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Dwindling Supply A Headwind for Higher Municipal Yields…In September and October, states and locals sold 40% fewer municipal bonds compared to the same period last year. Low municipal bond supply is forecast for the near-term. Less than $5.8 billion new muni sales are on the 30-day calendar, a 50% drop from last year. January is typically a low-supply month. This year’s municipal bond supply is 17% below last year. Wall Street firms are slashing their municipal bond supply forecasts. Higher yields draw in buyers. However, the light supply could be a headwind for higher muni bond yields. Low supply versus high demand could prevent muni yields from moving higher as the Fed hikes rates.
Municipal Bond Yield Could Fall in 2023 Says Bank of America…Municipal bond yields could fall by about 100 basis points in 2023 per Bank of America strategists. “Next year looks much better as peak muni rates are either already available, or if not, soon,” BofA strategists expect 10-year top-rated municipal bond yield to drop to 2.2% and 3-year to 2.85% by the end of next year based upon the fed-funds rate not materially exceeding 5%. Supply/demand conditions should be much stronger even before the Fed wraps up its tightening program if mutual funds outflows slow down and turn around.
Rate Hikes Have “A Way To Go”…Willing to err on the side of “overdoing” rate hikes to lower inflation that has become “more and more challenging over the course of this year” Fed Chair Powell said that rate hikes have “a way to go.” The Fed is hiking rates at the fastest pace since the early 1980s. It has raised interest rates by 3.75% this year. Financial conditions have tightened significantly with rate hikes, particularly for the most interest-rate sensitive sectors of the economy, such as housing, Powell explained “That’s why we say in our statement that in determining the pace of future increases in the target range, we will take into account the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation.”
Powell Hints Slower Rate Hikes...The pace of rate hikes is no longer the Federal Reserve’s most pressing concern. The bigger question is how high to raise rates and how long to keep monetary policy restrictive. Powell stated that at some point it will become appropriate to slow the pace of rate hikes. “So that time is coming, and it may come as soon as the next meeting or the one after that. No decision has been made. It is likely we’ll have a discussion about this at the next meeting – a discussion,” responded Powell when asked if slower rates could be expected in December. The Fed seeks a ‘sufficiently restrictive’ monetary policy and its principal focus is how high to raise rates and how long to keep monetary policy restrictive. With smaller rate hike increments, it could take longer to get to peak fed-funds rate.
Higher Peak Fed-Funds Rate…Futures markets estimate that fed-funds rate could exceed 5% by mid-2023. Noting uncertainty, the Fed steered away from providing its latest estimate of how high rates could go. Any updated Fed estimate might have been higher than Fed officials’ median September estimate of a 4.6% peak fed -funds rate, given recent strength in the labor market and high inflation readings Powell added “To the extent rates have to go higher and stay higher for longer, it becomes harder to see the path” that avoids a recession.
Recession Warning Signs…Particularly sensitive to fed-funds rate hikes, the two-year U.S. Treasury yield jumped to 4.8%, the highest since 2007. The two-year note yield exceeded the 10-year note yield by as much as 58.6 basis points, last seen about forty years ago when then-Fed Chair Paul Volcker’s rate hikes to break inflation tanked the economy. Curve inversions have a track record of preceding economic downturns by 12 to 18 months. Another slice of the yield curve, the difference between three-month yields and where they are expected to be in 18 months’ time, is also near inverting. Powell has said the Fed favors that spread as a predictor of conditions that could lead to rate cuts.
PREPA Debt Plan by December 1…Judge Swain will not put up with more delays to PREPA debt plan. Should the debt plan not be received by December 1, Judge Swain warned “Every possible way of reacting to that will be on the table.” The mediation team is in talks while litigating how much of Prepa’s revenue bondholders are entitled to. “Creditors have been kept waiting, but more importantly the people of Puerto Rico have been kept waiting,” mediator Judge Shelley Chapman said added “It’s just gone on too long.” Pushing for a June-2023 confirmation for Puerto Rico debt plan, Judge Swain stressed “I want to see momentum here,” she added “I want to see real engagement and momentum toward June.”
Tax Hikes For Transit Likely…“If it makes it to the ballot, voters overwhelmingly support public transit – we’ve seen this over and over again.” Nationwide, 31 ballots will ask voters to raise taxes for transit-related spending. Last year, all eleven transit measures got the green signal from voters. Orange County, Florida officials are asking voters to consider a one-cent sales tax increase to fund a $12 billion upgrade to roads, bridges and transit over twenty years. Wayne County, Michigan is seeking renewal of property tax measures to fund regional transportation. Cities are keen to leverage federal infrastructure funds with taxpayer money. Transit measures have a strong track record of voter approval.
Fewer Insured Municipal Bonds…The volume of insured municipal bonds sold in the primary market during the first three quarters of 2022 has dropped by a fifth this year. About 7.8% of new bonds issued in the primary market carry bond insurance, down from 8.6% a year ago. Build American Mutual has seen its market share grow to 43.8% this year, up from 39.9% last year. Assured Guaranty’s market share slid to 56.2% from 60.1% last year. Build America Mutual has seen “consistent demand for insured bonds due to the ongoing volatility in the market, which highlights the advantages of high-quality, insured bonds as a tool for value preservation in both retail and institutional portfolios.” Top bond insurer, Assured Guaranty said it believes investors see its guaranty on high-quality credits as a mitigant of downgrade risks. Lower bond supply in the primary municipal bond market has echoed through the insured municipal bond sector. ‘Peace-of-mind’ that comes with insured bonds becomes increasingly important to investors when recession fears loom.
Compare 30-Year taxable U.S. Treasury yield 4.20% to 30-Year tax-exempt muni bond yield “AAA” 4.13%; “AA” 4.70%; “A” 5.23%. For investors in the 35% tax-bracket, a 5% tax-exempt yield is equivalent to a 7.69% taxable yield. Top rated long-term tax-free bonds yield 98% of comparable taxable U.S. Treasuries.