Week of 6/27/2022

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Wall Street Sees Municipal Market Rebound…Fed Inflation Fight “Unconditional”, Powell…Municipal Bonds Rally…Muni Demand Hinges on Fund Flows… Pensions Face Double-Digit Losses…Favorable Outlook For Bond Insurer…PREPA Mediation Deadline… Lower State Sales Tax Collections…

Wall Street Sees Municipal Market Rebound…Higher municipal bond prices this summer, and a reversal of outflows from municipal bond funds is predicted by Bank of America, the largest underwriter of state and local debt. “A stable or bullish Treasury rates market would be a prerequisite for the return of a more constructive muni rates market performance,” Bank of America strategists added “Given the Fed’s stance, that prerequisite has been met in our view.” BlackRock and Nuveen have also stated that municipal bond valuations have cheapened, giving rise to a buying opportunity. A Nuveen portfolio manager said that municipal bonds “either longer on the curve or lower coupon have been oversold and would be an easy segment to see a recovery.” adding that “on-the-run” bonds such as frequently traded Puerto Rico general obligation bonds, sales tax bonds and tobacco settlement backed bonds typically see the largest price drops in a sell-off because they are the easiest to sell. Such bonds could bounce back quickly after municipal bond market stabilizes. “Sell-offs and volatility ultimately create better opportunities and better value,” a BlackRock portfolio manager said that a “a lot of value has been restored” in the market because of the rout this year. Back in April, some institutional investors said it was a good time to buy municipal bonds, but the municipal bond market slipped further in May. Barclays Plc strategists said they’re looking for chances to add on weakness, though they said the near-term outlook remains challenging. Another steep rate hike in July could put the economy on a slower growth track, favorable for municipal bond prices.

Fed Inflation Fight “Unconditional”, Powell…A recession is “certainly a possibility”, Fed Chair Powell told U.S. lawmakers last week “so there is a risk that unemployment would move up, from what is historically a low level though.” Powell acknowledged it was more challenging for the central bank to root out soaring inflation due to factors beyond its control such as the Russia-Ukraine war and China’s COVID-19 policy. “We really have to get inflation down to 2%,” the Fed chief added that “Inflation has obviously surprised to the upside over the past year, and further surprises could be in store.” Lawmakers discussed monetary policy actions to fight high inflation. The Federal Reserve’s stated to Congress, “The Committee’s commitment to restoring price stability — which is necessary for sustaining a strong labor market — is unconditional.”

Municipal Bonds Rally…Last week, a U.S. Treasury bond rally led municipal bonds to gain 0.8%, the second-best weekly gain this year. Long term municipal bond yields dropped ten basis points last week as Treasury yields fell. Recession fears, sparked by the Federal Reserve’s steep rate hikes, have boosted bond prospects. Investors are beginning to see that the Federal Reserve is willing to take strong action to control inflation, even if it brings a recession.

Muni Demand Hinges on Fund Flows…”We don’t think the outflow cycle will last through the rest of the year, we think it’s probably pretty close to the end,” a BlackRock portfolio manager said. Investors have liquidated over $80 billion of municipal bonds this year, equal to nearly three months of primary market supply. Bank of America strategists echoed that outflows have been declining in recent days along with yields. “As the market rally progresses, we believe funds flows should turn positive.” The outlook for the $4 trillion municipal bond market depends a lot on demand driven by fund flows to municipal bond funds.

Pensions Face Double-Digit Losses…Following stellar profits last year, public pensions’ investment returns have dwindled amid higher rates. Losses exceeding 12% for the year ending on June 30, 2022 are likely, Moody’s projects. Such an adverse outcome was earlier assigned a low probability. Public pension funds target investment returns of 6% to 7%. To dampen volatility from investment returns, governments recognize variances between actual and expected returns over several years rather than all at once, for ‘smoothing’ asset valuations. 2021 gains will help offset higher government contribution requirements triggered by losses incurred in 2022. 2022 could be worst single-year of returns since the 2008-09 financial crisis and could reduce pension assets close to 2020 levels.

Favorable Outlook For Bond Insurer…National Public Finance Guarantee won an outlook boost to stable from negative last week. Puerto Rico’s central government bankruptcy exit cut uncertainty on National’s Puerto Rico insured exposure. National’s remaining exposure to Puerto Rico consists of highway bonds and electric utility debt. Because National does not actively write new insurance on municipal bonds, it is considered to be in ‘run-off’ status. However, its sizeable capital resources in relation to a relatively smaller insured portfolio, given the continued amortization bonds, boosts is capital adequacy. National (Moody’s ‘Baa2’) is unlikely to be upgraded in ‘run-off’ mode.

PREPA Mediation Deadline…August 1 is the new deadline sought by mediation team members for filing a debt adjustment plan and other next steps for PREPA bonds. Talks about restructuring $8 billion utility bonds date back to 2015. In March, the Island administration called off a long-standing debt pact. In late- May, PREPA bondholders threatened to abandon talks and litigate seeking full debt repayment, should talks not come to fruition.

Lower State Sales Tax Collections…A fading consumer spending boom is wearing down U.S. state tax collections. Half of U.S. states saw monthly sales tax collection drop in April. In May, retail sales fell for the first time in five months amid high inflation. “It’s not a huge shock to see a slowdown in sales tax collections,” a Fitch analyst added “Most states were anticipating some slowdown from the growth we saw this fiscal year. It was just so robust, and no state really anticipated this level of growth to continue.” For example, New Jersey, which derives its biggest revenue chunk from sales tax, expects lower 2% growth next year down from a roughly 13% pace recently. The shift is forcing state governors to review how best to assign surplus dollars.

Compare 30-Year taxable U.S. Treasury yield 3.32% to 30-Year tax-exempt muni bond yield “AAA” 3.31%; “AA” 3.78%; “A” 4.23%; “BBB” 4.34%. For investors in the 35% tax-bracket, a 4.34% tax- exempt yield is equivalent to a 6.68% taxable yield. Top rated tax-free bonds yield 100% of comparable taxable U.S. Treasuries.