Bonds

Munis extend sell-off, one-year hovers around 3%

Municipals extended their sell-off Thursday, as the front end of the curve was hit the hardest. U.S. Treasuries were weaker, and equities ended in the red.

Triple-A benchmarks were cut 13 to 17 basis points at the one-year, depending on the scale, pushing it to around 3%.

Muni-UST ratios rose on the short end. The three-year muni-UST ratio was at 58%, the five-year at 59%, the 10-year at 63% and the 30-year at 89%, according to Refinitiv MMD’s 3 p.m. ET read. ICE Data Services had the three at 59%, the five at 59%, the 10 at 64% and the 30 at 90% at 4 p.m.

Disinflation took a hit this week, with most economic data suggesting “the economy is mostly stronger than what Wall Street was expecting,” said Edward Moya, a senior market analyst at OANDA. “Manufacturing and housing are still in a recession, but the rest of the economy isn’t looking too bad.”

 Thursday’s data, stronger than expected PPI numbers and fewer jobless claims forced investors to begin “to price in more Fed tightening,” he said.

Also, Cleveland Fed President Loretta Mester’s admission that she saw “a compelling case” at the last Federal Open Market Committee meeting for a 50-basis-point hike “helped send Treasury yields higher,” Moya said.

On the buy side, yields relative to Treasuries and the outlook for Federal Reserve Board policy and the direction of Treasury rates are overarching themes that have been driving the municipal market lately, according to Cooper Howard, director of fixed income strategy  at the Schwab Center for Financial Research.

They indicate rising rates in the near future, Howard said.

“The muni-to-Treasury ratio is extremely rich across the curve and poses a headwind to near-term performance,” he said.

“Muni-to-Treasury ratios tend to be mean-reverting so I would not be surprised if they rise in the near-term resulting in munis underperforming Treasuries,” he added.

Looking at monetary policy, Howard said, Tuesday’s consumer price index data and Wednesday’s retail sales report illustrate that inflation isn’t likely to quickly decline to the Fed’s 2% target, “and the path is going to be bumpy.” 

“There’s upside risk to short-term yields as the market recalibrates where the peak in the Fed funds rate may be,” Howard explained. 

“We expect a 25 basis point hike at the March meeting and indications that rate hikes will continue,” he added, noting the Fed’s updated dot plot, released after the March meeting, will be under the magnifying glass.

Meanwhile, the municipal analysts at BlackRock say the market is off to a fast start in 2023.

Munis posted historically strong returns in January, amid rallying interest rates,light issuance and improved demand spurred outperformance versus comparable Treasuries and waning seasonal tailwinds and potential for added volatility warrant some near-term caution, Peter Hayes, head of the municipal bonds group, James Schwartz, head of municipal credit research and Sean Carney, head of municipal strategy, wrote in their monthly report.

The team said municipal bonds posted their second-best start to the year in over 30 years, trailing only the bounceback from the global financial crisis in January 2009. 

“Strong performance was driven by improved supply-and-demand dynamics and rallying interest rates, amid expectations that the Federal Reserve will pause monetary policy tightening in early 2023,” Hayes, Schwartz and Carney wrote. 

They noted that the S&P Municipal Bond Index returned 2.82% and “considerably” outperformed comparable Treasuries. 

Longer-duration — securities more sensitive to interest rate changes —  and lower credit-quality bonds performed best, according to the analysts, who reported the asset class has now garnered returns of 7.61% over the past three months.

As far as issuance is concerned, it remained subdued at just $23 billion, or 12% below the five-year average, and was outpaced by reinvestment income from maturities, calls, and coupons by over $5 billion, according to Hayes, Schwartz and Carney. 

“At the same time, tax loss-driven outflows ended at the turn of the year, and the asset class accumulated $3.9 billion in net inflows in January,” they wrote.

“Despite rich valuations, attractive dollar prices and favorable taxable-equivalent yields kept retail investors engaged,” they added. 

As a result, selling activity fell 36% month-over-month to just over $1 billion per day on average, the analysts added.

The market technicals and seasonally changing environment caused the team to make some slight changes to its investment approach, they said.

“Given the outsized total returns harvested in January, we have shifted to a slightly more defensive posture and are looking to monetize gains as seasonal trends turn less favorable in February,” the team wrote.

“While we anticipate that supply-and-demand technicals will remain supportive, we expect heightened volatility throughout early 2023 in both interest rates and performance as the Fed tries to engineer a soft landing,” they said.

On the credit side of the market, defaults in municipals remain rare with only 0.1% of all issuers defaulting in 2022, the analysts noted.

However, they are proceeding with caution.

“With the probability of a U.S. recession increasing, credit deterioration across the municipal market increases the potential for downgrades,” they noted. “However, default risk will remain concentrated in a limited segment of the high yield market,” they said. The higher risk sectors include senior living facilities and small healthcare providers dealing with labor costs, as well as stand-alone projects that experienced cost overruns and construction delays.

These credits are “backed by defensive tax revenues and user fees for essential services, credit risk is much higher for non-rated issuers that are subject to competitive pressure and are vulnerable to changes in economic conditions,” the team wrote.

“A spike in municipal credit spreads should be viewed as an opportunity, and maintaining a diversified portfolio with strict issuer limits remains the optimal strategy when investing in high-yield municipals,” Hayes, Schwartz and Carney added.

Refinitiv Lipper reported $68.054 million was pulled from municipal bond mutual funds in the week that ended Wednesday after $775.006 million of inflows the week prior.

High-yield saw $79.944 million of outflows after $530.316 million of inflows the week prior, while ETFs saw outflows of $361.427 million after $474.684 million of outflows the previous week.

In the primary, Morgan Stanley & Co. priced for the California Pollution Control Financing Authority (Baa3//BBB/) $158.110 million of AMT water furnishing revenue bonds (Poseidon Resources (Channelside) LP Desalination Project), Series 2023, with 5s of 7/2026 at 3.40%, 5s of 7/2028 at 3.49%, 5s of 7/2033 at 3.91%, 5s of 7/2038 at 4.53% and 5s of 11/2045 at 4.78%, callable 1/1/2033.

Secondary trading
Maryland 5s of 2024 at 3.03%. Los Angeles DWP 5s of 2025 at 2.74%. Connecticut 5s of 2025 at 2.93%-2.84%.

Washington 4s of 2028 at 2.68%-2.63%. District of Columbia 5s of 2028 at 2.50% versus 2.28% Tuesday. California 5s of 2029 at 2.40%.

New York City TFA 5s of 2033 at 2.73% versus 2.57% Monday. Hennepin County, Minnesota, 5s of 2033 at 2.57%. Maryland 5s of 2036 at 2.95% versus 2.84% Wednesday.

Massachusetts Bay Transportation Authority 5s of 2052 at 3.85% versus 3.61% on 2/7. LA DWP 5s of 2052 at 3.80% versus 3.52% Monday and 3.30%-3.18% on 2/3.

AAA scales
Refinitiv MMD’s scale was cut eight to 15 basis points. The one-year was at 3.00% (+14) and 2.69% (+15) in two years. The five-year was at 2.39% (+15), the 10-year at 2.44% (+10) and the 30-year at 3.46% (+8) at 3 p.m.

The ICE AAA yield curve was cut seven to 16 basis points: 3.08% (+13) in 2024 and 2.78% (+16) in 2025. The five-year was at 2.42% (+14), the 10-year was at 2.42% (+9) and the 30-year yield was at 3.48% (+7) at 4 p.m.

The IHS Markit municipal curve was cut eight to 14 basis points: 2.99% (+14) in 2024 and 2.66% (+13) in 2025. The five-year was at 2.35% (+13), the 10-year was at 2.47% (+9) and the 30-year yield was at 3.47% (+8) at a 4 p.m. read.

Bloomberg BVAL was cut eight to 17 basis points: 2.99% (+17) in 2024 and 2.68% (+16) in 2025. The five-year at 2.44% (+16), the 10-year at 2.49% (+10) and the 30-year at 3.50% (+8).

Treasuries were weaker.

The two-year UST was yielding 4.644% (+2), the three-year was at 4.367% (+2), the five-year at 4.069% (+4), the seven-year at 3.982% (+5), the 10-year at 3.855% (+5), the 20-year at 4.055% (+7) and the 30-year Treasury was yielding 3.916% (+8) at 4 p.m.

Mutual fund details
Refinitiv Lipper reported $68.054 million of municipal bond mutual fund outflows for the week that ended Wednesday following $775.006 million of inflows the previous week.

Exchange-traded muni funds reported outflows of $361.427 million after outflows of $474.684 million in the previous week. Ex-ETFs, muni funds saw inflows of $293.373 million after inflows of $1.250 billion in the prior week.

Long-term muni bond funds had inflows of $158.856 million in the latest week after inflows of $1.018 billion in the previous week. Intermediate-term funds had inflows of $133.362 million after inflows of $233.018 million in the prior week.

National funds had outflows of $118.343 million after inflows of $556.638 million the previous week while high-yield muni funds reported outflows of $79.944 million after inflows of $530.316 million the week prior.

Primary on Wednesday:
Goldman Sachs & Co. priced for the California Community Choice Financing Authority $998.780 million of green Clean Energy Project revenue bonds, Series 2023C, with 5s of 10/2024 at 4.50%, 5s of 10/2028 at 4.40%, 5s of 10/2031 at 4.55% and 5.25s of 1/2054 at 4.60%.