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Week of 7/5/2022
Could The Municipal Bond Market Shrink in 2022?… The State of State Budgets…Federal Board Approves Puerto Rico Budget…New Jersey Budget Brings Record Surplus…High Inflation…U.S. Growth Outlook Cut… Municipal Bond Losses Make For Compelling Valuations…
Could The Municipal Bond Market Shrink in 2022?… 30% fewer tax-free bonds were issued by states and local governments in June-22 compared to a year ago. Taxable bond issuance dropped 86% last month. Last month’s low supply defies historical trend, as June is typically a high supply month. This year, volatile market conditions have put a pause on some primary market bond offerings as bond issuers seek to avoid uncertainty. With the Federal Reserve’s second 75 basis point rate hike within sight, states and local governments have more reason to wait it out. Timing new bond issues to avoid extreme volatility has led some issuers to hold off on primary market outings to put them out later on the bond calendar. In the first half of 2022, 15% fewer municipal bonds were issued than last year. This year, refunding bond issuance is minimal amid higher interest rates. Plenty of cash on government coffers also contributes to low municipal bond supply. States and local government can hardly be blamed for issuing fewer municipal bonds. 2022 municipal bond issuance could fall short of record-breaking supply in 2021 and 2020. At present, new supply is not at pace to replace municipal bonds that amortize, a predicament for investors seeking to reinvest tax-free coupon receipts. Over the past decade, municipal bond market has grown at a mere 0.3% rate per MSRB data, underscoring low leverage and conservative debt practices of states and local governments. A decade ago, supply woes caused the municipal bond market to shrink in 2012. Should current supply woes persist, the $4 trillion municipal bond market could shrink in 2022.
The State of State Budgets… All but two U.S. states have met their June 30 deadline for enacting Fiscal 23 budget. On July 1, 44 U.S. states began Fiscal 23 with adopted budgets. Only two states, Massachusetts and Pennsylvania, are still ironing out budget matters. A year ago, thirteen U.S. states did not have adopted full year budgets on July 1. The comparison speaks of a more smooth budget process and lends favorably to the financial progress made by the U.S. state sector over the last year. Historically, some U.S. states have a pattern of last-minute negotiations. At times, a few U.S. states need to adopt measures that provide more time to finalize budgets. Late budget adoption is often rooted in legislative and executive fiscal policy differences. The structure of most state general obligation bonds, as well as many states’ authority to fund debt service, insulates bondholders from budget delays. Many states have procedures in place that protect debt service including continuing appropriation, pre-funding, piecemeal resolutions or state treasurer authority to fund debt service. As lawmakers iron out details, the economic landscape for U.S. states faces changes yet again. Looking at recession prospects, U.S. state sector finances are relatively stable with robust reserves and liquidity to manage future revenue cliffs.
Federal Board Approves Puerto Rico Budget… Ending a legislative row over next year’s spending plan, the federally-appointed oversight board approved a $12.4 billion general fund budget for the Fiscal 23 that began on July 1. The board’s version of the budget was rejected last month by Governor Pedro Pierluisi because it reduced government spending by $100 million. He said at the time that legislators would submit their own version, but the presidents of the island’s Senate and House of Representatives clashed and failed to approve anything before the July 1 deadline. PROMESA Law stipulates that the oversight board’s budget proposal is ‘deemed approved’ and takes full force and effect on July 1, should the Island’s legislative assembly fail to enact a ‘compliant’ budget before July 1. The general fund budget provides for $2.6 billion in pension payments and $1.1 billion for debt service payments, as well as $700 million for capital expenditures to help revitalize the island’s economy.
New Jersey Budget Brings Record Surplus… New Jersey $50.6 billion budget for FY2023 includes a record $6.8 billion surplus which is roughly three times the surplus level last year. For the second year in a row, Garden State will meet 100 percent of the actuarially required pension contributions, due to supplemental pension contributions. It could take about two decades of similar supplemental contributions to whittle down New Jersey’s $100 billion of unfunded pension liabilities to a 80% funded level. In fiscal 23, New Jersey will use over $2 billion of unused federal direct aid America Rescue Plan funds, with $1 billion left for next year’s budget cycle. The budget brings tax relief and makes an over $5 billion down payment to fund capital plans to avoid future debt issuances.
High Inflation… The Fed’s preferred inflation guage, core PCE index, which excludes volatile food and energy prices increased 4.7% in May from a year ago, down from 4.9% in April. On a monthly basis, core prices rose a seasonally adjusted 0.3% in May, the same pace as in each of the prior three months. While the Fed tends to focus on the PCE price index, the public and many investors tend to be more aware of the Labor Department’s consumer-price index, which climbed 8.6% in May from a year earlier, the fastest pace since December 1981. On the path of aggressive rate hikes to counter high inflation, Fed Chair Jerome Powell said last week, “Is there a risk we would go too far? Certainly there’s a risk,” Mr. Powell said. “The bigger mistake to make—let’s put it that way—would be to fail to restore price stability.”
U.S. Growth Outlook Cut… Could U.S. GDP contract in the second quarter that just ended. U.S. GDP unexpectedly fell by an annualized rate of 1.4% in the first quarter of 2022–after expanding at an average of 5.7% in the past year. Slower consumer spending and fewer homes sold are signs of a cooling economy. The pace of growth in the US manufacturing sector declined sharply in June from May per the closely watched Institute of Supply Management survey. Goldman Sachs’ economists expect a lower 1.9% GDP growth in the second quarter, while Capital Economics estimates slashed growth expectations to 1%. The Atlanta Fed’s GDPNow measure, which tracks economic data in real time and adjusts continuously, sees second-quarter output contracting by 2.1%. Coupled with the first-quarter’s decline of 1.6%, that would fit a popular definition of recession. “Our forecast comes perilously close to a recession,” JPMorgan’s economists cut their second quarter growth forecasts. Amid a strong labor market, investors are bracing for a ‘mild recession’.
Municipal Bond Losses Make For Compelling Valuations… Municipal bond indices have lost over 8% in the first half of 2022, marking one of the worst first half performances for the $4 trillion municipal bond market in decades. Investors have liquidated over $85 billion of municipal fund holdings, already exceeding the previous full-year outflow of $72 billion in 2013. Tax-free yields have roughly doubled since the beginning of the year. Top-rated long -term tax-free bonds yield about 104% of comparable taxable U.S. Treasury bonds, significantly higher than 78% Muni-Treasury ratio at the end of 2021. Higher municipal bond yields have made municipal bond valuations compelling, particularly for wealthy investors in high tax states who face over 50% marginal tax rates.
Compare 30-Year taxable U.S. Treasury yield 3.10% to 30-Year tax-exempt muni bond yield “AAA” 3.25%; “AA” 3.67%; “A” 4.14%; “BBB” 4.04%. For investors in the 35% tax-bracket, a 4% tax-exempt yield is equivalent to a 6.15% taxable yield. Top rated tax-free bonds yield 105% of comparable taxable U.S. Treasuries.