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Municipal Bond Yields Hit Highs…Municipal bond yields are at multi-year highs. Benchmark tax-free yields have shot up almost 70 basis points in August. Top-rated state and local government bonds yield over 3.6% tax-free, the highest since COVID-19 related sell-off in March 2020. Back in 2020, yields fell sharply after federal aid fueled a sharp economic recovery from the COVID-19 national shutdown. This time, the uptrend in bond yields, in the making since the start of 2022, has brought volatile market conditions. Lower -rated state and local government bonds offer attractive yields that are equivalent to nearly 7% taxable yield for high tax bracket investors.
Municipal Bond Market Shrinks Amid Outflows…For the first time since 2014, the market value of outstanding municipal bonds has shrunk under $4 trillion. Bond prices have fallen for much of 2022, by an average of 11 cents on the dollar per MMA research. Investors have liquidated over $83 billion of municipal mutual fund investments in the first eight months of 2022. Investors briefly resumed putting cash into tax-free bonds for a few weeks during the summer when bellwether yields fell, but reversed course upon prospects of steeper rate hikes.
Bellwether Bond Yields Climb…10-year United States Treasury yield jumped to 3.49%, after falling to near 2.7% in early August. Higher than expected August inflation and Fed officials’ clear intent to “keep at” rate hikes has driven bond yields higher. Short-term bond yields, most sensitive to Fed-funds rate hikes, have risen to multi-year highs this year. However, longer maturity yields have risen less as investors foresee the need for lower rates in the future. Prospects of an economic slowdown are driven by higher odds of a 4.5% terminal fed-funds rate next year. The Conference Board forecasts that economic weakness will intensify and spread more broadly throughout the US economy in the second half of 2022, and expects a recession to begin before the end of the year. Investors reckon that higher rates could eventually lead to an economic recession, slower inflation, and allow for an eventual shift in monetary policy.
High Inflation Defies Expectations…August core prices, which exclude volatile food and energy, rose 0.6% in August, twice the forecast increase. Headline CPI climbed 0.1% from July, overturning expectations of a 0.1% drop. Higher August prices come after prices were mostly level in July relative to the prior month. From a year ago, August CPI is 8.3% higher, exceeding 8.1% forecast. The CPI surge comes despite a 10% drop in August gas prices, which are still elevated at about 25% higher than a year ago. Food, shelter, medical care and service costs have soared higher. Global developments such as oil shortages in Europe, fallouts from the war in Ukraine, and China’s COVID-19 lockdown policy are at play, while U.S. central bank restrictive policy has raised the cost of living. The surge in broad prices has generally belied expectations.
Odds Favor Steep Rate Hike…About 80% chance of a 75-basis point rate hike next week, do not rule out a 100- basis point move at the upcoming Fed meeting. Higher than expected inflation readings have prompted calls for steeper rate hikes. A peak fed-funds rate of 4.25% to 4.50% by next year is suggested by futures markets. That could imply another large rate hike in November 2022. “I do know that we need to be increasing interest rates up to a substantially higher level than where they are now,” Chicago Fed President Charles Evans noted, and Fed Governor Christopher Waller echoed “another significant increase” in the fed-funds rate. “We need to act now, forthrightly, strongly as we have been doing,” Fed Chair Powell has vowed, “My colleagues and I are strongly committed to this project and will keep at it.”
New Jersey Earns Rating Upgrade, Outlook Boost…New Jersey has bagged three rating upgrades since the enactment of its latest budget. All three ratings agencies carry a positive outlook. Last week, Fitch upgraded New Jersey general obligation bonds to ‘A’ from ‘A-’. A sizable fiscal cushion, robust revenue collections in recent years, and actions to address debt and pension liabilities have driven favorable ratings actions. “We’ve made remarkable strides to get our fiscal house in order, from making our full pension payments two years in a row to building a strong, reliable surplus that will help our State weather potential storms,” Governor Phil Murphy added “There’s no doubt our fiscal position is far stronger than the situation we inherited”. The latest upgrade marks the first time Fitch has raised its rating, since it started rating garden state bonds in 1992.
Atlantic City Rating Boost…Moody’s raised its rating on Atlantic City general obligation bonds to ‘Ba2’ from ‘Ba3’. Atlantic City will continue making strides in improving its governance and finances, despite higher inflation, recession risks, and the lingering effects of the pandemic, Moody’s positive outlook reflects improved city operations, more predictable property tax payments from casinos and state oversight. Speculative-grade Atlantic City is highly dependent on the casino industry.
Wayne County, Michigan Upgrade…Fitch has become the third rating agency to award a double-notch rating upgrade to Wayne County, MI. Fitch’s two-notch upgrade to ‘A’ from ‘BBB+” comes on the heels of a Moody’s upgrade earlier this month. In January 2022, S&P lifted its rating to ‘BBB+’ on Wayne County, which had lost its investment grade in 2015. Wayne County, home to Detroit, has seen “continued improvements in financial resilience, driven by consistent positive operating results following several years of financial stress following the Great Recession” Fitch said. Wayne County CFO noted, “For us this does help to signal to not only investors but also to other stakeholders that we are solidly fiscally solvent.”
PREPA Debt Talks Stall…Lack of consensus opens a litigation path to resolve Puerto Rico electric utility debt dispute which dates back to 2016. When the Title III court-imposed mediation deadline struck last week, the parties hit an impasse. Governor Pierluisi said, “Prepa must reduce its debt to a sustainable level that Puerto Ricans can afford to pay.” Oversight board lawyers explained that “The parties’ respective positions on what is reasonable in the context of Prepa’s rates and needs, and on their legal rights have resulted in a currently unbridgeable gap on the economic terms of a restructuring.” A proposed litigation schedule that envisions summary judgement hearings early next year has been filed by the oversight board, which states that it is “open to negotiations at any time so a consensual deal or largely consensual deal can eliminate some or all of the litigation.”
Compare 30-Year taxable U.S. Treasury yield 3.55% to 30-Year tax-exempt muni bond yield “AAA” 3.65%; “AA” 4.15%; “A” 4.51%; “BBB” 4.56%. For investors in the 35% tax-bracket, a 4.5% tax-exempt yield is equivalent to a 6.9% taxable yield. Top rated long-term tax-free bonds yield 103% of comparable taxable U.S. Treasuries.