Week of 6/6/2022

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Retail Demand Boosts Municipal Bonds…Pace of Rate Hikes…New Jersey Windfall…Strong Revenues Propel California Budget, Fitch…PREPA Bondholders Sound Receiver Warning…Steady Air Travel Boosts COVID-19

Retail Demand Boosts Municipal Bonds… Attractive valuations have not gone unnoticed by retail investors. Tax-free yields recently dropped from peaks in mid-May. Last week investors poured $1.2 billion of cash into municipal bond funds after pulling out cash for fifteen straight weeks. The rally in municipal bonds continued for a second straight week. The first month in 2022 with positive returns, May brought 1.35% gains on municipal bond index benchmarks. Muni bonds have lost 7.3% this year. Reinvestment demand is set to surge. In June, holders of tax-free bonds will seek to reinvest $50 billion from principal and coupon payments, to be followed by $75 billion over two months in July and August. Meanwhile, primary market supply of municipal bonds is expected to trend lower. Last month, states and local governments issued 30% fewer taxable bonds and tax-exempt bond issuance dipped 7% from a year ago. A fallout of a higher rate environment, refunding bond volume dropped sharply by 70% in May relative to a year ago. As refunding activity ebbs, so does the supply of new issue municipal bonds. Plenty of unspent federal cash is in the coffers, and surplus budgets imply less need for local government borrowing although states tend to have more diversified long-range capital plans. A supply shortage in the primary market will be a tailwind for the $4 trillion municipal bond market.

Pace of Rate Hikes… Some of the Federal Reserve’s rate hikes could be reversed next year or in 2024, St. Louis Fed President James Bullard said front-loading rate hikes this year rather than spreading them out over two or more years would allow the Fed to counter inflation. Bullard has urged policymakers to raise interest rates to 3.5% this year, while San Francisco Fed President Mary Daly favors pushing the policy rate to 2.5% this year. Fed Vice Chair Lael Brainard and Cleveland Fed President Loretta Mester have endorsed fifty basis point rate hikes in June, July, and possibly September if inflation does not moderate enough. A September rate pause, suggested by Atlanta Fed chief Raphael Bostic, has been countered as central bankers will want to see more economic data. Last week, the Federal Reserve began shrinking its massive balance sheet at a monthly pace of $47.5 billion, ramping up to $95 billion in September, a process also called quantitative tightening. It is hard to say how much impact the shrinking balance sheet would have on financial conditions, but some estimates suggest it might be worth another two-to-three rate hikes. With solid jobs growth, May unemployment rate is 3.6%, just 0.1% above what it was in February-20 when COVID-19 struck. The U.S. economy is already beginning to slow in response to less monetary stimulus, cited in the Beige Book report on regional economic conditions. Growth should be expected to slow to a long-term trend rate of around 1.75-2% Bullard said “This doesn’t surprise me,” adding “I would say overall the anecdotal reports I’ve heard — some of which filtered in to the Beige Book — are consistent with continued growth in the US economy: In certain markets very, very strong. In others more tempered.” Four of the central bank’s 12 districts noted that growth has slowed. Inflation slowed a little in April but still remains high. Fed Vice Chair Brainard added, “We’re certainly going to do what is necessary to bring inflation back down.” All eyes are on the pace of rate hikes.

New Jersey Windfall… How to best utilize a revenue windfall is a hot topic in the Garden State. Fiscal 22 revenue could outperform estimates by $4.5 billion. “The rapid revenue recovery last year, followed by the continued revenue surge this year, is unprecedented” and marked a 35% increase “from a low of $38.0 billion in FY20” to “an estimated $51.4 billion today,” NJ Deputy Treasurer stated. More surplus funds, as much as $8 billion, are a priority for some lawmakers. Others are rallying support for a historic tax relief plan. Paying off as much as $8 billion of New Jersey debt is under consideration. “They could, again, take additional revenue that they’re receiving now and further reduce their debt burden,” a Moodys analyst reiterated that recent moves to pay off debt were rewarded with favorable ratings actions. Governor Murphy is looking to support proposals that “include a healthy surplus, reduces State debt, and delivers property tax relief to New Jersey families.”

Strong Revenues Propel California Budget, Fitch… California’s ‘exceptional’ revenue growth in the current year (Fiscal 22), 23% higher than prior year, comes despite the Ukraine war and related sanctions on Russia and supply chain disruptions. Golden State GDP level surpassed pre-COVID-19 levels in Q1-21. However, stock market- related capital gains tax revenue, factored into California revenue estimates, heighten uncertainty in forecasts. A 3% real national GDP growth in 2022, an underlying assumption for Governor Newsom’s “May Revise” updated Fiscal 23 budget plan, is in line with Fitch’s U.S. economic outlook. “As has been the state’s practice, the governor takes a fairly conservative approach to using increased revenue by limiting growth in ongoing spending, rebuilding reserves, and paying down long-term liabilities,” Fitch Ratings anticipates that while the enacted California budget may vary from Governor Newsom’s blueprint, its ‘general approach of limited recurring spending growth, focus on one-time actions, and restoring resilience will likely carry through.”

PREPA Bondholders Sound Receiver Warning… A receiver appointed by bondholders is not out of the question should current PREPA debt mediation efforts not yield results. “After five years without any progress having been made towards a confirmable plan of adjustment, and numerous instances of the government parties committing an about-face and abandoning longstanding settlement agreements, the PREPA Bondholders intend to move to dismiss this Title III bankruptcy case and/or seek appointment of a receiver absent a consensual resolution. At some point, enough is enough,” PREPA bondholders consisting of bond insurers and Ad Hoc PREPA bondholder group informed Judge Swain. PREPA Bondholders believe that valid and perfected liens on PREPA revenue were granted by PREPA to bondholders. PREPA’s unsecured creditors, who have challenged bondholder liens, have also asked Judge Swain to open litigation on certain issues, alongside mediation. Litigation could be costly. Bondholders highlighted “the absurdity and bad faith of the evolving positions adopted by the various parties in this case, as well as PREPA’s ability to pay its bondholders” as they urged that “the parties should take the opportunity in mediation to try to reach one more settlement agreement.”

Steady Air Travel Boosts COVID-19 Hit Sector… Airport traffic hit 91% of pre-Covid-19 levels in April, the highest since the pandemic began. Steady enplanement recovery is driven by higher domestic travel, and international travel is picking up too. International travel at Miami airport has surpassed pre-COVID-19 activity. After hitting a speed bump during the year-end holiday season when Omicron curtailed travel, air travel picked up steadily in 2022. Airport-related municipal bonds were hit hard by COVID-19 bonds, leading airports to generally defer capital plans and focus on refinancing higher cost debt to save interest. While demand is strong, airline capacity is constrained by labor shortages, a drag on passenger recovery. This year, New York’s JFK, and airports in Austin, Dallas, Charlotte have embarked on capital plans with newly issued municipal bonds.

Compare 30-Year taxable U.S. Treasury yield 3.12% to 30-Year tax-exempt muni bond yield “AAA” 2.85%; “AA” 3.38%; “A” 3.69%; “BBB” 3.91%. For investors in the 35% tax-bracket, a 3.9% tax-exempt yield is equivalent to a 6% taxable yield. Top rated tax-free bonds yield 91% of comparable taxable U.S. Treasuries.