The arrival of summer highlights an interesting development in the municipal market: outstanding bonds will be retired at a faster pace than the issuance of new securities. During the months of June, July and August, the municipal market should benefit from this favorable technical condition. Historically, the three-month period beginning in June has been the heaviest of the year in terms of maturities and bonds called for redemption. The trend continues this year: $125 billion of municipal bonds will be redeemed next month, eclipsing the prior record for June set in 2015, when $117 billion in bonds were called or matured. While the anticipated amount of redemptions has been known by the market for some time, the forecasted decline in new issuance in the period ahead might have been a surprise. This supply/demand technical is suggesting fewer bonds for reinvestment. The chart below highlights this fact. Bond redemptions (maturities plus calls) will exceed new issuance by nearly $40 billion over the next three months. This represents a significant departure from the same time period in previous years, when new issuance exceeded bond redemptions by over $27 billion (2016), and less than $2 billion in 2015.
|Total Net Issuance||1.8||27.2||-39.6|
Inclusion of the impact of coupon payments adds to investors’ cash hoard. Compared to last summer, investors will have five times as much capital for potential reinvestment this year, and twice as much as in 2015. While the amount of coupon payments approximates prior years’ totals, this year’s negative net issuance is much higher and highlights the excess cash available to municipal bond investors.
|Total Net Issuance||1.8||27.2||-39.6|
|Net Cash to Invest (Coupon Payments- Total Issuance)||41.6||16.7||83.6|
With fewer bonds available, we expect the municipal market will continue to perform favorably versus taxable alternatives. Year-to-date, the Bloomberg Barclays Municipal Bond Index has returned 3.94% through May 31, compared to 2.04% for the Bloomberg Barclays U.S. Treasury Bond Index.
An additional factor backing the municipal market’s better relative performance has been the steady flow of new money into the municipal asset class. A useful proxy of investor demand is the weekly mutual funds flow of funds data provided by Lipper Analytics. Municipal funds have recorded eight consecutive weeks of positive inflows. If the trend continues, cash-rich investors could push market prices higher while the supply/demand imbalance expands.
The decreased supply of bonds combined with consistent investor demand has already decreased the relative value of municipal bonds compared to U.S. Treasuries. Evidence is most pronounced in the intermediate maturity range. For example, a ten-year “AAA” municipal bond can be purchased currently at a yield of approximately 1.90%, or 86% of the 10-yield Treasury yield of 2.20%. Municipal bond relative value has decreased. Over the trailing twelve months, the yield ratio (municipal yield/Treasury yield) has averaged 93%.
Diminished expectations for individual tax reform could be partly responsible for the market’s most recent upswing. While SMC FIM has held the view that tax reform would ultimately prove to be inconsequential to the municipal market, others have maintained the opposite opinion and assumed that tax reform legislation would move quickly through the Republican-controlled Congress. The prospect of reduced income tax rates is often mistakenly expected to be detrimental to tax-exempt asset returns, since yields would have to increase in order to compensate for lower income tax rates. Historically, tax rate changes have proven to have little impact on tax-exempt interest rates.
As the outlook for significant near-term tax reform diminishes, we think that retail and institutional investors, who are waiting on the sidelines for a tax plan to emerge, will have to reconsider. In recent weeks the odds for significant tax reform have weakened. Maintaining the status quo on individual taxes, combined with a strong technical municipal market, we believe supports our constructive market outlook. We do not anticipate any meaningful market price deviation through the summer months. Recent trading activity suggests investors are more comfortable today investing in fixed income securities compared to any time since last November’s post-election sell-off.
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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