Munis take a breath, ICI reports $4.3 billion outflows

Municipal yields were little changed Wednesday and the primary saw some action while U.S. Treasuries were slightly better on the day and equities were in the black ahead of Thursday’s CPI numbers.

Triple-A benchmark yields were little changed while UST yields were slightly better outside of two years. The municipal to UST ratio five-year was at 66%, 76% in 10 and 86% in 30, according to Refinitiv MMD’s 3 p.m. read. ICE Data Services had the five at 65%, the 10 at 79% and the 30 at 85% at a 4 p.m. read.

The market took a slight breather on Wednesday following Tuesday’s $1.35 billion of bids wanteds, the eighth time they surpassed $1 billion since the start of the year, but customer selling was still outweighing buys.

The Investment Company Institute on Wednesday reported $4.263 billion of outflows from municipal bond mutual funds in the week ending Feb. 2, up from $2.189 billion of outflows in the previous week. It marked the largest reported outflows since March 2020 and the third week of outflows after 45 straight weeks of positive flows into the long-term funds.

ICI’s data is a $1 billion increase from Refinitiv Lipper, which reported a roughly $3 billion loss of fund assets last week.

Pat Luby, senior municipal strategist at CreditSights, said the discrepancy stems from ICI’s and Lipper’s different methodologies to compile their reports. Luby said the Lipper numbers are always helpful because of the timeliness, but there is generally a difference between the two weekly numbers.

ICI also said exchange-traded funds saw outflows at $13 million in the week ending Feb. 2 after $523 million of outflows the week prior. Luby said last week muni ETFs pulled in $476 million of net new assets, while the past six days — Feb. 3 through Feb. 8 — had muni ETFs up $414 million.

“This demonstrates again why it is so important to watch mutual fund and ETF flows separately,” he said.

Luby said both products are widely used by individual investors, but ETFs are also used by institutional asset managers, both as products in ETF strategies and complements to portfolios of individual bonds. He said professional portfolio managers are much less likely to react to market volatility by shifting out of municipals, while it is not unusual for some individual investors and advisors to do so. When yields increase and prices and mutual fund NAVs decline, some fund shareholders react by redeeming shares, he said.

“I expect that the market overall is in for a couple of months of weakness, which could very well result in more investors reacting by redeeming mutual fund shares,” Luby said. “At the same time, some will react to higher yields and income by putting money into mutual funds, but I do not know if that will be enough to fully offset redemptions.”

Despite this, Matt Fabian, partner at Municipal Market Analytics, said the muni demand side isn’t lacking without the billions loss of fund assets last week.

“There is still exceptional net demand via strong reinvestment and 2022 has started with only moderate issuance, the 3-week rolling net supply total has only just hit $30 billion,” he said.

Fabian said two weeks of huge fund withdrawals will have a negative impact on market psychology, as most investors are aware of muni prices’ over-reliance on funds in recent years. He said another cautionary note is last week’s 11-basis-point jump in the SIFMA 7-day index, which followed a fresh record-low reading on money fund assets of $86.4 billion.

That drop in 2a7 assets will be linked to both the impending Fed raise and the termination of LIBOR, he said. The latter will prompt temporary investor risk avoidance, but in any case, Fabian said there was a spike in dealer inventories of variable rate demand obligations to $3.7 billion at the end of January.

Fabian said short and intermediate 5s have underperformed longer maturity 3s and 4s, allowing the long-maturity exchange-trade fund TFI to raise significant assets as investors have been raising cash with their most liquid holdings. He said this is a positive net investment, with investors banking on a prolonged price rebound; but, if yields rise again and the pain extends to less liquid securities, the performance downside might be worse.

In the primary market, Siebert Williams Shank & Co. priced for Arlington Independent School District, Texas (Aaa/AAA///) $176.745 million of unlimited tax school building and refunding bonds, Series 2022. Bonds in 2/2023 with a 5% coupon yields 0.68%, 5s of 2027 at 1.32%, 5s of 2032 at 1.69%, 5s of 2037 at 1.84%, 4s of 2042 at 2.15% and 4s of 2047 at 2.28%, callable 2/15/2031.

BofA Securities priced for Indianapolis Local Public Improvement Bonds Bank (/AA-/AA//) $126.765 million, Series 2022B. Bonds in 2/2023 with a 5% coupon yields 0.75%, 5s of 2027 at 1.44%, 5s of 2032 at 1.86%, 5s of 2037 at 2.09%, 4s of 2042 at 2.42% and 4s of 2047 at 2.59%, callable 2/1/2032.

In the competitive market, Florida State Board of Education (Aaa/AAA/AAA//) sold $151.945 million of public education capital outlay refunding bonds, 2022 Series C, to BofA Securities. Bonds in 6/2023 with a 5% coupon yields 0.7%, 5s of 2027 at 1.26% and 5s of 2032 at 1.55%, noncall.

Wisconsin (Aa1/AA+//AAA) sold $73.475 million of general obligation bonds to Morgan Stanley & Co. Bonds in 5/2023 with a 5% coupon yield 0.68%, 5s of 2027 at 1.20% and 5s of 2028 at 1.25%, noncall.

Secondary trading
Woburn, Massachusetts 5s of 2023 at 0.8%. NYC TFA 5s of 2024 at 1.07%. New York City Municipal Water Finance Authority 5s of 2025 at 1.15%.

District of Columbia 5s of 2026 at 1.21% versus 1.22% Tuesday. Connecticut 5s of 2026 at 1.29%-1.28%.

Georgia 5s of 2028 at 1.86%-1.85%. Florida 5s of 2028 at 1.38%. Coppell, Texas 4s of 2029 at 1.53%. Harford County, Maryland 5s of 2030 at 1.48%.

New York City Municipal Water Finance Authority 5s of 2031 at 1.63%-1.61%. Ohio common schools 5s of 2032 at 1.62%-1.61%. Ohio common schools 5s of 2033 at 1.72%-1.71%. New York City waters 5s of 2032 at 1.69%.

Michigan trunkline 5s of 2035 at 1.76%, same as 2/2.

Ohio 5s of 2038 at 1.80%. California 5s of 2041 at 1.91% versus 1.88% Tuesday. Connecticut 5s of 2041 at 2.03%.

Triborough Bridge and Tunnel 5s of 2047 at 2.25% versus 2.20%-2.18% Monday and 2.15% original. NYC TFA 5s of 2047 at 2.24%. New York City 5s of 2047 at 2.26% versus 2.18%-2.10% on 2/2. Piedmont, California 5s of 2051 at 2.08%.

Washington 5s of 2047 at 2.04%-1.94% versus 2.04% original. New York City waters 5s of 2052 at 2.28% versus 2.27%-2.22% Tuesday and 2.15% original.

AAA scales
Refinitiv MMD’s scale saw were steady at the 3 p.m. read: the one-year at 0.63% (unch) and 0.90% (unch) in two years. The five-year at 1.19% (unch), the 10-year at 1.48% (unch) and the 30-year at 1.91% (unch).

The ICE municipal yield curve saw small cuts: 0.62% (+1) in 2023 and 0.93% (+2) in 2024. The five-year at 1.19% (+1), the 10-year was at 1.52% (unch) and the 30-year yield was at 1.92% (+4) in a 4 p.m. read.

The IHS Markit municipal curve was little changed: 0.64% (unch) in 2023 and 0.87% (unch) in 2024. The five-year at 1.21% (+2), the 10-year at 1.48% (+2) and the 30-year at 1.91% (unch) at a 4 p.m. read.

Bloomberg BVAL was cut a basis point in spots: 0.67% (unch) in 2023 and 0.89% (unch) in 2024. The five-year at 1.23% (unch), the 10-year at 1.50% (unch) and the 30-year at 1.90% (unch) at a 4 p.m. read.

Treasury yields were steady while equities ended in the black.

The two-year UST was yielding 1.361%, the five-year was yielding 1.814%, the 10-year yielding 1.946%, the 20-year at 2.312% and the 30-year Treasury was yielding 2.253% near the close. The Dow Jones Industrial Average gained 317 points or 0.80%, the S&P was up 1.42% while the Nasdaq gained 1.96% near the close.

Economy
Markets were somewhat comforted by Federal Reserve Bank of Atlanta President Raphael Bostic’s comments suggesting the Fed will not be as aggressive as the markets suspect.

Appearing on CNBC, he said he expects three or four rate hikes this year and the inflation rate should fall to 3% by the end of the year. Bostic said he will be looking for moderation in monthly CPI gains because trajectory remains important.

His tone was different than when speaking to the Financial Times two weeks ago when Bostic suggested a 50-basis point hike in March is possible.

Federal Reserve Bank of Cleveland President Loretta Mester also downplayed the possibility of a 50-basis point liftoff.

With the Federal Reserve poised to raise interest rates, economic growth is expected to slow, but, as always, economists have differing views about growth and Fed rate hikes.

“The first year of a tightening cycle is usually good for the economy,” said Ned Davis Research Senior U.S. Economist Veneta Dimitrova and Chief Global Macro Strategist Joe Kalish. “But momentum begins to slow towards the end of that first year and has averaged only 1.6% in the second year after the start of tightening, reflecting the lagged effect of Fed policy on real economic activity.”

The pace of rate hikes is also a factor, they said, with slower tightening often “shrugged off.” NDR expects four or five ¼-point rate hikes, compared to market expectations of six. “Combined with a run-off in the Fed’s balance sheet later this year, this may be a fast tightening cycle,” Dimitrova and Kalish said.

GDP should gain 3.5% to 4% this year, they expect. Should tightening lead to a recession, as nine of the 12 cycles have, they said, contraction generally starts about two years after the first increase, which should put any chance of a recession into 2024.

And while Omicron appears to be fading, “it has already taken a meaningful toll on first quarter growth,” said Wells Fargo Securities. They cut first quarter GDP growth projections to 0.7% on an annualized basis and trimmed growth projections for “the next two years, reflecting a less accommodative policy environment.”

The economy has become less sensitive to COVID outbreaks, Wells said, although Omicron “still disrupted activity over the past two months.”

Wells expects five rate hikes in 2022. “If, as we expect, inflation remains hot by the end of the year and the labor market continues to tighten, we forecast the FOMC to lift rates an additional 75 bps in 2023,” they said. “The reduction of the Fed’s balance sheet, which we expect to be announced in July and begin in August of this year, will act as another form of policy tightening.”

While the economy recovered quicker than expected, Megan Horneman, chief investment officer at Verdence Capital Advisors, fiscal stimulus and accommodative monetary policy “have also left us with challenges that we have not faced for decades.”

Expect “notably” slower growth through midyear as inflation remains at a pace not seen since the 1980s. “The supply chain will need time to repair itself and Americans are still reluctant to return to a normal work atmosphere,” she noted. “In addition, the support line from the federal government and Federal Reserve is abating and will be a drag on growth compared to previous years.”

The Fed is “now tasked with a balancing act of pulling back excess liquidity to combat inflation but also not threaten the economic expansion,” Horneman said.

“Last year, investors witnessed the first decline in the broad bond market (Bloomberg Barclays Aggregate Index) since 2013, and we think 2022 will be another challenging year for bonds,” she said. “The Fed is in a position where they need to normalize interest rates faster than previously forecast, we are left paying for the record amount of debt that was issued during the pandemic, inflation is reducing overall returns and excess liquidity has propelled some public sector valuations to levels not seen since the dot-com bubble.”

But, James Solloway, chief market strategist at SEI, sees “subdued” economic growth. “We expect the investment environment to remain favorable to more economically sensitive areas of the capital markets, like value-oriented and cyclical sectors, in 2022.”

Not only does Solloway expect a “more intensive” tightening than currently priced in, he also expects a higher terminal Fed funds rate. “The expected five-year inflation rate five years from now (the so- called 5-year/5-year forward inflation expectation rate) still reflects a transitory view of the inflation landscape, which we believe means it’s underpriced today.”

The last time the Fed was in a tightening cycle, it raised once a quarter, noted Bryce Doty, senior portfolio manager at Sit Investment Associates. “With inflation raging and the Fed feeling like they are behind the curve, they are going to move more quickly this time,” he predicted. “We expect the Fed to get to 2.0% as quickly as they think investors and financial markets can handle it.”

He sees “a tough year for bond investors,” suggesting “TIPS and floating rate bonds look attractive right now.”

Thursday’s CPI report could play a role in market expectations, said Scott Ruesterholz, a portfolio manager at Insight Investment. “A particularly hot report could increase market speculation of a 50 bp hike, though that remains unlikely in our view as the Fed does not want to create undue volatility in its first hike, which only makes further increases more difficult,” he said. “Rather, the Fed would be more likely to guide to an accelerated pace of hikes at consecutive meetings to crack down on inflation.”

Primary to come:
The University System of Maryland is set to sell $23.95 million of auxiliary facility and tuition revenue bonds, 2022 Refunding Series B, at 10:45 a.m. eastern Thursday.

The University System of Maryland is set to sell $97.64 million of auxiliary facility and tuition revenue bonds, 2022 Series A, at 10:30 a.m. Thursday.