Municipal Market Update: September

Municipal Market Update: September

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


Performance

  • There were modest price declines across maturities during September, marking only the second month during 2017 where municipals posted negative returns.
  • The Bloomberg Barclays Municipal Bond Index retreated -0.51% in September compared with a -0.48% decline in the Bloomberg Barclays U.S. Aggregate Bond Index. 
  • However, for the first 9 months of 2017, the Bloomberg Barclays Municipal Bond Index generated a 4.66% total return compared with 3.14% for the Bloomberg Barclays U.S. Aggregate Bond Index.
  • During September, BBB and A securities outperformed AA and AAA bonds and investment grade outperformed below-investment grade.
  • Yield ratios on long maturity bonds were stable while ratios on bonds with maturities short of 10 years bounced higher from tighter levels.
  • Despite the modest pullback in municipal bond prices during September, a stable domestic economic backdrop, coupled with modest inflation, is fostering a climate where credit spreads remain tight and spread dispersions within and across various sectors remains low. 

 

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

 

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

Source: Bloomberg Barclays, as of 9/30/17. 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.

 

Technicals

  • New issue supply has been manageable for the market and mutual fund cash flows have been positive.
  • New issue supply continued to run at a slower pace this year versus last year’s supply. Total supply so far in 2017 is running about 16.7% below the pace of 2016.
  • Investors’ appetite for munis remained steady as evidenced by positive cash flows into mutual funds each month so far in 2017, totaling more than $27 billion.

Muni issuance: 2017 YTD vs. 2016 YTD

 

Muni issuance: 2017 YTD vs. 2016 YTD

Source: Bloomberg Barclays, as of 9/30/17.

 

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 10/04/17. July flows are estimated as of the week ending 9/27/17. 

 

Valuation

  • A handful of factors are contributing to current valuations:
  1. Manageable new issue supply
  2. Positive mutual fund cash flows
  3. Steady fundamentals across both general obligation and revenue bond sectors
  4. Attractive yield ratios versus their taxable counterparts
  5. Credit dramas unfolding in the headlines, including Chicago, Illinois, NJ faded to the background, while the Virgin Islands and Puerto Rico are not acting as agents of contagion
  • During September, the muni yield curve steepened from 2 to 10 years, but flattened from 2 to 30 years, as intermediate-term yields rose more than long-term yields.
  • The 10-year AAA muni to US Treasury ratio is currently at 86%, and on the long end is slightly above 100%.
  • Although rates are low, we remain neutral duration based on our modest inflation outlook.
  • The most attractive maturity range is ten to twenty years, in our opinion.
  • In terms of credit quality, we will continue to look for opportunities in lower investment-grade securities and below-investment-grade markets, but the current low credit spread dispersions and tight credit spreads more broadly are leading us to an “up-in-quality” bias.

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 9/30/17. 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 

 

 Muni YieldUST yieldsMuni/Treasury RatioTaxable Equivalent Yield
AAA    
1 year0.92%1.29%71.21%1.62%
3 year1.13%1.62%69.65%2.00%
5 year1.37%1.94%70.82%2.42%
10 year2.00%2.33%85.79%3.54%
30 year2.90%2.86%101.36%5.12%
BBB Revenue    
1 year1.61%1.29%125.22%2.85%
3 year2.04%1.62%125.90%3.61%
5 year2.32%1.94%119.63%4.09%
10 year3.07%2.33%131.76%5.43%
30 year4.07%2.86%142.17%7.18%

Source: Bloomberg Barclays, as of 9/30/17. 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.

 

Outlook

  • We continue to favor mid-investment grade revenue bond sectors where we feel confident about our assessment of credit stability, but significant outperformance of revenue bonds during the past few years is presenting an opportunity to strategically shift between revenue and general obligation bonds.
  • Should healthcare or IDR valuations weaken, or our outlook for them improve, these sectors may present opportunity.
  • Individual and corporate tax reform is back in the headlines as the current administration released their Tax reform proposal at the end of September, which was more of an outline and will require specifics to be negotiated during future congressional legislative sessions.
  • We believe tax reform will prove mostly positive for munis because tax-exemption does not appear to be in jeopardy and tax reform itself will take a good amount of time.

Puerto Rico

  • The territory was already hammered by a severe fiscal storm before the natural disaster caused by Hurricane Maria hit the island.
  • On top of all that, another squall erupted in the bond market when some investors began to speculate that potential recovery rates may turn out to be far below market expectations, as indicated by bond prices.
  • It is clear to us that island officials must first attend to the humanitarian crisis that is building, then look to repair and rebuild their infrastructure before they can even begin to think about addressing bondholder recovery rates.
  • This situation will take time before it settles.
  • Western Asset muni strategies have zero exposure to PR debt.
Top

IMPORTANT INFORMATION: All investments involve risk, including loss of principal. 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.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

Legg Mason, Inc., its affiliates, and its employees are not in the business of providing tax or legal advice to taxpayers. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties or complying with any applicable tax laws or regulations. Tax-related statements, if any, may have been written in connection with the promotion or marketing of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

 

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.