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Below we review the market this past week as well as how December was a record-breaking month for the municipal market. Next week, we will publish our full 2018 Outlook for the municipal industry.
Issuance Stalls and Investors Take Profits on Political Instability
Over the last week munis have outperformed Treasuries on most parts of the curve. While the Dow Jones Index hit all-time highs, we are seeing investors profit-take and move into safer assets given the political instability associated with the current Administration and international affairs.
The conflux of international politics and the historical record of economic trends in the United States, converging with Dodd-Frank regulations and an expected lower issuance flow for investors leads us to believe that outperformance to Treasuries and other domestic fixed-income asset classes is expected. Issuance thus far in January has been very low and expected issuance for the rest of the month confirms this expectation.
December 2017 was a game changer, due to the uncertainty associated with tax-reform implications, subsequent Federal Reserve movements, continued credit implications associated with at-times difficult political behavior and the changing regulatory landscape impacted market participant behavior in ways not seen in some time.
Let’s review December 2017.
Issuance: Biggest December issuance in history since the 1985 prelude to the last Tax Reform legislation cannot be overlooked -- munis clocked in at $62.5 billion. Perhaps most surprising to those not attuned to the ebbs and flows of our marketplace was that this large amount of bond issuance was generally easily digested by investors looking to get ahead of what is now expected be a paltry year to come in terms of issuance expectations, given the loss of the advanced refunding option for many bond issuers.
Taking this a step further, the secondary market saw a daily total volume of bids-wanteds in December that was two-times the average for the entire of 2017 (per Bloomberg) as many market participants exited the marketplace, given said uncertainty, along with significant turnover due to tax-loss selling and replacement of old paper with newly issued December bonds. High volatility clearly played a role in the secondary selling as well.
We also saw a give-and-take approach from the mutual fund community with mixed Lipper results on the inflow/outflow figures from investors with $48 million of outflows this most recent week and modest inflows throughout the previous month. The volatility of the Inflow/outflow data over the past two months has relegated them insignificant.
The slope of the curve. It flattened. The short-end of the curve has changed dramatically. In the last 12 months we’ve seen 100 basis points plus flattening of the triple-A curve. This has caused a real shift in how asset managers are positioning their clients’ portfolios to address the new market dynamic.
We expect this market dynamic to continue as the policy impacts play a role in how market participants trade the market. A big part of the flattening was simply the spillover of the same factors that hit the Treasury curve: 3 tightenings and the expectation of three more next year, but with limited inflation expectations keeping the long end grounded.
Additionally in December, two more factors: a lot of refunding volume generated a lot of pre-res—the short end got clogged. Also, institutional investors putting cash to work didn’t want very short paper, given very light supply in Q1 this year. The SIFMA Index spiked in December. Clients should expect forward comment on the collapse of the Libor Index in future commentary.
Another item—revenue bonds versus general obligation securities. We wrote two years ago about how general obligation bonds have taken a hit in terms of credit perception in light of Puerto Rico and other challenged states, such as New Jersey, Illinois and Connecticut. The data over 2017 proves that the buyers of this asset class are requiring more of a risk premium on these credits and trading supports that.
What Now on Tax Reform: A Teaser
Following the enactment of the tax cut bill, we review our thoughts of the new law’s effects on munis.
A very sharp decline in new-issue supply relative to the $445 billion done in 2016 and the $405-425 billion or so done in 2017. Total supply in 2018 could easily drop 25% to the $300 billion range, as issuers who rushed to market move to the sidelines, and refundings drop by close to $100 billion.
Some resale of bonds originally sold in 2017 during the November/December rush to market;
Very slow issuance during the first quarter of 2018, in particular;
Ultimately, more use of complex structures to achieve needed refundings;
In some cases, a move to a first call date shorter than 10 years, but with a significant yield penalty for doing so—the desire by investors either to get 10-year protection or compensation for shorter calls isn’t going away;
Sharply more market volatility and less liquidity as banks become a weaker and less consistent buyer of munis;
Much greater challenges in placing bonds with lower coupons than the 5% level that the institutional market (including especially bond funds) desires. In recent years, the biggest buyers of below-5% coupons have been banks.
Specific maturities that become difficult to place in the absence of P and C demand and with weaker bank demand. It is important to note that Separately Managed Accounts mostly function inside 10 years, and muni funds tend to prefer mostly long paper, so that there will sometimes be a demand “hole” in the 10-17 year range that is difficult to fill except at yields very close to taxable yields.
A potentially greater role in exchange-traded funds and electronic trading platforms in providing liquidity;
Periods when it becomes extremely difficult for smaller issuers to sell longer serial maturities except at yields sharply higher than current “benchmark” yield levels;
Ultimately a larger role for foreign investors and “crossover” buyers during the much more frequent periods when demand from traditional buyers of tax-exempts dwindles, and non-traditional buyers see an opportunity to accomplish a total return trade with total yields higher than they expect to accomplish in the taxable market.
In many cases, narrower yield spreads between PABs subject to the AMT and other bonds that are not. Under the new bill, fewer individual investors will be subject to the AMT, and the effect of the AMT on corporations has essentially been eliminated; and,
Still-uncertain implications of the cut in tax rates for pass-throughs. We suspect that for many pass-throughs, the effective tax rate on taxable investment income will still be at the investor’s individual tax rate, because the investment portfolio will be outside the pass-through. If this is the case, the benefit for high-tax-rate individuals would be preserved—we will need to see how this plays out.
The above only begins to describe the new complexities facing tax-exempt issuers in this “brave new world.” Nevertheless, we anticipate that higher yields relative to corporates, more volatility, less liquidity, and a greater role for crossover buyers is inevitable. Ultimately, these changes could lead to more reliance on non-traditional investors for many projects, including more use of Public-private partnerships—but that is a story to be told in more detail at another time.
More to come next week in our 2018 Outlook.
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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