Keeping You Informed: Municipal Commentary
Continued apathy in the tax exempt market carried over from the first quarter, and the lack of volatility created a difficult trading environment for dealers. Market participants are still adjusting to changes in the tax exempt market following the tax reform bill from last year that introduced numerous changes to the tax code and the tax exemptions on certain issuers. This period of price discovery should continue for some time and, coupled with the Federal Open Market Committee (FOMC) raising short-term interest rates, could add to some market ambiguity.
- Supply demand imbalance kept the muni/treasury ratio lower for the quarter compared to historical averages.
- Municipal bond performance experienced the largest first quarter loss in over 20 years as expectations of interest rate hikes drove negative performance.
- The Supreme Court handed down two credit-meaningful decisions benefiting state and local governments.
Supply Demand Imbalance
The second quarter had municipal bond buyers struggling to find paper as money continued to flow into muni mutual funds and the new issue market lagged previous year totals. June and July represent two of the largest months for coupon payments and bonds maturing for the year, so cash in client accounts tends to build up this time of year. In addition, Lipper has reported inflows into mutual funds for the past eight consecutive weeks, further adding to the demand side for municipals. Supply has not kept up with this increased cash, with new issuance coming in at a four-year low through May. Some of this can be traced back to changes in the tax bill that eliminated the ability of muni issuers to advance refund (pre-refund) older dated debt. The supply demand imbalance has kept the Muni/Treasury ratio lower for the quarter compared to historical averages.
The first quarter of 2018 saw the largest first quarter loss in over 20 years as expectations for interest rate hikes from the Federal Reserve drove negative performance. Most of the negative performance was seen in January, followed by a curve flattening trade that continued through the balance of the first half of the year. The yield curve 10 years and longer held mostly steady for the next five months despite the FOMC telegraphing multiple hikes in the short-term funds rate.
For the second quarter, municipal bonds saw positive performance at all points on the curve, with the best spots being the seven year and longer returning between 0.90% and 0.97%. Improved performance for the quarter helped bring performance positive year-to-date on the front end of the curve, but the long end still has room to go to get back to even. The one year Bloomberg Barclays Index is the best spot for the year at 0.97%, and the 10 year Bloomberg Barclays Index is the worst performer at -0.72%.
Supreme Court Decisions
In two small, but credit-meaningful decisions, the U.S. Supreme Court handed down victories for the states that could have far-reaching impacts. The first, Janus v. AFSCME, found that mandatory union fees violated the First Amendment and thereby weakened public sector unions. The impacts could be seen in labor relations and union membership that will benefit state and local governments. The second ruling held that states can require online retailers to charge sales tax on purchases. In South Dakota v. Wayfair, Inc., the Court handed states a credit-positive ruling, especially for states reliant on sales tax collections.
An improving credit story for state and local governments and projected light new issuance for 2018 sets munis up for the potential for positive performance. The obvious objection to that argument would be a more aggressive FOMC and a steeper yield curve. Only time will tell, but we would expect to see the curve flatten as the market continues to adjust to the 2017 tax code changes and attempts to establish new equilibrium levels on ratios to Treasuries. Macro issues continue to hold the markets attention, with tariffs and trade dominating most headlines of late.