State and local governments have flooded the municipal bond market with over $53 billion of new bond issuance this month, the largest monthly total since December 1985. Tax-exempt issuers are attempting to lock in the lowest debt financing costs in a generation. Increasing bond supply has pressured interest rates higher, resulting in a 1% monthly loss in the Barclays Municipal Bond Index; year-to-date the Index has returned 2.92% through October 31.
The first half of 2016 generated most of this year’s positive performance. In January, sinking global equity prices, perpetuated by the threat of further global economic weakness and disinflation, propelled bond valuations higher, as investors sought safety in fixed income securities. In June, safe-haven assets such as U.S. Treasury bonds received an additional boost when Brexit worries unnerved European financial markets. The United Kingdom’s late June decision to quit the European Union sent a final jolt to the global financial system and triggered an exit stampede out of equities and other risk asset markets. Once again, the valuation of high-grade bonds increased at the expense of riskier investments. Soon after the Brexit decision was reached, the benchmark U.S. Treasury 10-year note fell to a record low yield of 1.36% on July 5th.
The price performance pattern exhibited by tax-exempt securities so far this year has closely mirrored the move that has occurred in Treasuries. Persistent strong investor demand for municipal securities, coupled with a modest new issuance calendar, helped keep tax-exempt interest rates close to their historic lows through the end of the third quarter. Following the same seasonal pattern of prior years, new debt issuance has once again accelerated during October, which is now putting upward pressure on interest rates, but to a larger degree than in the past due to the record amount of securities being sold. The graph above shows how the municipal yield curve has steepened: long-term (30-year maturity) bond yields have appreciated by 63 basis points, 2 1/2 times the rate move of short maturity bonds. The yield differential between 2-year and 30-year bonds has widened from 134 bps to 172 bps during this time, leading to a steeper configuration.
The fourth quarter has historically proven to be a challenging period for the municipal market when municipalities typically accelerate the sale of new debt issuance. In order to entice buyers, lower prices are needed. We anticipate a significant slowing in the recent heightened pace of debt issuance over the next month; only $20 billion of new security sales are expected over the next 30 days. December issuance should fall even more from the November estimate.
A slowdown in mutual fund investment flows might also be contributing to market anxiety. Investors have curtailed their buying. A record 54 consecutive weeks of cash inflows into mutual funds reversed earlier this month when the weekly measure turned negative for one seven-day period. However, the positive trend in fund flows resumed the following week. It is too soon to determine if this is a sign of a shift in investor sentiment.
Two important events occur in November that might help alleviate investor unease. First, the election will have concluded and financial markets will have better clarity regarding the balance of power in Washington. The outcome of many key House of Representatives and Senate races will be crucial to both Democrat and Republican agendas, particularly pertaining to important tax and infrastructure spending plans.
While there are still two months left until year-end, practically speaking, the municipal market begins to "shut down" after Thanksgiving. By the end of November, the marketing of new issues will slow significantly. The municipal market’s technical posture will improve dramatically and market volatility should alleviate. A final possible impediment that will still be confronting the market before year-end is the upcoming December 14th meeting of the Federal Reserve’s Open Market Committee. Financial markets are anticipating another short-term rate hike of 25 basis points will be approved that day. The next few weeks, leading up to the meeting, might be a buying opportunity.
SMC believes investors are overly anxious concerning the possibility of a short-term interest rate hike before year-end. A vote to lift the upper boundary of the Federal Funds overnight rate-borrowing target has already been mostly discounted by the financial markets. We don’t believe this event should be much of a concern to investors, especially since the latest spate of economic data indicates a very moderate pace of growth and inflation pressures are not being registered to any meaningful degree. Also, the Fed has recently indicated that it might be willing to tolerate a rate of inflation above its 2% target.
Looking ahead to the first quarter of 2017, there are a number of constructive considerations for tax-exempt investors. The current glut of new bond issues will likely have been distributed to investors by then. Market seasonals will flip; instead of having to absorb a significant amount of new debt issuance, buyers will be searching for inventory to buy. The timing will coincide with many investors receiving the proceeds from a large percentage of maturing municipals on January 1st. Cash will need to be reinvested. Historically, municipal market prices have benefited in January as buyer demand exceeds the supply of available bonds.
Both presidential candidates have promised significant infrastructure spending. SMC discussed the market implications of their plans in the August 31, 2016 Commentary: Presidential Candidates and the Infrastructure Void. If more funding or assistance is forthcoming from Washington, state and local governments are likely to benefit and have federal funding to help finance major road and transportation projects. Also, if the Democrats manage to capture more Congressional seats, the party’s agenda will likely garner more support and stand a better chance of passage.
Assuming today's voter polls prove accurate, we anticipate that a Clinton Presidency will make a very concerted effort at the outset to engage Congress in a serious dialogue regarding taxes and spending initiatives. Her plan for imposing higher marginal rates on the richest Americans would bolster the tax-exempt market. Investors subject to the highest marginal federal income tax rates would benefit further from the ownership of tax-exempt securities. Higher individual income tax rates are generally good for municipal bonds since the tax-exempt rate of interest paid on the securities can be maintained at a lower percentage of taxable bond interest rates.
Financial markets do not like uncertainty, which translates to volatility. During the weeks ahead the unknowns will diminish. Investor insecurity should subside and the current spate of municipal bond issuance will abate significantly by the end of November. SMC believes today’s unsettled environment may provide an opportunity to purchase bonds at the best yield levels in six months. Our recommended portfolio structure seeks higher coupon (4% to 5%) bonds bearing short or intermediate maturities. The recent reconfiguration (steeper slope) of municipal interest rates and bond maturities supports our view that portfolio performance maximization may accrue to bonds having the most “roll-down” potential – increase in security value as time-to-maturity decreases.
The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management ("SMC FIM"), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.
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