Municipal Bond News 4/3/23

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Municipal Bonds Rally…Higher Recession Odds…Inflation Moderates…Lost Decade for Global Growth, World Bank… Chicago Board of Education Bonds Upgraded…Illinois Earns Fitch Positive Outlook…Connecticut Surplus Grows…Largest Underwriter Cuts Municipal Bond Supply Forecast…

Municipal Bonds Rally…The Federal Reserve nearing the end of its rate hike cycle, and a ‘flight-to-quality’ caused by banking system concerns has boosted the prices of municipal bonds. State and local government bonds are considered a haven asset, with an ultra-low default rate and overall high credit quality. Municipal bonds offer significantly higher long-term yields relative to comparable U.S. Treasuries. Long- term top-rated municipal bonds offer taxable equivalent yield 5.2% for high tax-bracket investors, about 170 basis points more than comparable U.S. Treasury bond yield. Demand for tax-exempt bonds has picked up, and outflows from municipal bond mutual funds have abated. This year, states and local governments have issued 23% fewer bonds than a year ago. Shortage of bond issuance in the primary market has also contributed to higher bond prices. Municipal bond prices gained 2% last month, bucking the trend of seasonal weakness in Spring. The $4 trillion municipal bond market had its strongest March performance since 2008.

Higher Recession Odds…“I think the recession is here in a few months,” acclaimed bond expert Jeffrey Gundlach suggested last week that the Federal Reserve is near a fork in the road. Either the Federal Reserve can continue raising rates to tackle painfully high inflation before it takes root, or can cut them to stabilize ailing lenders. “You can’t have it both ways. You can’t have your cake and eat it too,” Gundlach told CNBC. Market conditions and stringent lending by banks already appear to be helping the Fed cool off inflation, he suggested. Regional le nders are now beginning to turn off the flow of credit to local businesses. It is only a matter of time before the economy starts to contract. Goldman Sachs economists reckon reduced credit availability will be headwind that helps the Fed keep growth below potential, not a hurricane that pushes the economy into a recession and forces the Fed to ease aggressively. Goldman Sachs has raised the odds of a U.S. recession in the next year to 35%, while a Bloomberg survey of 48 economists assigns 65% chances of the economy backsliding on credit woes. Reduced credit access, and higher borrowing costs bring a greater chance of a hard landing for the U.S. economy.

Inflation Moderates…Prices increased 5% in February from a year ago, down from 5.3% annual pace a month ago. The Fed’s preferred inflation gauge, personal consumption expenditure (PCE) index increased 0.3% in February, a smaller hike than January’s 0.6% price gain and lower than expected. The annual rate of headline price gains in February is the lowest since October 2022. Core prices, which exclude volatile food and energy prices, rose 0.3% from a month earlier, lower than consensus forecast.

Lost Decade for Global Growth, World Bank…Across the world, a structural growth slowdown is under way, the World Bank said that the war in Ukraine, COVID-19 pandemic and high inflation compound existing structural challenges. An aging workforce, weakening investment and slowing productivity could drag global economic growth in the 2020s to the lowest in three decades. Global growth from 2009 to 2018 averaged 2.8% a year, compared with 3.5% in the prior decade. World Bank expects global growth to slow to 1.7% in 2023. High inflation has raised the risk for a worldwide recession.

Chicago Board of Education Bonds Upgraded…Last week, S&P upgraded the Chicago Board of Education bonds to ‘BB+’ from ‘BB’. Operating surpluses in the last few years and stronger reserves led to the rating upgrade. The upgrade also reflects improved liquidity and reduced reliance on short-term cash-flow borrowing. The board’s financial position has continued a positive trajectory, bolstered by substantial federal stimulus funds, as well as Chicago’s outperforming property tax collections. Illinois’ own stabilized fiscal position, leading to stronger state revenues than forecast, will continue to lend stability to the nation’s third largest school system. Rising expenses, an upcoming teachers’ contract in 2024, a large, underfunded pension liability and enrollment declines are pressures for the speculative grade rated school system. This year, Chicago Board of Education expects to issue $600 million general obligation bonds secured by pledged state school aid.

Illinois Earns Fitch Positive Outlook…Fitch raised its outlook on Illinois general obligation to positive from stable. Strong commitment to material fiscal improvements led to the positive outlook. Illinois’ decisions earlier this year to pump more funds into reserves, pay off its federal unemployment trust loan were followed by the unveiling of a budget that “maintains the fiscal momentum with a supplemental pension contribution of $200 million, defeasance of $450 million in outstanding tobacco settlement bonds, and ongoing commitments to add to reserves,” Fitch added “Collectively, the moves suggest the state’s recent fiscal improvements are becoming increasingly embedded in its decision-making.” Fitch’s ‘BBB+’ rating reflects operating performance that is adequate but well below other states, a long record of structural imbalance primarily related to pension underfunding and recent incremental steps toward more sustainable budgeting practices. Moody’s and S&P have both recently lifted Illinois’ rating to the single ‘A’ category. Favorable rating actions have narrowed the additional yield bond investors demand from the lowest-rated U.S. state.

Connecticut Surplus Grows… Budget reserves and pension funding are poised to grow. A larger-than- expected surplus of $1.4 billion comes from budget outperformance. Connecticut has collected $900 million more than expected and spent $244 million less than budget in the current fiscal year. State budget reserves could have $6.6 billion by June, or about 30% of general fund spending. State law caps reserves at 15% of spending, the remainder will boost pension contributions.

Largest Underwriter Cuts Municipal Bond Supply Forecast…Bank of America, the largest underwriter of state and local government bonds, has cut its forecast for 2023 municipal bond issuance by 25% or $100 billion. The lower estimate follows a similar dip in actual first quarter bond sales. In the first quarter of 2023, $75 billion of municipal bonds were issued, down from $100 billion a year ago. The downtrend in bond issuance began in 2022, which saw 21% fewer bond sales than 2021. Typically, April sees the lowest bond issuance of the year.

Compare 30-Year taxable U.S. Treasury yield 3.68% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.40%; “AA” 3.77%; “A” 4.31%. For investors in the 35% tax-bracket, a 3.5% tax-exempt yield is equivalent to a 5.38% taxable yield. Top-rated long-term tax-free bonds yield 92% of comparable taxable U.S. Treasuries.