Week of 6/13/2022

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High Inflation Spurs Steep Rate Hike Odds… Municipal Bonds’ Fleeting Rally Snaps… Puerto Rico Hosts Bondholders… MTA Welcomes Federal Boost… Chicago Public Schools Fiscal 23 Budget…

High Inflation Spurs Steep Rate Hike Odds… Last month, consumer price index increased 8.6% from a year earlier, the largest annual increase in broad-based prices since 1981. While broad-based prices in May surged 1% higher from last month, core CPI, which strips out more volatile food and energy prices, rose 0.6% from prior month and 6% from a year ago. Former Treasury Secretary Lawrence Summers said yesterday that the path of inflation depends on the war in Ukraine. Fed-funds futures prices reflect more than three 50 basis point hikes in each of the next three Fed meetings, with about one-in-five odds for a 75 basis point move. By year-end, the Federal Reserve’s policy rate could be over 3%. A peak rate of 3.50%-3.75% is plausible per futures market, while Nomura economists expect the fed-funds rate to hit 4% next year. Amid calls for a 75 basis point rate hike as early as this week, Fed watchers are looking for updated and realistic economic projections from the Federal Reserve. Most sensitive to Fed rate expectations, two-year U.S. Treasury bond yields surged close to 3.2%, the highest since 2007. Since last week, short-term U.S. Treasury yields are about 40 basis points higher, while long-term Treasury bond yields rose about 10 basis points.

Municipal Bonds’ Fleeting Rally Snaps… Municipal bonds lost steam with inflation at a fresh 40-year high. Long term top-rated municipal bond yields rose to 3%. Last month, benchmark municipal bond yields were even higher, at 3.3% for 30 years, the highest since the March 2020 pandemic related sell-off. Early June saw municipal bonds rallied for about two weeks with a short burst of inflows to municipal bond funds upon comforting economic data and attractive municipal bond valuations. That changed when investors yanked out over $2 billion from municipal bond funds last week. Friday’s high inflation figure exceeded analyst consensus estimates. Aggressive rate hikes by the Federal Reserve are likely to counter high inflation. Municipal bond benchmark indices, which lost 0.8% this month, are down 8.2% in 2022. Municipal bonds are outperforming taxable Treasuries, which have lost 9.87% this year. The outperformance is partly driven by seasonal trends, and also due to municipal bonds’ tax advantaged status. Reinvestment demand is at its peak in summer months amid lower supply of tax-free municipal bonds in the primary market. Most analysts have lowered prior forecasts of primary market supply in 2022. Municipal bond issuance in 2022, so far, is 23% lower than last year.

Puerto Rico Hosts Bondholders… Puerto Rico wants to eventually earn credit ratings for its general obligation and sales tax secured bonds, Island officials say. Droves of institutional investors attended Puerto Rico’s bondholder conference, the first such event in a while. Renewed investor interest in Puerto Rico’s triple tax exempt bonds comes on the heels of a lower debt load, about $7 billion in March-22, down from $22 billion before exiting bankruptcy. Meanwhile, its economy is strong, with unemployment at its lowest since 1940s. “The debt has been downsized so substantially that relative to the size of the Puerto Rican economy, it looks manageable and serviceable without the kinds of stresses that forced the commonwealth into restructuring several years ago,” a Nuveen portfolio manager stated. Permanent infrastructure, such as roads and electric grid, being built with federal aid will help make the Island economy more competitive, Governor Pierluisi stressed. Puerto Rico’s economy is projected to grow by 3.5% this fiscal year and next, but may contract again in fiscal 2024 and remain flat in fiscal 2025. Population is expected to continue declining through fiscal 2026. Bondholders probed on how the Island’s finances would fare when the federally appointed oversight board eventually leaves, Island officials committed to fiscal responsibility once the ‘training wheels’ come off. Governor Pedro Pierluisi spoke of “a new era of economic stability and progress-oriented politics.” Higher yields and tax benefits have led institutional investors to buy more Puerto Rico bonds. Puerto Rico general obligation bonds yield about 2% more than top-rated benchmarks. Mutual funds including Nuveen, T Rowe Price Group, Invesco, Mackay Shields and Vanguard are the largest holders of Puerto Rico bonds. While an end to bankruptcy has lifted a ‘cloud of uncertainty’, investors are closely watching the Island’s progress given its recent past. Ratings agencies look for sustainable improvement in finances and government decision making, and could take their time before moving forward. The Island’s posture to host bondholder questions boosts investor confidence. Puerto Rico bond indices have lost 1.6% this year outperforming U.S. state and local government tax-free bonds.

MTA Welcomes Federal Boost… The $1.2 trillion Infrastructure Investment and Jobs Act is a “huge shot in the arm” for infrastructure needs, MTA’s finance director said. MTA does not plan to drop or delay any projects due to inflation. “When you plan for big infrastructure, that process can take months or, in New York, years of planning, and then conditions change and we need to be nimble to react to change that is going to impact the cost of delivery and financing the project,” an MTA official added. One such change is that MTA’s congestion pricing plan faces delays stemming from a longer than anticipated federal government environmental review. Congestion pricing is expected to bring in $1 billion of annual revenue that the MTA could pledge towards a $15 billion bond financing, part of its $51.5 billion multi-year capital plan. In the meantime, boosting subway ridership, currently at about 60% of pre-COVID-19 levels, is a priority. For more than a year, cars crossing MTA’s seven bridges and two tunnels have been near or above pre-pandemic levels.

Chicago Public Schools Fiscal 23 Budget… The junk-rated school district expects to maintain a $1 billion unrestricted general fund balance in Fiscal 23 and Fiscal 2022. Chicago Public Schools’ (‘CPS’) $9.5 billion spending plan for Fiscal 23 is $200 million more than prior year. State aid, pledged to Chicago Board of Education general obligation bonds, will rise by $62 million to $1.6 billion as the state’s budget fully funds the annual $350 million scheduled hike. CPS is required to set aside long-term debt service one year in advance for state aid secured bonds. Higher local funding sources include an additional $310 million in property taxes, $145 million from the personal property replacement tax on corporations and $96 million from a city-declared TIF surplus. The budget includes $730 million of unused COVID-19 related federal aid, which is being ‘strategically invested’ per CPS CEO Pedro Martinez, overseeing his first CPS budget in the top job. The Chicago Board of Education will vote in June-end.

Compare 30-Year taxable U.S. Treasury yield 3.27% to 30-Year tax-exempt muni bond yield “AAA” 3.02%; “AA” 3.78%; “A” 3.96%; “BBB” 4.15%. For investors in the 35% tax-bracket, a 4.15% tax- exempt yield is equivalent to a 6.3% taxable yield. Top rated tax-free bonds yield 92% of comparable taxable U.S. Treasuries.