SUMMARY
- Investment grade municipal bonds retreated in August – their first month of negative returns since April – while lower-rated issues gained ground.
- Although performance was mixed, the municipal market saw nearly $12 billion in August inflows – including the second-highest weekly total in a decade.
- Elevated taxable supply in late August, coupled with expectations for net positive supply in September, spurred the first monthly pickup in municipal yields since June.
IMPORTANT NOTICE: Please note that the following contains the opinions of the manager as of the date noted, and may not have been updated to reflect real-time market developments. All opinions are subject to change without notice.
Month in Review
The U.S. stock market continued its upward charge in August, with major equity benchmarks posting their strongest month since April. In the municipal market, elevated supply triggered the reversal of a nearly two-month downward trend in yields. Investors saw municipal yields end the month up from 3 to 19 basis points (bps) as the AAA Municipal Market Data (MMD) curve steepened. The 10-year tenor closed out August at 0.81%, up 16 bps from July’s historic month-end low of 0.65%.1 Taxable municipal debt continues to represent a sizable component of total issuance in this low rate environment, comprising nearly one-third of the robust $41.3 billion brought to market in August. Year-to-date issuance now totals $293.9 billion, with taxable issuance accounting for $86.6 billion.2
- At the Jackson Hole economic symposium last month, Federal Reserve Chair Jerome Powell announced significant changes to the central bank’s policy-setting framework as it relates to inflation. Rather than targeting a static 2% inflation level, the Fed will now seek to compensate for past misses of the target by temporarily allowing inflation to run modestly above 2% as conditions warrant. The shift likely signals the Fed’s intent to leave U.S. interest rates very low for the long term. Fed Vice Chairman Richard Clarida said a re-evaluation of the Fed’s framework was necessary as policy makers will have less room to spur growth by reducing borrowing costs in a near-zero rate environment.3
- Investment grade municipals and high yield municipals moved in opposite directions in August. While the Bloomberg Barclays Municipal Bond Index was down 0.47% for the month, the Bloomberg Barclays High Yield Municipal Bond Index returned 0.26%. Year-to-date total returns for the two indices now stand at 3.31% and 0.27%, respectively.4
- With August’s increase in the one-year municipal/Treasury ratio, this figure now stands at 100% or greater across all tenors of the curve. The one-year ratio ended the month at 125% (up from 92% at the end of July), the two-year ratio ended the month at 123% (up from 118%), the five-year ratio at 100% (down from 105%), and the 10-year ratio at 114% (down from 120%). Further out along the curve, ratios decreased slightly with the 20-year ratio ending the month at 110% (down slightly from 119%) and the 30-year ratio at 106% (down slightly from 114%).5
- Municipal/Treasury taxable-equivalent spreads* increased modestly in August. At month-end, spreads equated to 13 bps at the one-year tenor, 14 bps at the two-year tenor, 18 bps at the five-year tenor, and 66 bps at the 10-year tenor.6
Muni technicals in focus: Muni yields reverse course as seasonal dynamics shift
The Dow and S&P experienced their strongest August since the 1980s, returning 7.6% and 7.0%, respectively, while the Nasdaq jumped 9.6% for its strongest August since 2000.8 Despite the surge in equities, the market continues to weigh the potential for a COVID-19 vaccine, another round of federal stimulus, the upcoming U.S. election, persistent unemployment claims, and the Fed’s revised policy concerning inflation targets. The Bloomberg Barclays Municipal Bond Index returned -0.47% in August, signifying the first month of negative returns for the municipal market since April.9
Municipal funds saw a nearly $12 billion influx in August, including the second-highest weekly inflow ($5.4 billion) since 2010.10 However, municipal market dynamics in the first half of the month were distinct from those in the latter half. The first half of the month saw heightened levels of reinvestment capital outweighing primary market sales – a tailwind for the municipal market that we generally observe during the summer months. Strong demand pressured municipal yields, with the 10-year AAA municipal yield reaching a record low of 0.58% around mid-month.11 This imbalance appeared to evaporate in the latter half of the month. Given expectations for net positive supply in September, municipal yields pivoted upward, changing direction for the first time since June.12 The 10-year AAA municipal yield climbed to 0.81% to close the month.13
After facing criticism that the program was too prohibitive, the Federal Reserve revised borrowing costs for the Municipal Liquidity Facility (MLF), reducing the interest rate spread in each credit category by 50 bps.14 Soon after, the New York Metropolitan Transportation Authority (MTA) became the second borrower to utilize the MLF at a 1.92% rate on $451 million in notes.15
From a credit standpoint, August continued several trends we have discussed in recent months, including political gridlock that has stalled additional federal relief, projected state and local government budget shortfalls by high-profile municipal issuers such as the City of Chicago and NY MTA, and sporadic credit downgrades. We expect that additional federal aid will be necessary to stave off additional austerity measures across the public finance landscape. And although we anticipate downgrade trends to continue, we believe that strong obligors have the necessary tools such as healthy liquidity to manage through an uncertain environment.
August brought the first major storm of the 2020 hurricane season, as Hurricane Laura barreled towards the Louisiana coast, ultimately making landfall as a Category 4 storm on August 27. While the storm caused upwards of $9 billion in damage along the Texas and Louisiana Gulf Coast, we do not believe it will result in credit events for investment grade municipal credits.
Finally, for a number of schools across higher education and K-12, August marked the first month of classes. For those attempting in-person classes, we anticipate an uneven process. Throughout the month, we saw several large universities shift plans to remote instruction after recording significant positive tests for COVID-19 among returning students, and we continue to see the challenges of opening up campuses as other large universities face outbreaks. We saw similar trends across K-12 campuses as schools in Georgia and Indiana that attempted to reopen were forced into going remote following early positive tests. While the fall semester is likely to be chaotic, we do not expect a shift in learning modes to affect the near-term credit quality of municipal obligors.
1 Thomson Reuters TM3 MMD Interactive Data, 31 Aug 2020; Alexander Osipovich and Anna Isaac, “U.S. Stocks Post Biggest Monthly Gains Since April,” Wall Street Journal, 31 Aug 2020.
2 The Bond Buyer: Primary Market Statistics – A Decade of Bond Finance, 31 Aug 2020
3 Nick Timiraos, “Fed Approves Shift on Inflation Goal, Ushering In Longer Era of Low Rates,” Wall Street Journal, 27 Aug 2020; Nick Timiraos, “Top Fed Official Says New Framework Provides More Humble Approach to Setting Rates,” Wall Street Journal, 31 Aug 2020
4 Bloomberg Barclays, 31 Aug 2020
5 Thomson Reuters TM3 MMD Interactive Data, 31 Aug 2020
6 Thomson Reuters TM3 MMD Interactive Data, 31 Aug 2020
7 SIFMA: US Municipal Trading, 1 Sep 2020; The Bond Buyer: Secondary Market Data, 31 Aug 2020
8 Bloomberg, 31 August 2020
9 Bloomberg Barclays Indices, 31 August 2020
10 Refinitiv Lipper, 2 September 2020
11 Thomson Reuters TM3 MMD Interactive Data, 31 August 2020
12 Thomson Reuters TM3 MMD Interactive Data, 31 August 2020
13 Ibid
14 Federal Reserve Release, “Federal Reserve Board announces revised pricing for its Municipal Liquidity Facility,” 11 August 2020
15 The Bond Buyer, “NY MTA rejects bids, heads to the Fed,” 18 August 2020
DISCLOSURES
Past performance is not a guarantee or a reliable indicator of future results.
A word about risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes.
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Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
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