Week of 5/9/2022

Are Municipal Bond Yields Near Highs?… Retail Investors See Opportunity in Municipal Bonds… First 50 Basis Point Fed Funds Rate Hike in 20 Years… Illinois Earns Upgrades From All Ratings Firms… Puerto Rico Tax Revenue Outperforms… Tobacco Bonds Underperform…

Are Municipal Bond Yields Near Highs?… The bellwether 10-year U.S. Treasury yield hitting 3.19% last week, its highest level since December 2018, could be seen as a signal that bond prices may be near a bottom. Long-term tax-free bonds yield 97% of taxable U.S. Treasury yields, a gauge of relative value. Municipal bonds “might be one part of the market that is most underappreciated,” a Strategas analyst said. Municipal bond valuations are “unusually attractive” a PIMCO analyst echoed. Higher U.S. Treasury yields have led an extended financial market selloff and driven negative 9.5% index returns on broad municipal bonds this year. Individual investors have been putting money into municipal bonds, whose yields have risen ‘nicely’ this year, a J.P. Morgan fixed income strategist noted. There may be “a light at the end of the tunnel” Nuveen analysts said municipal bond demand and supply factors bode well for municipal yields, which generally ‘may have crested’. An Oppenheimer analyst echoed “While positive flows may not appear immediately, a slowing pace of outflows should be visible as demand is beginning to advance,” adding “There is ample cash awaiting direction, and at currently attractive ratios and absolute yield levels, interest should take hold and make for a different muni market during the second half of 2022.” Multi-year highs on bellwether bond yields, along with narrower outflows from municipal bond funds are shaping the case for investing in the municipal bond market.

Retail Investors See Opportunity in Muni Bonds… Finding a bottom or a top, an elusive search, is often termed ‘a fool’s game’ in trading idioms. Individual investors are seriously considering whether to buy municipal bonds now when tax-free yields are high or wait some more. “Tax-exempt yields above a 4% have caused people to re-engage in the asset class,” a Wells Fargo municipal bond sales head said. “We have been seeing a lot more interest from retail investors lately,” another municipal bond portfolio manager echoed “While yields may go higher due to pressure from market outflows, I think we are in an opportunistic range of yields already. These are yields that the market has not seen since 2018, excluding the start of the pandemic.” Recently, outflows from muni bond funds have narrowed and so has the volume of municipal bonds seeking bids for sale. For twelve straight weeks, outflows from bond funds have pummeled municipal bond prices. “It would be wise for investors to lock in yield during this buying period, rather than arrive at the party too late when the market normalizes,” a municipal portfolio manager told Bloomberg. Daily trade activity is still low, around levels last seen during the 2020 Covid- 19 related selloff. But buying and selling in the municipal bond market has picked up since last month. Since April-end, the number of daily muni bond trades surpassed 60,000, up from a daily average of 42,000 trades in March per MSRB data. More retail trades suggest that investors are keen to take advantage of market conditions. Retail bondholders are rolling up their sleeves to find bargains in the municipal bond market.

First 50 Basis Point Rate Hike in Twenty Years… No one was surprised that the Federal Reserve hiked rates last week by 50 basis points to target Fed funds rate of 0.75%-1%. The Fed will also begin the process of reducing its balance sheet by not replacing some bonds that mature, a tool for tightening broader financial conditions. “Inflation has obviously surprised to the upside over the past year, and further surprises could be in store. We therefore will need to be nimble in responding to incoming data and the evolving outlook,” Powell added that “there’s a broad sense on the committee that additional 50 basis increases should be on, 50 basis points should be on the table for the next couple of meetings.” Financial markets are skeptical if a steady spate of 50 basis point rate hikes would reign in high inflation. Trading in fed funds futures suggests the possibility of some 75 basis point rate hike this year although Powell said last week “A 75 basis point increase is not something that the committee is actively considering.”

Illinois Earns Upgrades From All Ratings Firms… Both S&P and Fitch upgraded Illinois general obligations bonds to ‘BBB+’ last week. The upgrade, which brings Illinois one notch higher on its S&P rating and two notches higher on the Fitch rating scale, follows Moody’s upgrade last month. Fundamental improvements in Illinois’ fiscal resilience such as unwinding of pandemic-related and other non-recurring fiscal measures, meaningful contributions to reserves and sustained improvement in finances are cited for the upgrade, which also reflects the state’s elevated long-term liability position and its long record of structural imbalance from pension underfunding. “These achievements bear repeating: balanced budgets four years in a row, paying the state’s bills on time, early repayment of pandemic-related borrowing, clearing out debts left by previous administrations, making higher-than-required pension payments, setting aside $1 billion in savings for a rainy day. After more than 20 years without receiving a credit upgrade, the rating agencies are taking notice of our tremendous progress,” Governor Pritzker noted. Between 2015 and 2017, Illinois received eight credit downgrades. In the past year, Illinois turned a corner and bagged five credit upgrades in all from three ratings agencies.

Puerto Rico Tax Revenue Outperforms… The Island’s general fund revenue collections for the first three quarters of Fiscal 22 is 13.5% higher than prior year and 7% more than budget. Sales and use tax revenue outperformed budget by $110 million, and personal income tax collections were $250 million above estimates. Higher employment and wage growth have boosted the Island’s coffers. Last week, the Island administration halted gas tax collections for 45 days, a step that could run foul of the federal oversight board. Despite a significant cash outlay in February-22 when the Island exited bankruptcy, the government Treasury boasts a robust $16.6 billion cash balance.

Tobacco Bonds Underperform… Tobacco settlement payments to 46 states have surged 10% this year. High inflation requires manufacturers to boost annual payments while lower cigarette shipments does the opposite. Inflation, which rose 7% in 2021, continues to be high at 8.5% at present, but smoking tapered off in 2021 after surging in 2020. A one-time legal settlement brought a windfall for Illinois tobacco bond issuers which received $548 million. Tobacco-settlement revenue secured tax-free bonds, $90 billion outstanding, are among the riskiest corners of the municipal bond market. Tobacco bond index returns have underperformed with losses of over 17% this year, relative to negative 9.5% returns for the overall municipal bond sector per Barclays indices. A spate of outflows from high yield municipal bond funds has driven the negative returns on the tobacco bond sector, despite higher tobacco settlement revenue.

Compare 30-Year taxable U.S. Treasury yield 3.26% to 30-Year tax-exempt muni bond yield “AAA” 3.15%; “AA” 3.90%; “A” 4.02%; “BBB” 4.29%. For investors in the 35% tax-bracket, a 4.3% tax-exempt yield is equivalent to a 6.6% taxable yield. Top rated tax-free bonds yield 97% of comparable taxable U.S. Treasuries