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Municipal Bond Losses…September-22 became one of the worst months for municipal bonds in two decades. State and local government bonds lost 3.8% in September, the biggest monthly decline since September 2008. Municipal bonds have lost 12% this year, relative to 13% losses in U.S. Treasury bond indices. The credit quality of municipal bond issuers remains robust. “To be fair, the muni market itself does not appear to be the issue,” Bank of America muni strategists said. The Federal Reserve is slated to hike rates by another 1.25% in 2022, even at the risk of triggering a recession. The rout in bond prices has brought higher tax-free yields. Top-rated tax-free bonds yield close to 4% tax-free, equivalent to a 6.15% taxable yield for high tax bracket investors. Yields on tax-free bonds are hovering near their highest since 2011.
‘Cross-Over’ Investors Favor Tax-Free Bonds…Municipal bonds’ attractive yields are enticing ‘cross-over investors’ that tend to invest in taxable bonds. Cross-over investors, usually banks, insurers, pension funds and foreigners do not value tax-exemption offered by municipal bonds, but are driven by the higher yields offered by state and local government bonds relative to U.S. Treasury bonds. Currently, tax-free municipal bonds offer 107% of taxable U.S. Treasury bonds. “They haven’t come back in force yet, but they are interested,” Vanguard’s municipal bond head explained that cross-over buyers are often first movers, driving recovery from selloffs, and are often followed by retail investors, the largest buyers of municipal bonds. Cross-over buyer purchases drove a short-lived municipal bond rally in late May to early June, and another similar recovery is possible, Vanguard’s muni chief said “All the pre-conditions are there for a snapback.”
Municipal Bond Supply Slump…40% fewer municipal bonds were issued in September relative to prior month. September municipal bond supply is the least in two years. The slump in primary market issuance defies the historical trend of higher supply in September. Higher interest rates are leading states and locals to hold back on issuing new municipal bonds. Refinancing bond deals, a major portion of prior year bond sales, are no longer viable given high interest rates. Volatile market conditions have led a few states and cities to cautiously ‘time’ a bond deal. So far this year, 15% fewer municipal bonds have been issued.
August Prices Higher…A key inflation gauge, PCE price index, is higher than expected. In August, the PCE index rose 0.3% from prior month, and is 6.2% higher than a year ago. Excluding volatile food and energy, ‘core’ PCE index is 4.9% higher than a year ago, still a long way from the Fed’s 2% target. However, Americans expect inflation to ease over the long term. Prices are expected to climb at an annual rate of 2.7% over the next five to ten years, the lowest in eighteen months per a University of Michigan survey, which added “Inflation expectations are likely to remain relatively unstable in the months ahead, as this uncertainty is unlikely to wane in the face of continued global pressures on inflation.”
Central Bankers Mull Global Recession Risks… It is “quite likely that inflation is near peaking and perhaps may have peaked already,” Susan Collins, a newly appointed voting member on the Federal Open Market Committee added “A significant economic or geopolitical event could push our economy into a recession as policy tightens further.” Fed officials are beginning to weigh the Bank of England’s move towards quantitative easing. Higher U.S. interest rates have fueled a strong appreciation of the U.S. dollar against other currencies. “We’re going to set monetary policy that is appropriate for the U.S. economy, but we don’t set it in a vacuum thinking that we’re an independent island and we’re not connected to the rest of the world,” Cleveland Fed President Loretta Mester said. “I don’t think it’ll be appropriate for us to continue to tighten and increase your rates until inflation gets to 2%,” Atlanta Fed President Raphael Bostic said last week. “That will be guaranteeing that we’ve gone too far and we’ll take the economy into a negative space.
PREPA Debt Plan by December 1…Puerto Rico’s electric utility must file a debt plan by December 1, 2022. The court ordered a three-pronged approach which includes litigation, mediation, and plan of adjustment development. Litigation will likely focus on how much of the power utility’s revenue bondholders are entitled to. This includes the issue of bondholders’ perfected security interest in utility revenue, and ‘whether bond obligations are non-recourse to PREPA’s general assets’. Judge Swain has steered away from bondholder calls to put a receiver at PREPA and seeks confirmation hearings to be held in June 2023. Meanwhile, Luma Energy has reported that 80% of power outages from Hurricanes Fiona have been restored. Luma Energy is slated to face questions on its management of the Island’s electric grid from U.S. House lawmakers this month.
Hurricanes Ian, Fiona Rack Up Costs…Up to $100 billion of damage from Hurricane Ian, could make it among the more costly natural disasters of recent years. Florida alone could suffer $45 billion to $55 billion from Ian’s wreckage, with substantially lower damages in the Carolinas Moody’s estimates. Hurricane Fiona, a Category 1 storm that hit Puerto Rico recently, possibly dealt less destruction than Hurricane Maria, which was a Category 4 when it made landfall on the Island in 2017. President Biden’s designation of Hurricane Fiona-hit Puerto Rico as a major-disaster zone and a statewide emergency declaration in Hurricane Ian-hit Florida will allow federal disaster aid to flow. Rebuilding with federal and insurance money mitigate the economic impact of the storm. Florida’s strong demographic and economic fundamentals are likely to support vigorous post-storm rebuilding, as in prior hurricane events in the state. In Puerto Rico, lawmakers are seeking close to $3 billion this year for disaster relief. Historically, Congress has provided emergency supplemental funding after major natural disasters, and did so in the wake of Hurricanes Katrina, Rita, and Wilma in the summer of 2005, following Hurricane Sandy in 2012, and after Hurricanes Maria, Harvey, and Irma in 2017.
New Jersey Earns Another Outlook Boost…Moody’s lifted its outlook on New Jersey to positive from stable, while affirming its rating at ‘A2’. The favorable rating action comes on the heels of S&P’s outlook boost last month. “The state’s improved reserves position it to better withstand potentially less favorable economic and revenue trends in the year ahead.” Moody’s said. New Jersey’s unfunded pension obligations are among the highest in the nation. New Jersey won accolades from rating agencies for paying down billions of dollars of bond debt and starting to make annual pension contributions after nearly 25 years. Governor Phil Murphy said the outlook boost is “further proof that the steps we’ve taken to right our fiscal ship have led to real progress.” All rating agencies carry a positive outlook on New Jersey.
Compare 30-Year taxable U.S. Treasury yield 3.68% to 30-Year tax-exempt muni bond yield “AAA” 3.94%; “AA” 4.60%; “A” 4.99%. For investors in the 35% tax-bracket, a 5% tax-exempt yield is equivalent to a 7.7% taxable yield. Top rated long-term tax-free bonds yield 107% of comparable taxable U.S. Treasuries.