First-Quarter 2018 Munis: Challenging

The first quarter of 2018 was a wobbly one for municipal bonds. Supply, as we know, was taken from this quarter and moved up to December of 2017 in order to beat the tax bill. Most of this “moved up” issuance was in the form of advance refunding issues (which were not allowed under the new tax law) and private activity bonds (which ended up being allowed). The result was a December with over $65 billion of issuance – a record. It did not hurt markets, as retail and institutional investors snapped up supply, aware that there would be a dearth of offerings come January.

Both Treasury scales and tax-free scales moved higher during the quarter:

 

The rise in yields earlier this year was due in part to the bond market’s catching up to offer competing yields with stock markets, and munis did move up smartly in January. Of the 30-basis-point rise in long yields, half happened in January and the other half in the six weeks since February 1. So the upward movement of yields has slowed down.

We continue to emphasize a “barbell” approach on the muni side because of its relatively steeper yield curve.

 

The muni yield curve has almost always been steeper than the Treasury yield curve. Often it is a function of the different segments of buyers in the muni universe, with banks and insurance companies being segmented in the “belly” of the yield curve and bond funds and individual accounts being traditionally longer-term buyers. We think the longer end has offered an extra yield premium because of the volatility associated with bond funds in the longer end of the market – think the taper tantrum of 2013 and the Trump sell-off in late 2016 as the latest iterations of this volatility. We remain hopeful that muni bonds will be included in the new definition of high-quality liquid assets. (See last week’s commentary: “A Short Note on Bank Muni Holdings” – http://www.cumber.com/a-short-note-on-bank-muni-holdings/). Assuming Congress passes this measure, the development should spur on municipal bond demand in the belly of the curve and potentially longer.

Many bonds in the A and AA categories are trading at yields substantially higher than the corresponding US Treasuries. We believe this cheapness eventually evaporates as short-term yields move higher and the economy continues to return to “normal” – in other words to an economic environment akin to the one we experienced before the financial crisis: a Fed that is raising short-term interest rates because the economy is growing, employment expanding, and companies prospering. In the 2004–2006 period when the Fed raised short-term interest rates, long-muni/Treasury yield ratios declined from over 100% to approximately 85%. We believe this should happen again, partly because only about 75-80% of the rise in a Treasury yield is needed to approximate the same rise in the taxable equivalent yield of a municipal bond, and partly because the drop in supply should eventually work into lower ratios on a long-term basis.

The forward calendar visible supply has moved higher in March, as depicted below.

 Municipal Visible Supply

 

So far 2018 has been marked by a supply drop, with total municipal bond issuance down through the first two months of the year from $59.4 billion in January-February 2017 to $36.5 billion this year. This reduction in supply did not keep prices from being volatile in January. The lack of supply ($17 billion in January 2018 – down from $36 billion last year) meant that most prices (as marked) on municipal bonds were essentially moved down because of the rise in Treasury yields during January. The ten-year Treasury rose from 2.41 to 2.70 during January, and the lack of municipal issuance meant that evaluators used the change in Treasury prices to change muni prices and clearly overreacted. Since that time we have seen municipals perform better as supply has picked up and evaluators have had a sufficient amount of municipal bond trades to be able to base muni pricing on movements in municipal bonds, not Treasury bonds.

John R. Mousseau, CFA
Executive Vice President & Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Here’s why muni-bond demand could get a lift from bank legislation

Excerpts below:

As municipal bondholders continue their struggle to make sense of last year’s tax legislation, Congress is set to knock down one argument against participating in the $3.8 trillion market.

Investors are expecting the Senate to pass a bipartisan bill that would include municipal debt in the coveted category of high-quality liquid assets as part of a bid to roll back some elements of the Dodd-Frank law put in place after the financial crisis. The proposed legislation would stoke appetite for municipal bonds among banks, steadying a market still reckoning with the recent tax cuts.

“It takes one of leg of the argument against the muni market as it goes through a shake-up,” said John Mousseau, director of fixed-income strategy at Cumberland Advisors.

“Why wouldn’t you want better credit collateral than you’re getting with existing legislation on corporation debt,” said Mousseau.

Moreover, municipal debt could hold good value for banks with extra cash. The yield difference between municipal bonds and comparable Treasurys have widened, with the tax-free yield on a 10-year municipal bond slipping to around 85% of the taxable yield on a 10-year Treasury TMUBMUSD10Y, +1.32%   for most of this year, well below the 95% seen in early 2017. A lower ratio implies munis are cheaper relative to Treasurys.

Though the revamped bank legislation should boost their investment in municipal paper, its unlikely to return Wall Street to their previous role as the linchpin of the market.

Nonetheless, Mousseau says the bill, if passed, is an under-appreciated step that could prove a boon to smaller financial institutions and commercial banks that have few avenues for long-term investments.

Read the full story here: MarketWatch




A Short Note on Bank Muni Holdings

The Wall Street Journal had a story on the front page of the “B” section Wednesday morning about banks getting some relief with regard to counting municipal bonds among their “liquid assets.” On Tuesday the Senate voted to formally debate a bill containing that provision, and it should have enough Democratic support to pass. The debate over this issue has been going on for some time, and we wrote about it in 2015 (http://www.cumber.com/hqla-and-lcr/).

We always thought it was a mistake on a number of fronts that munis were left off the list of high-quality liquid assets (HQLA). First and foremost is the importance of banks in the marketplace. Because of the tax exemption, banks have been buyers of tax-free municipal bonds for years. The level of taxation on municipal bonds clearly has an effect on banks’ decisions to own tax-free or taxable debt. So changes in the tax structure are one input into the buying decision. The banks’ book (purchase) yields are another input, and the designation of bonds as either “available for sale” or “hold to maturity” is another input. (Without getting overly complicated, the distinction is that realized gains or losses from “available for sale” bonds flow into the income statement, while bonds in the second category are generally held to maturity and recorded at cost.) However, one of the most important purchase considerations is the generally high credit quality of the overall municipal bond market. Moody’s publishes a study that is updated approximately every two years in which it compares municipal bond and corporate bond default rates by rating categories over a ten-year period. In the last report, for 2016, in the broadest category, “A”-rated municipal bonds had a cumulative default rate over ten years of .07%, while that of corporates (globally) was 2.22%. While both numbers are low, the corporate default rate is 31x that of municipals in the “A” category. If you look at the numbers cumulatively, including AAA to A, the default rate for munis is .09% in total and 3.38% for corporates. In this case the corporate default rate is 37x that of municipal debt, which implies that there is higher event risk in corporates (e.g., in high-quality bonds subject to the stress of takeovers).

The fact that high-quality corporates were included in the 2014 bill as high-quality liquid assets but municipal bonds were not has always stuck in our craw. General Electric was rated AAA by Standard & Poor’s up to 2009, when it lost its gilt-edged credit status and is now rated A, yet the State of Maryland has been a AAA credit before, during, and since the financial crisis. Our point is that on a credit quality basis municipals have outshined corporates for many years and in most cases have provided better taxable-equivalent, risk-adjusted yields for banks. Why would regulators be prejudiced against the muni credit? Our thought is that lobbying by state and local governments was lacking four years ago when these regulations were first promulgated. And there tends to be inertia among banks to modify rules once regulations are in place. But make no mistake; this new bill is a winner for banks and a winner for the muni bond market. Banks may have a lower tax rate but that will not necessarily disturb higher purchase yields. And the fact that munis should be able to be counted as high-quality liquid assets will further cement their part in banks’ portfolios. Indeed, this bill will help Congress put the “quality” into the “high-quality” designation.

John R. Mouseau, CFA
Executive Vice President & Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.