Index, returned 0.82% for the quarter.
- March’s performance was led by long duration and high grade munis, as longer maturities shrugged off renewed concerns over Puerto Rico and a 25 basis point (bps) Federal Reserve (Fed) hike.
Revenue bonds outperformed G.O. bonds over the past 12 months
Source: Bloomberg Barclays, as of 3/31/17. 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.
- Following a robust January, issuance in the last two months has been below average. March supply came in at $31 billion which was roughly 11% lower than 2016. Net issuance was approximately $10 billion lower for both the month and year to date periods.
- Excluding the first two weeks of this year, muni fund flows have remained somewhat steady, inclusive of high yield (HY) fund flows. Disaggregated, investment-grade fund flows have mostly been negative-to-flat for most of the year while HY fund flows remain robust and have averaged $270 million per week.
Muni issuance: 2017 YTD vs. 2016 YTD
Source: Bloomberg Barclays, as of 3/31/17.
Monthly net new cash flows into long-term muni funds and ETFs
Source: Source: Investment Company Institute, Washington DC, as of 4/05/17. March flows are estimated as of the week ending 3/29/17.
- From a curve perspective, the muni curve moved flatter and higher for the month. 2yr and 5yr yields gravitated higher after the Fed hiked rates, while 10yr rates rallied.
- Generally speaking, munis continued to richen, offering less incentive to investors particularly in concern of potential tax risk. 2yr ratios were unchanged as the front end underperformed, whereas the 10yr and 30yr ratios richened by about 3-4 percentage points.
Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury
Source: Bloomberg Barclays, as of 3/31/17. 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 3/31/17. 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.
- In our previous outlook, we discussed how investor optimism over the pro-growth proposals by the Trump administration may have been overdone. This view now appears to be shared by many investors, especially in light of the failure of the repeal and replacement of the Affordable Care Act. To be sure, we could see certain initiatives, such as increased infrastructure spending and changes to personal and corporate tax rates. However, they will take time to make their way through the legislative process and could be scaled back versus the initial proposals. Against this backdrop, we were not surprised to see Treasury yields decline from their mid-March peak.
- In our view, fundamentals remained solid overall during the first quarter, although they may have plateaued. Still, we don’t expect fundamentals to be overly challenged going forward and they could even firm somewhat should the economic environment improve.
- New muni supply during the first quarter of 2017 was down sharply versus the same period a year ago. We anticipate supply to pick up as the year progresses, but to be manageable. We also expect investor demand to be steady, as munis continue to provide compelling after-tax yields versus other fixed income sectors. It’s noteworthy to mention, we've also seen an increase in demand from foreign investors, in particular for taxable muni securities.
- We continue to favor revenue bonds over GO bonds. In particular, we remain focused on finding value in single A-rated revenue bonds. That being said, in recent months we have pared our overweights to certain revenue sectors given relatively tight credit spreads. We have also trimmed our underweight to select GOs whose spreads have not narrowed as much as their revenue bond counterparts.
- From a curve perspective, we are maintaining our overweight to the intermediate and longer bias which includes the 10-20yr area.