Tax-Exempts Performed Well in the Midst of Market Volatility
The municipal market remained resilient as it navigated through a number of issues during the quarter, including anticipation of potential Federal Reserve action on interest rates and volatility in global financial markets. Additionally, the municipal sector continued to avoid any contagion risks due to the negative credit developments in Puerto Rico. During the quarter, as expected, the Commonwealth did indeed default on its appropriation-backed debt payments due for the Puerto Rico Public Finance Corp. Further defaults are expected as the Commonwealth faces a liquidity crisis as its cash balances continues to dwindle during the fourth quarter.
In the face of these developments, municipals performed well, with 10-year yields during the quarter collapsing by 25 basis points (bps). The sector was largely supported by very strong seasonal technicals. On the demand side, the market was buoyed by heavy reinvestment flows of coupons/calls/maturities, which are at their highest levels of the year during the summer months. Supply technicals during the quarter were also beneficial to market performance. Although new issuance in July and August increased by 26% versus the same period in 2014 to a total of $66.1 billion, September issuance plunged to $18.3 billion, a drop of 27.3% relative to the same period in 2014. That was the lowest monthly total reported over the last 19 months. The dramatic drop off in issuance was likely driven by a reluctance of issuers to come to market during expectations for both a lift-off in short term rates by the FOMC (Federal Open Market Committee) and a thinning of market participation due to vacations and holidays during the month.
Underlying credit fundamentals also provided support for the sector. As reported by the U.S. Census Bureau, state and local government revenues exhibited a strong showing in the second quarter with a growth rate of 6.9% versus second quarter 2014 levels. That compares favorably to revenue growth over the prior three quarters that averaged 4.2%. Additionally, outside of the ongoing fiscal struggles of Puerto Rico, Illinois and New Jersey, and a budget stalemate in Pennsylvania, headline risk has remained muted and the sector has continued to exhibit slow, but steady improvement in fundamentals. The improving credit profile, combined with the FOMC’s postponement in raising rates, has already resulted in solid improvement in mutual fund flows over the last month. After funds reporting on a weekly basis reported average outflows of $359 million per week from August 26 through September 16, fund flows have turned positive, with a weekly average of $300 million in inflows over the last four weeks. Additionally, these flows have largely targeted longer duration assets. Funds that were classified as “long-term” recorded a four-week average of $459 million of inflows.
Looking forward, with the rally in rates during the quarter, the current level of yields could provide headwinds for relative market performance during the fourth quarter. As of this writing, 10-year yields are at 2.03%, which has historically been very conducive to a heavy refinancing/refunding cycle. During the first four months of this year, “AAA” 10-year rates averaged 1.96% and during that period, deals that were classified as straight refinancings/refundings, averaged approximately $17 billion per month. Since that time, as rates moved higher during the year, the average over the last five months plunged by 41% to $10 billion per month. If rates remain near current levels or move lower from here, we could see some upside surprise in new issuance levels.
However, we remain constructive on the sector. As of the end of the third quarter, total refinancings are up over 56% versus the same time period in 2014 and have made up over 64% of total new issuance for the year. We believe that the called bond proceeds generated from this spike in year-to-date refinancings will provide solid sponsorship for the expected overall increase in issuance during the fourth quarter, and make supply technicals appear manageable. Additionally, although we could experience some near-term volatility in relative valuation levels on heightened supply concerns, strong seasonal technicals return in December, as supply begins to wane into the new year and heavy reinvestment flows enter the market starting on December 1. If the sector experiences any deterioration in relative valuation levels, we would view this as an opportunity to further increase our overweight position to the sector.
Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products
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