Municipal Momentum: Historical Opportunity

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Fundamentals

Finding equilibrium is going to be a longer work in progress for municipals. The combination of a larger Q4 calendar, mutual fund outflows (although the exact nature of net ownership may be changing), and global inflation risks exacerbated the selloff into quarter end. Short-term yields not only traded into the 2% range, but have now eclipsed 3% on a 60-70 basis point correction that occurred during September. The bear flattener has moved the MMD slope to 86 basis points — approaching the level that occurred in the early pandemic lockdown period and within range of reaching the five-year low of 72 basis points (September 2019). Further out the curve past 10 years, sub-5% coupons continue to undergo a repricing in recognition of an inflationary theme. A sale of Aaa/AAA Texas Water 4s due 2036 at 4.07% is an adjustment of 65 basis points off its August closing evaluated yield. In 3% structures, a similar yield rise has occurred —Aa1/NR New York Dormitory Authority Personal Income Tax 3s due 2050 changed hands at 4.81%, a full 50 basis points behind late August trading. Long-term munis trading at yields over 4.50% have seen TEYs jump to over 7% for a similar gain on a net basis. At these levels, high-grade munis have moved into a similar yield/return range of the S&P 500 over the last 20 years.

Supply conditions have been materially impacted by the yield rise this year, as refundings via taxable municipal structures have been dramatically curtailed. The graph compares Q3 supply and yield histories from 2017 to the current cycle:

Low yield ranges that prevailed between 2019 and 2021 drew the largest Q3 supply cycles. In each year, a 10-year AAA MMD spot that traded in the low-1% range offered issuers unique entry points for new money financings and historically low rates by which to refund older, higher yielding debt. Both years saw Q3 volume of $106-$125 billion. In 2020, the third quarter presented the most opportune environment for issuing debt — with a sub-1.00% 10-year AAA yield bringing $140 billion in supply during the period.
The lowest 3Q volume came in 2018 with a higher yield curve in play — the 10-year AAA benchmark traded above 2.50%. Supply in 3Q2018 failed to reach $100 billion as the market had a negative return — an ICE BofA muni index lost 0.24% during that quarter as the full-year gain was just 1.05%. This year’s 3Q supply total won’t surpass 2018 by much, as indications point to around $90 billion in volume will have priced. Along the way, the 10-year MMD has reached a new decade high, approaching 3.25% as the quarter comes to a close. The last period when 10-year AAAs yielded more was in 2011.
A higher yield curve will continue to affect the balance of new money and refunding volume. Bond Buyer figures show this year’s ratio of new money/refunding issuance is 87% — as compared to the prior five-year average of 69%.

Source: Bond Buyer; Refinitiv MMD

Technicals

Municipal momentum continues to undergo a paradigm shift. The market is acquiescing to macro pressures as inflationary forces infiltrate the yield curve. January’s opening yield curve saw no AAA implied yield above 1.50%; current levels are such that no bond yields less than 3% with the trend heading toward shorter-dated 4% high grade levels. While the technical shift continues, credit at the state and large-issuer local issuer level hold strong surplus conditions. Pew Trust research shows that in FY2021, the average number of days which states could run on rainy day funds rose to 35, up from 30 in FY2019 and more than double that of FY2008. So while all municipals are on sale, a decade-long move at new yield highs presents opportunities to commit new funds at favorable taxable equivalent yields.

This year’s yield correction has set up potential adjustments among various sectors. The graph compares the spread history between the Bond Buyer 25 Revenue index and the 20 GO index history since 2017:

The BBI Revenue index is comprised of 25 revenue bonds with 30-year maturities and average A1/A+ ratings. It closed on 9/19 at 4.17% — a new high from May 2019. The absolute high since 2017 occurred in October 2018 with a 4.88% yield. The average spread between the BBI 25 Revenue and BBI 20 GO traded above 40 basis points between 2018 and 2020, with a period high of 51 basis points in August 2018.
Last year’s Revenue/GO spread narrowed as yields remain suppressed and demand pushed tighter conditions. The year’s low spread came late in December when the revenue index traded 9 basis points through the GO index. During all of 2021, the median spread ran at 36 basis points as the Revenue index yield average was 2.53% and the GO index traded to an average 2.18% yield.
This year’s spread has held to a tighter range of -9 to +28, with a constant +28 spread holding since March. That consistency in revenue credit levels vis-à-vis GOs bears watching as year-end approaches. Buyer preferences for balancing quality over quantity of yield are growing, considering some recession themes building in certain sectors. Components within the BB 25 Revenue index include airport, housing, turnpike, and utility credits. An ICE BofA Airport index has lost 2.5% this month — about on parity with AAA and GO indices — but a Housing Index is down 2.8% during the same period.

Source: Bond Buyer; Bloomberg

The momentous yield moves this year have had a noticeable impact on the coupon stack. Trading in 3s and 4s has been reactive to selling conditions as well as the overall pullback. The graph shows 10- and 20-year tenor 3% and 4% coupon spreads against implied AAA MMD 5% levels over the last year:

A year ago, 10-year 3s traded +15/AAA 5s. The selloff that began in Q1 moved that spread as high as +25/AAA 5s as an inflation theme developed and buyers gravitated to higher premium structures. Current 3% spreads are approaching +40/AAA 5s and in AA-rated names the gap widens further. At the 20-year mark, what were spreads of less than +40/AAA 5s in 3% coupons have moved to highs of +70/AAA 5s.
During 2021’s rally that moved 5% coupons above $140 prices, the 4% structure became a go-to allocation as a balance of some coupon protection without the onerous premiums. Intermediate 4s traded nearly flat to 5s and even after a selloff in Q1 and Q2 the spreads only gapped out by a nominal amount. Since the end of June, a growing inflationary bias has widened the 4s/5s spread to nearly 20 basis points in this range. A more dramatic widening has occurred in the 20-year range based on heavier selling of 4% structures. A year ago, the 4s/5s AAA spread sat at +15 and had moved to +47 by the end of June. Current spreads sit near +50 but in AA- and single-A names the gap widens dramatically. Actively-traded New York City GO 4s due 2050 now carry spreads near +100/AAA 5s.

Source: Refinitiv MMD

Credit

Economic considerations certainly permeate municipal credits, with tax revenue and employment playing a large role across many sectors. Housing has been in the forefront in recent years, first for its meteoric price gains and now with a focus on the potential for a weaker period. The graph shows June’s S&P CoreLogic housing price data across the 20-city index:

General market no/low tax states such as Florida, Texas, and Arizona are continuing to draw buyers. June’s month-over-month and year-over-year gains are among the highest in these states across the 20 cities. Tampa and Miami realized 2% or higher gains in June from the prior month and have year-over-year price gains of 30% or more. Dallas and Phoenix have housing price improvements of 26%-28% from a year ago. At the national level, the average monthly house price gain was 0.41% in June with an 18% yearly gain.
A reversal of high-fliers San Diego, Los Angeles, San Francisco, Seattle, and Denver appears to be occurring. Yearly price gains are still strong but recent data shows monthly declines of as much as 2% in some areas. The coming months with slowing home starts and resales of existing homes challenged with higher mortgage rates could mean wider corrections in municipal housing credits.
Vintage low-coupon housing bonds have undergone a material price change. A Pennsylvania Housing Finance issue from August 2021 that drew a 2.55% of 2051 at par (+107/BVAL) now carries an evaluated price of $62.55 (5.01 yield). The rapid rate rise this year has had dramatic effects on these structures’ performance — an ICE BofA Housing Index has given up 15% this year, a 400 basis point underperformance to the main index.

Source: Bloomberg

Sector credit strength has played a key role while yields undergo a massive upward shift. State GO spread movements show investors’ reaction to balancing the duration/inflation equation. The graph compares current GO spreads in a basket of 20 state GOs with three-month averages:

Large issuer states such as California, Texas, Florida, and Washington have seen 10-year spreads widen out as much as 20 basis points over the last three months. California’s implied GO spread sits at +26/BVAL, up from an average of +11/BVAL. Due to heavier in-state issuance, Texas GOs are trading about 20 basis points wider and Washington’s spreads have moved above +30/BVAL.
Specialty states have not been immune to wider conditions — North Carolina, South Carolina, and Georgia state GO spreads have moved into double digits against the AAA spot. The combination of wider spreads and higher yields offers buyers high-quality bonds with TEYs approaching 6% in this range (a 3.50% NC GO yield carries a 5.55% TEY).
Lower-rated state GOs show a similar, but not necessarily deeper, reaction. Pennsylvania GOs hold implied spreads of +36/BVAL (up 10 basis points over the last three months), and New Jersey’s GOs have widened out 20 basis points to around +75/BVAL. Likely in response to the new issue Illinois GOs, the state’s recent 10-year implied yield gapped out 40 basis points.
Absolute yield points across the entire basket of state names are more than 200 basis points above last year’s range. When combined with strong fiscal conditions, the opportunity value is among the highest in a decade.

Source: Bloomberg BVAL