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The key driver of the capital markets over the past week has been the interplay between Fed tightening concerns, the risk of higher Treasury yields, and the responses to these factors in the stock market.

When the markets became concerned about higher inflation and Fed responses, the stock market got slammed, hard, last Friday and Monday. Then, when the stock market got hit, market participants began to wonder whether this pattern would continue, leading the Fed to tighten less aggressively.

Despite all of this back and forth, the trend toward higher Treasury yields ultimately resumed on Wednesday, with longer Treasury yields up 5-6 basis points on the day. Also contributing to higher Treasury yields, we suspect, were concerns regarding the likely size of the federal budget deficit. On Thursday, everything reversed again, as the stock market got slammed through mid-day and Treasury yields eased a bit. What seems certain is that the capital markets are in a period of much higher volatility, which doesn’t seem likely to go away any time soon.

10yr If the two-year Senate deal were to be confirmed in the House, estimates are that as much as another $1-1.5 trillion could be added to the 10-year Federal deficit, adding to the supply of Treasuries while also adding to concerns that the Fed would feel compelled to offset this clear case of fiscal stimulus through additional monetary tightening, which might pressure yields all along the curve. While the muni market finally outperformed slightly on Wednesday on continued light new-issue supply, the lack of retail appetite for munis was an ongoing concern—one that is consistent with our view about demand after Tax Reform, but one which apparently surprised some market participants.

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Note on January issuance:

Total volume for the month plummeted 53.8% compared to January 2017, to $16.75 billion in 490 transactions from $36.01 billion in 777 transactions, according to Thomson Reuters data. The month went by without a single billion-dollar deal. The largest negotiated deal was the Port Authority of New York and New Jersey’s $832.28 million. There were several reasons for the tight supply, not the least of which was the elimination of advance refundings, and the issuance of Private Activity Bonds (PABs) earlier in the project cycle (December) than usual as issuers worried that they, too, might be eliminated by tax reform.

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We continue to believe that the muni market will face considerable challenges on the demand side. The “good news,” for now, is that new-issue supply should be down in the $320 billion range, from $436 billion in 2017, so that pressure on yields should generally be limited—but not entirely.

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Helping support the market should be a move to sharply negative net supply: In 2016—the last year with complete Fed data—issuance was $444 billion, and net supply was $42.2 billion, meaning $402 billion in bonds were retired through calls and maturities. We would put issuance close to $320 billion this year, which with similar calls/maturities, would put net at -$80 billion. Calls and maturities may be slightly higher this year, so we think that net supply of -$100 billion is reasonable.

A still-damaged direct retail market. Many market observers continue to think of munis as a largely retail investor market, because Household Sector holdings, according to the Fed, were $1.561 trillion, or 41% of outstanding bonds, at 9/30/17. However, this ignores the facts that a) household sector holdings are down $312 billion since 12/2010, b) Separately Managed Account (SMA) holdings, which are included in households, are up $250 billion over that period, leaving c) net flows in direct retail over that 6 ¾ years down about $560 billion. And, as we have noted, much of that direct retail is relatively short in duration/maturity. Will direct retail holdings rebuild over time? We expect so, but it won’t be easy—see the next 2 points.

The structure of retail distribution of securities, including municipals, has shifted strongly since 2010 or even before, and it isn’t going back. Namely, most investment advisors have become asset gatherers, after which they pass on those assets to surrogates, such as SMAs and bond funds. Direct purchase and sale of munis by a retail investor’s advisor has permanently become a less common way to purchase and hold tax-exempt securities than it was before the Great Recession.

Commercial banks will continue to purchase a fair amount, but the annual purchase level will likely be down relative to the average estimated net purchase of $47 billion or so from 2010-2017, given a tax rate of 21%. Demand for bank-qualified munis should remain solid, but lacking separate Fed data on this sector, we suspect that net holdings here haven’t budged much with gross issuance in the sector of only $17.6 billion in 2017. We suspect that some privately held munis will be refinanced as public issues once they become callable.

We expect issuance to rebound over time. Some portion of the hole in new-issue supply this year is a result of the lack of advance refunding capacity—much of that issuance will come back, as issues reach 90 days before the first call, when they become current refundings. In addition, as noted, some PABs were rushed to market in 2017 in November and early December, as issuers worried that PAB issuance might be eliminated.

There will be more frequent “holes” on the demand side, and the market will be thinner and more volatile. We are hard pressed to identify where demand for 10-17 year paper, in particular, will come from on a consistent basis. That paper is beyond the SMA range, and shorter than the paper most desired by long-term muni funds. Some additional thinness and volatility will occur as a result of attempts by issuers to adapt to the elimination of advance refundings.

Issuance in high-tax states will be supported, a bit, by the sharp reduction in deductibility of state and local taxes, but even in these states, whenever extra-heavy supply occurs, the result will be market pressure and volatility. We also expect that the market will be much more sensitive to ebbs and flows in fund demand, given weaker demand in other institutional sectors.

This increased volatility will lead to cheaper trading relationships, at times, versus taxable bonds—good news for both individual investors seeking maximum after-tax yields, and institutions seeking a total return opportunity, but a considerably expanded challenge for issuers.

Issuers will be seeking creative new ways to maintain flexibility after the elimination of advance refundings by tax reform. Issuers will consider shorter calls, shorter calls at a premium (few call provisions recently had premium prices), lower coupons than 5% so that the urgency to call existing bonds will not be as great going forward, and a handful of other techniques that give an issuer more capacity to eliminate a bond before it’s the 10-year target that would apply with existing law and structures, or would reduce the need to eliminate high-coupon paper. The challenge will be that in the new, thinner and more volatile market, the cost to the issuer in terms of higher yields on short-call paper will increase, as will the penalty (at times) for using coupons well below 5% that funds don’t appreciate. So, the extra flexibility issuers will seek in the post-tax reform world lacking advance refunding capacity may get more costly over time.

We continue to wonder whether competitive sales will decline as a proportion of total issuance, as underwriters find that it often becomes more difficult to distribute a deal quickly after purchase. Given the potential for increased after-purchase risks on competitive sales, there may be fewer underwriting syndicates on many deals, and bids on competitive sales may become less aggressive relative to negotiated sales where bonds are mostly put away prior to final pricing. Couponing rules on competitive sales may also become more of a challenge, in environments where lower-coupon paper is tough to sell at a point in time.

The bottom line is that issuers and their underwriters will have to be increasingly nimble, and well-tuned to ebbs and flows in absolute yields, and in yields relative to Treasuries and corporates. If pockets of unsold paper arise, issuers will sometimes be well served postponing a proposed deal, until a better supply/demand balance becomes available. Right now, we do not believe that munis are sufficiently cheap relative to taxables in the 10-17 year range to attract the direct retail demand the market requires, especially if new-issue supply rebounds.

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