FHN Financial – Municipal Market Commentary

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Fundamentals

A crush of issuance into quarter-end did not materially impact the yield curve. Across nearly 20 negotiated issues that included a variety of sectors were several that had large enough order books to bump final yields, while others saw steady levels into final pricings. In particular, Texas accounted for a good portion of that total with school and GO credits giving the star to the Lone Star State. Spreads in intermediate PSF-backed issues approached +30/AAA in 5% structures, about a 10 basis point concession to recent secondary levels. Longer-dated 4s were made available at discounted yields — a testament to current sub-5% spreads but also unique opportunity for high-grade inquiry where TEYs for a 21% corporate-rate buyer exceed 5%. The outsized spreads are coming ahead of July 1 redemptions that appear to be creating new demand — a win-win for both issuers and investors. Secondary activity showed an increase in bids wanteds volume of down-in-credit names. Higher line items counts in single-A and lower rated bonds reflect portfolio repositioning for quarter-end and heightened in light of the rate volatility over the last three months. Trade examples include sales of NR/BBB+ Chicago IL GO 5s due 2034 (call 2031) at 4.52% after trading in May 15 basis points higher (but well off its December 2021 original yield of 1.81%). Near the 20-year range, trading in A2/A Long Island NY Power Authority 5s due 2039 (seasoned 2024 call) at 2.57% contrasts with a sale a month ago near 3.50%. June’s yield rebound is helping to limit losses from the weakest period in May. Generic yields stand at the upper ranges of this year, offering new inquiry more opportune entry points. With a new quarter about to begin, bids wanteds volumes and secondary activity appears to be stabilizing. The graph shows this year’s activity in both metrics with the overlay of the 10-year AAA BVAL yield:

Since January, the level of bids wanteds has been closely linked with higher secondary volumes. Exaggerated yield spikes resulted in late January and then again during April and May due to heavy selling from fund outflows. The 10-year AAA BVAL traded from 1.04% at the start of the year to a high of 2.95% in mid-May.
MSRB data shows that daily secondary volumes have averaged $12 billion this year — a 70% increase from 2021’s level. Increased volatility this year has shifted not only generic yields but also credit and coupon curves. Whereas 2s and 3s were the go-to structures last year, inflation concerns have seen a return to premium coupon bonds.
Is a bottom forming in the yield curve? A yield plateau since mid-June has seen bid list volume decline 13% from the previous two months. Bid list tallies are still above $1 billion par value, but the $2 billion-plus range has only been reached two times this month. As Q3 is set to begin, ICI and Lipper fund flow figures will be integral inputs for the yield curve.

Technicals

A good portion of late-2Q22 supply fell within AAA and AA general market names — a range that has seen spread compression. In 10-year maturities, AAA state-level Texas names, Massachusetts GOs, and Ohio GOs have tightened to single-digit spreads against AAA spots — an improvement of 10 basis points or more over the last month. Further out the curve, credits such as AAA Ohio Water 5s due 2038 (callable 2029) which traded mid-June at +49/AAA are now 20 basis points tighter on spread. Another nuance that has surfaced is bidding that shows more value being assigned to short call dates. Several structures with 10-15 year finals and 4-6 year calls are commanding smaller concessions to the call dates than has been the case. Whether buyers feel inclined to further tighten the spread-to-call value might become a function of where relative value ratios settle. Buyer demand appears to have ratcheted down to ratios above 80% yield-to-worst from the near-100% levels that had surfaced — a testament of just how much absolute yields have corrected from the beginning of the year as well.

The end of a quarter brings a focus on how returns have played out since the pandemic began. The graph compares monthly closing yield changes in the 10-year MMD spot:

The strongest monthly performances since 2020 have occurred in May, July, and November. First half demand that originates from heavy reinvestments begins in May and continues into the summer period. May 2020 saw an impressive rebound occur as the 10-year AAA spot rallied more than 60 basis points. July 2020 and 2021 drew yield improvements as high as 25 basis points. November’s returns in the last two years averaged around 1.25% as the 10-year rate notched 20 basis point rallies.

Since 2020, the weakest months have been April, June, and September. Smaller rollover demand either side of the summer period has led to the 10-year AAA fading an average of 22 basis points in April and 14 basis points in September. The anomaly in June is that high redemption totals don’t always generate a meaningful rally — in both 2020 and 2021 the 10-year spot barely budged but this month has seen the 10-year AAA spot fade more than 30 basis points.

Moving into the typically strong seasonal cycle, July’s and August’s estimated redemption figures reach nearly $80 billion (per CreditSights). This year’s yield direction will not only draw input from intra-market fundamentals, but the tightening cycle will have an impact as well as to just how much price performance can be found.

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Market Returns

June’s municipal results were less damaging than April’s, but all in all the quarter has been challenging on many fronts. Bids wanteds volumes surged 50% to a daily figure of $1.56 billion on fund outflows (ICI data) that increased 250% from Q1 levels. To say liquidity was compromised doesn’t tell the whole story — but the takeaway is a yield set that is much more buyer-friendly than was the case in 2021. The graph shows specific sector results for the month and year-to-date:

A main index will post a loss of just under 2% for June and now sits down 9.2% for the year. There is no common-era comparison — however, the conditions of post-March 2020 and through 2021 represented historic financing opportunities for issuers and less-than-ideal conditions for investors. Given the evolving outlook for the economy, buyer interest in quality of rating over quantity of spread has hindered the revenue sector. Its loss for June will exceed that of GOs by more than 50 basis points and the year-to-date return moves to more than 100 basis points of underperformance against GOs (revenue bonds with a year-to-date loss of 10%).

Individual revenue categories reflect the broader trend towards lower-risk bonds. Healthcare issues gave up more than 3% in June and are down 11.5% this year. Credit spreads in the single-A and BBB range, in particular, are widening out in response to revenue challenges through many systems. A new issue pricing of NR/AA- Public Finance Authority WI Healthcare Revenue bonds for Cone Health came in early June with a 5% due in 2052 at +118/AAA, as compared to Aa3/AA- Illinois Finance/North Shore Health issue from March that priced a 5% due 2051 at +91/AAA. In between is the Transportation sector that returned negative 2% in June and sits with a 2022 loss of almost 10%. Bond Buyer data indicate supply this year is off 15% from last year’s pace as the federal Infrastructure Act has potential impacts on public finance efforts. Utility bonds have outperformed the broad market as safer sectors draw better bidding conditions. June’s result is a loss of 1.7% and for the year the sector has outpaced the main index by about 40 basis points.

Shorter durations were more heavily favored during June as buyers take a wait-and-see approach during the tightening cycle. A short-term index will close out June with a flat return and has a modest 1.2% loss this year. Intermediate bonds gave up 1.3% during the month and have lost 8.5% in 2022, while long-durations fared the worst losing 4.3% in June. Generic yields in both ranges will close out June up about 175 basis points from December’s close. Of particular note in longer maturities is the nuance of sub-5% couponing that prevailed in the last few years. Data from Refinitiv MMD show that 25-year 3s have widened out 30 basis points since January and 25-year 4s are now wider by 34 basis points.

Taxable muni returns are not being helped by lower supply. Issuance this year is off 40% from 2021 as higher rates have had a material effect on advance refunding opportunities. Volume has reached $31 billion this year, as compared to 2020 and 2021 (ultra-low yield range) when $51 billion was issued in the sector through the first half of the year. June’s taxable muni index loss will be just under 1% and the 1H22 result is a loss of 14.5%. That compares to the Bloomberg Barclay’s US Aggregate and Treasury indices that are down 9%-10% (albeit with shorter duration models).

High Yield munis are following other revenue sectors with larger losses as buyers demand wider concessions for more risk. The index gave up more than 3.5% in June and is off 12% this year. Bloomberg figures show $250 million par has been issued in BB and lower sectors during Q2 — a 70% drop from the same period last year.

Credit

The beginning of a new fiscal year for many states on July 1 puts a focus on tax revenue sources and how the current tightening cycle may affect state finances. A breakdown of tax data is shown below:

Pew Research reported on data from the US Census Bureau that shows the Personal Income tax and Sales tax account for 70% of states’ revenue collection. The average national share of taxes from the personal income tax is 33%, with Oregon collecting the highest portion at 63% of its total revenue. Eight states receive no personal income tax collections. The sales tax accounts for an average of 30% of all state revenue, with Texas collecting 61% of its total revenue from that source. Five states assess no sales tax.

Corporate tax income registers a smaller portion of state revenue, with an average share of 7% across all states. New Hampshire’s 31% corporate tax rate is the national high and four states (Nevada, Texas, Washington, and Wyoming) assess no corporate income tax. Property tax revenue accounts for just an average of 3% across the nation, but Vermont’s 29% share of total revenue stands as the high rate.

The post-lockdown environment has brought a shift among state worker populations, with implications for state revenue collections. Company announcements of relocations from high-tax to low/no-tax states could begin to impact overall tax collections and how states utilize the public finance markets.

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