Week of 8/1/2022

Muni Bonds Rally…Recession Alarm Rings Louder… Pace of Fed-Funds Rate Hikes…Puerto Rico Tax Collections Outperform…PREPA Debt Talks Extended…“Inflation Reduction Act”… Emerging Demand For Municipal Bonds…

Muni Bonds Rally… The second half of 2022 kicks off on a positive note, with five straight weeks of positive returns for municipal bond market. Last month, municipal bonds had the best showing since May 2020. High yield municipal bonds outperformed with 3.5% gains last month, exceeding overall municipal bond market’s 2.5% index return. The gains come on the heels of a Treasury bond rally. Benchmark 10-year Treasury yields fell 85 basis points last week to 2.6%, down from a peak in June. Longer dated Treasury bonds yield about 40 basis points lower than a June peak. A ‘flight to safety’ spurred by loud recession warnings drives investors towards Treasury bonds. Municipal bond yields declined between nine and nineteen basis points last week. Municipal bond yield changes tend to lag Treasury yield changes. The recent rebound is partly fueled by seasonal spike in principal and interest repayments to municipal bondholders, that leads to elevated re- investment demand in mid-summer. July supply of new municipal bonds issued in the primary fell 32% from a year ago. Many municipal bond issuers held off on borrowing plans amid higher interest rates. Meanwhile, retail investors are beginning to take advantage of municipal bonds’ higher yields, while they last. The $4 trillion municipal bond sector saw its worst sell-off in four decades. The recent rally has erased some losses, with municipal bond index losses at 6.5% year to date. Bond investors are looking ahead to the eventual peak of fed-funds rates.

Recession Alarm Rings Louder… A valid question about whether the U.S. is in a recession or heading towards economic contraction comes on the heels of two straight quarters of falling economic growth. U.S. economy contracted at a 0.9% pace in the second quarter of 2022, following a 1.6% GDP fall in the first quarter. Amid political agendas, the official declaration of a recession comes retroactively. It is quite clear that the post-COVID -19 recovery, that fueled inflation to forty-year highs, has ended. However, labor markets and wage growth remain strong. Residential investment fell 14% in the second quarter, and businesses cut back on inventory suggesting a dimmer outlook. Consumer sentiment, measured by the University of Michigan survey, remains near record lows. The Fed’s aggressive rate hikes have begun to put the brakes on the economy.

Pace of Fed-Funds Rate Hikes… Faced with the fastest pace of rate hikes since 1981, bond investors are looking for cues on upcoming rate hikes. After 75 basis point rate hikes at each of the last two consecutive Fed meetings, the Fed expects that “another unusually large rate rise” could be in the cards, although it “will likely become appropriate to slow the pace of increases” at some point. Stepping back from tipping their hand on detailing future hikes, the Fed will take a “meeting-by-meeting” approach on the pace of rate hikes. Latest Fed projections show that the fed-funds rate could be 3.4% by year-end and peak at 3.8% in 2023, up from a target range of 2.25%-2.50% at present. The Fed’s preferred inflation gauge, core personal consumption expenditure index (core PCE) which strips out volatile food and energy, rose 0.6% in June, outpacing prior month’s 0.3% monthly increase. On a year-over-year, core PCE is up 4.8%, reflecting the central bank has more work to do to achieve its 2% core PCE target. Suggesting the Fed is going to have to do more in rate hikes Atlanta Fed president Raphael Bostic said “Because of that we really need to address the high levels of inflation and get this economy back into a more stable and sustainable situation.”

Puerto Rico Tax Collections Outperform… The Island’s general fund revenues for eleven months ended May 2022 are about 16% higher than prior year and close to 13% more than board projections. However, May revenue is 13.7% lower than prior year, still 40% above board projections. Sales and use tax collections have outperformed. In essence, the Island collected a full year’s worth of taxes in just eleven months ended May 2022. The oversight board has often been blamed for underestimating the Island’s revenue potential. The Island’s contingent value securities would pay bondholders more if revenues outperformed estimates. Tax revenue collections, a gauge for the Island’s economy, are closely watched by the mediation team seeking to restructure the Island’s electric utility debt.

PREPA Debt Talks Extended… Talks on Puerto Rico’s debt restructuring could take a few more weeks. Judge Swain has extended a August 1 deadline to August 15, and potentially to September 9, at the option of the mediation team. So far, the board and mediators have mainly engaged with bondholders, and are now beginning to speak with labor unions, retirees and fuel lenders. “The negotiations with bondholders have understandably consumed much time and effort because of starkly different legal positions leading to starkly different economics involving bond claims approximating $9 billion,” the board added that progress has been made on the structure of new electric utility securities. PREPA has been negotiating with bondholders since 2014. By mid-August, a restructuring plan, term sheet, litigation schedule or reasons why the Title III court should not dismiss the electric utility’s bankruptcy case are expected.

“Inflation Reduction Act”… A new ‘Tax-and-Spend’ deal between Senate Majority Leader Chuck Schumer (D) and Senator Joe Manchin (D) could hike taxes for Americans. The “Inflation Reduction Act” seeks to invest $433 billion on clean energy, climate and health insurance. It would offset these costs with $451 billion in revenue raised from higher taxes on corporations and wealthy households, as well as prescription drug savings. A congressional study released by Republicans finds that taxes would jump by $16.7 billion on American taxpayers making less than $200,000 in 2023 and raise another $14.1 billion on taxpayers who make between $200,000 and $500,000. The bill known as ‘IRA’ will beef up IRS tax enforcement. The proposal, which trims President Biden’s failed sweeping tax haul agenda, could head for a Senate vote as soon as this week, and will need to pass the House.

Emerging Demand For Municipal Bonds… Returning to buy municipal bonds, investors put cash in municipal bond funds last week. So far in 2022, only four weeks have brought inflows to municipal bond funds. Rate hikes spurred a wave of municipal bond fund sales, and pummeled municipal bond prices. The first half of 2022 saw the municipal bond market’s worst return in four decades. However, a brighter second half is emerging. “In our view, the worst for the muni asset class is likely behind us, and we have already likely seen the highs for ratios and yields,” Barclays strategists wrote. Municipal bond underwriters and institutional investors including Citigroup, Nuveen and BlackRock have rosier outlooks, and Goldman Sachs is “moderately bullish” on municipal bonds. More clarity on the impact of the Federal Reserve’s rate hikes have brought cheer to bondholders. Investors are optimistic that a lot of the pain in the $4 trillion municipal bond market has already been priced in.

Compare 30-Year taxable U.S. Treasury yield 3.02% to 30-Year tax-exempt muni bond yield “AAA” 2.94%; “AA” 3.43%; “A” 3.82%; “BBB” 3.81%. For investors in the 35% tax-bracket, a 3.8% tax-exempt yield is equivalent to a 5.8% taxable yield. Top rated long-term tax-free bonds yield 97% of comparable taxable U.S. Treasuries.