Head - Fixed Income Strategy
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Longer-dated munis have seen yield ratios drop but opportunities still exist.
US municipal bonds continue to produce extraordinary performance this year, relative to other high quality, taxable fixed income assets. Indeed, muni benchmark returns have managed to crawl back to being flat on the year, despite higher US Treasury yields. After reaching the lows on performance in April, US munis have since returned 1.7%, outperforming US Treasury debt by 70bp. More notable, has been the muni markets ability to outperform high quality taxable high yield bonds. BB-rated high yield corporates have only managed to produce 50bp of return between April-July.
A supportive technical backdrop continues to defined the US muni market, despite a recent pick-up in new issuance. However, gross issuance is still down 17% versus 2017, and net issuance is expected to remain negative all year. Technicals in July and August are also expected to be relatively more significant, as redemptions from matured, pre-refunded or called bonds total nearly $100 billion. This has helped maintain fairly robust trading volumes, despite summer months which are typically classified as slower, and less liquid.
Flows in muni bond funds also remain strong, as July saw its strongest monthly inflow since January. Indeed, the week ending July 18 saw an inflow of $1.2 billion, the largest weekly inflow since April 2017. Bond funds have now accumulated $4.5bn in AUMs since May, and $8bn for the year.
The combination of strong demand and relatively weaker supply has weighed on Treasury yield ratios. Most notably on the short-end, where 2-year ratios at 60% are near their lowest levels since 2014. Short-end yields have moved meaningfully lower, falling 40bp to 1.6%, after reaching its highest levels since 2008.
The richness in short-end muni yields has also increased the value proposition for US T-Bills, as taxable-equivalent yields in high quality munis are somewhat comparable. Even yields on VRDN (variable-rate demand notes) have fallen on strong demand, with the SIFMA Municipal Swap Index yield dropping to 0.95%, its lowest level on the year.
Longer-dated munis have also seen yield ratios drop some over the last month, however, opportunities still exist. As we discussed in Outlook 2018, US tax reform would likely alter the relative value proposition for banks and insurers. With the US corporate tax rate dropping to 21%, tax-exempt munis have become less attractive for these investors. Considering their preference for longer-dated bonds, some banks have begun reducing their muni holdings, adding pressure to the long-end of the muni curve. As a result, muni yield curves have steepened, despite a flatter US Treasury curve.
With the muni curve steeper by 100bp, we think the long-end weakness presents value for North American investors, in high tax brackets. However, long-duration exposures should still be managed appropriately. Barbell strategies are likely the best portfolio approach, despite the higher (and less attractive) valuations on the front-end. Or, investors could consider extending duration to the 10 to 15-year part of the muni curve, where you can still pick up 80% of the curve steepness, with 50% less duration risk (vs. 30yr debt).