Municipals performed very well during the quarter, as the sector continued to follow closely behind the strong performance in Treasuries. Treasury yields overall were lower by 30 basis points (bps) during the quarter. Most of the move was attributed to the flight-to-quality rally that followed Britain’s decision to exit the European Union. Municipal performance was even stronger, with 10yr rates falling by 35 bps during the quarter.
The strong demand for municipals remained in place in the face of potential headline risk from the credit events surrounding Puerto Rico. As expected, on July 1st, the Commonwealth defaulted on approximately $800 million in debt service payments on its general obligation debt, preferring instead to make payments due to its employees. The Governor declared a moratorium on the island’s debt a day after the President signed into law the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). The legislation creates a federal seven-member control board, which will have broad fiscal management oversight powers and the authority to restructure the debt of the Commonwealth. Passage of this legislation was seen as the first important step towards putting the island on a path toward fiscal recovery; however, there are some market concerns that the law does not provide any economic stimulus initiatives to improve revenues going forward. Market prices were generally up after passage of PROMESA and prices since the default are generally unchanged, as the market fully expected the Governor to declare the moratorium.
The overall muni market also saw very little reaction to the Puerto Rico headlines. The sector has generally been consumed by a build in momentum of technical imbalances heading into the summer months. Collectively, June and July experiences the heaviest reinvestment flows of the year resulting from coupons/calls/maturities, while new issue supply was expected to plunge 25% in July from June’s $44 billion in issuance. With seemingly few challenges to curtail demand in the near term, these improving technicals should provide solid relative performance versus taxable alternatives for the 3rd quarter. Even with yields hovering near record low levels, tax-exempt investors have remained consistently engaged all year. Mutual fund flows through July 6th have experienced 40 consecutive weeks of inflows and a year-to-date weekly average of $1.25 billion. With expectations that the Federal Reserve will likely slow the pace of normalizing rates, these fund flows are expected to continue to support the market over the balance of the year.
Although the trend in demand appears to be very supportive for strong relative performance over the 2nd half of the year, a heavier-than-expected new issuance cycle could pose some potential headwinds. In the near term, supply technicals appear to be favorable. After the market produced $119 billion in supply during the 2nd quarter, the market should see a 20% drop in the 3rd quarter, which would be consistent with long-term historical trends. However, today’s near record low yield environment has created very compelling refinancing opportunities for municipalities. Low absolute yields, combined with the flattening in the slope of the muni yield curve, have now increased the universe of outstanding deals that could be refinanced going forward. At the beginning of the 2nd quarter, the only deals that provided compelling refinancing opportunities were debt structured with call features of 3 years or shorter. With the muni yield curve flattening by 58bps since April 1st and high-grade rates starting the 3rd quarter at 1.35% in 10 years, older deals with calls as long as 5 to 7yrs now provide enough in debt service savings to be considered for refinancing. If rates remain near current levels, we expect to see this potential increase in refinancings enter the market late in the 3rd quarter at a time when demand techincals move to much weaker levels on October 1st and November 1st. Consequently, we are moving to a neutral bias for the sector and awaiting opportunities to build exposure to the sector on any potential market dislocations that develop late in the 3rd quarter.
Gregory Bell, CFA, CPA
Director of Municipal Bonds