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A rally in the stock market and a sell-off in Govies where the 10-year Treasury yield flirted with 2.60% for the first time since March of 2017 hit the municipal market hard this week.
The dynamic of minuscule supply thus far in January versus the largest December in nearly 30 years underscores the odd dynamic market participants are currently dealing with (see chart below on Visible supply). Last week saw just more than $1 billion in competitive supply and only a single negotiated deal more than $100 million. This is very atypical for a January and would suggest strong performance (especially given the historical precedent of strong January performance).
However, secondary bids-wanteds were very telling with several days last week over the $1 billion mark, and perhaps what was most interesting is what was being sold. We noted a lot of short-call structures (tax reform) along with a lot of selling in the intermediate range. This is an item we’ve discussed for some time now as tax reform changes will have a broader impact on the intermediate part of the curve but benefit the ever growing separately managed account (SMA) space.
The market saw more than $1 billion in inflows to mutual funds, according to Lipper. Funds are a lagging indicator. We do not expect funds to see this type of interest after the result of this past week are made more clear and performance is reported.
Bloomberg data shows only 6 states with projected positive supply outlook over the next 30 days. This would suggest performance should improve next week, especially given the Lipper figure.
Direct evidence of market challenges this past week was a benchmark-influencing triple-A rated Fairfax County, Virginia competitive deal that was trading out of the gates on Wednesday 10-basis points weaker than originals. Massachusetts GO did not fare much better with similar cuts and challenges with its 5% coupons.
This is not a knock on these credits whatsoever but an indication of dealer response to the current market uncertainty/volatility along with the massive amount of bids-wanteds noted above.
See disclaimer on new deals below.
Moving forward, supply does not look to be increasing in the coming week and we expect continued volatility given:
- Low supply (which reduces price discovery) and continued limited secondary liquidity; Concern about Federal Policy as it pertains to global politics;
- Headlines about a potential infrastructure bill on the way;
- The likelihood of daily and then weekly outflows reported after very poor performance this past week; and,
- Uncertainty regarding the outlook for inflation and Fed policy
The muni market got slammed pretty hard last week, as three lagged effects seemed to hit home hard, at the same time. The first simply resulted from the fact that not all of the massive $62 billion of new issuance that came to market in December was well placed, and some of it began to leak back into the market this past week. The second, we think, was the beginning of a realization that the demand side of the muni market was not going to be in such good shape under Tax Reform, for reasons we discussed in last week’s Outlook. The third was related to concerns about rates generally, as the yield curve in most sectors finally began to reverse a bit of the curve flattening that had occurred late in 2017.
In the Treasury market, the result was a modest steepening from 2 years on out, with 10- and 30-year paper up 8 and 10 basis points in yield from January 2, while 6-month paper actually rallied very slightly.
So, overall market conditions put pressure on the slope of the curve, and in munis, the other two lagged factors compounded the pressures, so that yields on 10-year paper were up about 10 basis points, and yields on the long end were up as much as 15 basis points. In addition, bids wanted volume was running at around double recent patterns, at over $1 billion daily.
A couple of large institutions apparently concluded that they wanted to get out of the way of potential market pressure, and they added considerably to secondary market offerings. It is also worth noting that historically, most or all of the “January effect” in the muni market was actually discounted by December. This past month was no exception.
Going forward, we expect volatility in the muni market to remain high, and relative yields in comparison with taxable yields to bounce around quite a bit. The result will be that buying opportunities should crop up from time to time that are more pronounced than had been the case, pre-Tax Reform.
In the muni market outlook, some uncertainties remain
In last week’s discussion, we laid out a number of demand factors that could lead to a thinner and more volatile market in 2018. Not the least of these is the sharply lower tax rate on corporations, and the extra reduction in the effective benefit for Property and Casualty Insurers in owning munis, resulting from the increase in the P and C “haircut” to 25%.
In our view, a number of uncertainties remain, however. These include:
- The extent to which reductions in demand from bank portfolios will also spill over to the dealer function, creating reduced liquidity and more volatility;
- The extent to which nontraditional buyers, including foreign investors, will become a more constant source of demand;
- The extent to which private placement of bonds in bank portfolios will decline as the bank appetite for tax exempts declines;
- The outlook for a Federal infrastructure financing bill and the shape of any such bill. One factor in the discussion of any bill is the extent to which public/private partnerships—P3s—are either permitted or limited. We discuss the issues involved in that choice very briefly, below.
- A House Working Group this week released a 12-page report on Rebuilding America’s Infrastructure in which they advocate to expand private activity bonds and expand the use of P3s, explore increasing the federal gas tax and mileage-based taxes, among other provisions. It can be found here. We still remain dubious that a large infrastructure package will be enacted in 2018.
P3s and Privatization are entirely different structures
As the Trump Administration prepares for a proposal on infrastructure funding, a number of issues remain to be addressed on this key topic.
First, we find it difficult to envision that any infrastructure proposal with high costs for the Federal government will gain any momentum in Congress, just after the size of the Federal Deficit has been increased by $1-1.5 trillion over the coming 10 years.
Second, we continue to see considerable confusion between the roles of “Financing” and “Funding.” What is much needed is additional funding—new sources of revenue or capital as needed to pay for added projects. There are already vast numbers of sources of financing for projects that are adequately funded.
Third, as noted in the Washington Post, “President Trump expressed misgivings about his administration’s infrastructure plan Friday at Camp David, telling Republican leaders that building projects through public-private partnerships is unlikely to work — and that it may be better for the government to pursue a different path.”
In our view, there is massive confusion here that we have been dealing with for years. A significant chunk of what is being described as a P3 is actually a privatization: the actual sale of a public facility to a private entity in exchange for an up-front chunk of cash, or for a defined revenue stream. A significant number of these, including a famous parking meter project and a highway project in Indiana, have been quite problematic— potentially not priced through an arms-length transaction, the sale of the revenue stream at too low a price, etc.
A true P3, on the other hand, involves private participation in a publicly owned project. In the current day and age—and in our view, forever going forward—a well-designed P3 will bring the government owner of a project a vast amount of additional expertise, that can improve project design, sharply cut initial construction costs, and permit the government owner to adapt to rapidly changing technological inputs that affect operating costs and the operating environment.
Often, but not always, the old-style projects were design/bid/build, while the P3 is done as design/build, with technological expertise tied in at the onset. Good, simple comparisons on major projects are between two huge P3s—the replacement of the Tappan Zee Bridge and the new Laguardia Airport Terminal that are generally considered to be successful—and two publicly designed and constructed projects being handled by the MTA that are setting all-time records in costs per mile.
We thus encourage the planners of any new infrastructure program to carefully consider incorporating rules to extract maximum benefits from well-designed P3 structures. And, we encourage states to create more modern enabling legislation that recognizes the value of a well-designed P3 structure. As technological change continues to accelerate, the value-added from incorporating private vendors into well-designed government projects is only going to increase.
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George Friedlander is Managing Partner at Court Street Group Research. He has more than 40 years of experience as a lead strategist in the municipal industry, previously at Citigroup.View author