Muni Bond Sales Surge as Issuers Ride Demand Wave

 

February 19, 2019 [Municipal Bonds, high yield, fed rate]
Dominic Alto and Charles Roth


Caveat emptor: current technical supply and demand flows favor issuers more than buyers. But diligent, disciplined investors can always find attractively priced, fundamentally sound bonds.

 

Municipal bonds have been on a tear so far in 2019, with surging investor demand readily greeting increased supply, in what appears to be more than the typical “January Effect.”

While the usual tax-loss selling into year end was prevalent, and the tide of fund flows came back in last month as expected, investor inflows have continued to rise, hitting $3.3 billion in the week through February 6. That marked the biggest weekly inflow since at least 2007 and the fifth straight week of muni fund inflows, Investment Company Institute data show.

Moreover, high-grade muni funds across the maturity spectrum saw net inflows in both January and early February. Even speculative-grade muni funds saw a massive $1.8 billion pour in the first month of 2019, matching the net inflow into the space for the whole of 2018, according to Morningstar.

Supply, meanwhile, amounted to $36.38 billion in total short- and long-term fresh muni paper from the beginning of the year through February 13, up 38% from the year-earlier period, according to Bloomberg. But that’s still a far cry from the $45.26 billion over the first six weeks of 2017. Perhaps a recovery in issuance is underway after the 21% decline to $355.65 billion in calendar 2018 muni sales from the $450.01 billion in 2017.

It’s clearly a great time for states and municipalities to sell new bonds, given how low muni rates have fallen compared with U.S. Treasuries. The muni-Treasury ratio, which reflects a generic AAA-rated muni bond’s yield against that of the U.S. 10-year Treasury, stands at 81%, down from 84% a month ago and not far off its 2007 low of 78%.

Strong investor demand has driven down the front end of the muni yield curve sharply, causing an overall steepening, even amid somewhat softer demand at the long end given less appetite for muni bonds from institutional investors such as banks, which have reduced their holdings of muni bonds from $570.2 billion in 2017 to $530.7 billion in the third quarter of 2018, according to Bank of America Merrill Lynch.

 

AAA MMD Curve


 

Source: Bloomberg

 

Why would so many investors pour into relatively pricey shorter-term munis when the U.S. Federal Reserve recently signaled “patience” in continued monetary tightening? The late 2017 tax reform and the structure of the $3.8 trillion muni market investor base may have something to do with it.

According to the Fed’s Flow of Funds data, households represent 42% of muni market investors, though retail investors no doubt also comprise a number of the 7% in the “Other” category, which groups ETFs, closed-end funds, and public sector entities, among others. Banks and insurers make up around 28% of the investor base, while mutual funds account for 18% and muni money market funds the remaining 3%.

Perhaps some households are chasing the outperformance of shorter-term munis in 2018, when the Fed was still steadily raising rates. Maybe others don’t want to lock their money up in longer-maturity bonds. Certainly tax reform has spurred demand for munis of various maturities among wealthier taxpayers, particularly in states with high personal income tax rates. While the reform reduced the incentive for banks and insurers to invest in munis by cutting the corporate tax rate to 21% from 35%—hence the decline in muni demand from banks—it also capped the deduction individuals could take on their state and local taxes at $10,000. That raised the attractiveness of munis, especially in “blue” coastal states, as munis are exempt from federal taxes, and in many cases from city and state taxes, too.

Yet investors would be well advised to be highly selective in taking on more duration and credit risk, particularly in high-yield munis. To be sure, the recent rise in yields is pushing relative value metrics farther out the curve. But credit spreads remain near all-time lows, which doesn’t inspire confidence when the economy, while still quite solid, is nonetheless slowing, with drags in housing, auto-financing, student loan and credit card segments.

Meanwhile, the Bloomberg Barclays Muni High Yield Index’s yield to worst has compressed to around 4.9%, which might make those rushing into high-yield munis a little more circumspect. Investor flows in the segment can also be exceedingly volatile and tend to heavily influence returns.

 

HIGH-YIELD PERFORMANCE AND CASH FLOWS - A SELF-fULFILLING PROPHECY(3/1/2010 - 12/1/2018)

Source: Bloomberg.

 

Fundamental, bottom-up credit research matters, particularly when technical supply and demand flows favor issuers more than investors. To be sure, there are always pockets of value to be found for those willing to look.

Late last year, for example, as corporate high-yield spreads blew out, new-issue deals and spreads in the pre-paid gas sector increased. The bond sales involve a municipality borrowing at tax-exempt rates and then engaging in a contract with a large investment bank for the delivery of natural gas over the next 10 to 20 years. The credit quality is tied to the banks’ underlying credit, which moves in concert with corporate spreads. The credit quality in select cases was strong, while the broad market volatility in late 2018 took the spreads to attractive levels.

The same goes for duration risk: caveat emptor. Yes, Fed rate normalization has lifted yields over the last three years, a period in which bond laddering made especially good sense for investors who systematically reinvest. But now its new-found patience means less pressure on net asset values, while the higher yields mean more total return with less duration risk. But heavy investor flows in short-maturity munis may not be advisable if they’re driven by last year’s performance, while the intermediate duration munis, which saw the heaviest inflows in January, could quickly become a crowded trade. And if less institutional demand weighs on yields at the long end, the marginal extra basis points may not be worth it.

Deals, of course, can be had in all segments of the curve. But ultimately they’re found in the value propositions of select issues within each of them.

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