Munis weaker, but outperform UST selloff; outflows intensify

Municipals cheapened across the yield curve Thursday, but outperformed U.S. Treasuries which sold off after better-than-anticipated payrolls numbers, leading the two- and 10-year to the highest levels since March. . Equities ended down.

Municipals could not ignore the large losses in USTs, though the July reinvestment dollars and lack of new-issue supply worked to stave off further cuts. Muni yields were cut three to six basis points, depending on the scale, while U.S. Treasury yields rose six to 12, pushing the two-year above 5% and the 10-year above 4%.

The two-year muni-to-Treasury ratio Thursday was at 59%, the three-year at 61%, the five-year at 61%, the 10-year at 65% and the 30-year at 89%, according to Refinitiv MMD’s 3 p.m. read. ICE Data Services had the two-year at 60%, the three-year at 62%, the five-year at 62%, the 10-year at 67% and the 30-year at 92% at 4 p.m.

Municipal bond mutual fund outflows intensified as Refinitiv Lipper reported investors pulled $855.719 million from the funds for the week ending Wednesday following $25.331 million of outflows the week prior.

Despite the pressure Thursday, Kim Olsan, senior vice president of municipal bond trading at FHN Financial, said “the market appeared primed to react to the [June 1] redemptions” beginning Wednesday.

June’s trade involved “some distraction from [Federal Deposit Insurance Corp.] liquidation lists as well as heightened volatility in USTs — a factor that impacted short-end ratios to a larger extent than longer maturities.”

But cash-flow needs relating to the July 1 redemptions “can be expected to keep bidding in daily and weekly reset floaters on the more active end — and just how much demand persists outside of money market product will circle back to projected supply,” Olsan noted.

Issuance was expected to be $7 billion as of Wednesday but 30-day visible supply rose to $11 billion, per Bond Buyer data Thursday, and the figure may be higher going forward if recent history is any guide, Olsan said

Since the onset of the pandemic, Olsan said total volume estimates for July have been as high as $19 billion in 2022.

This year’s outlook, she said, “is clouded by a Fed tightening cycle that is forcing higher UST yields and hence greater financing costs for issuers in the municipal space.”

July’s performance could also be impacted by “tepid open-end fund flows,” she said. Over the past decade, the month’s average return is 0.66%.

Since the start of the year, muni yields on the short end are up while yields on the long end have fallen, said Dan Garrett, a municipal bond analyst at SQX.

“Since March, rates went down and then they went back up, and the curves flattening ever since the beginning of the year,” he said.

He said there is opportunity at the short and long end with rates tighter in the middle of the curve while muni-UST ratios have been holding steady since the beginning of the year.

Garrett said there is a general widening across credit ratings in the muni market.

“It’s not very much, but enough to be a little concerning about the credit strength of all sectors,” he said.

He said further rate hikes from the Fed may create challenges for issuers looking to refinance due to higher rates.

“It’s probably more difficult for refundings,” he said.

However, the higher rates are “bringing in a lot of trading volume for the muni brokers,” he noted.

That increase in trading volume from a few years ago will help sales and trading desks going forward, noting that increased trading volume is an indication of a healthy market.

“There’s a lot more volume, probably a lot more investors looking at fixed income, with higher rates relative to the stock market,” he said.

So far, 2023 “has been a rough year for the current buy and hold” investor, but he thinks yields are attractive.

In the primary market Thursday, Wells Fargo Bank priced for the Dickinson Independent School District, Texas (Aaa/AAA//), $116.645 million of PSF-insured unlimited tax schoolhouse bonds, Series 2023, with 5s of 02/2025 at 3.11%, 5s of 2028 at 2.82%, 5s of 2033 at 2.90%, 5s of 2038 at 3.42%, 4s of 2043 at 4.15%, 4.125s of 2048 at 4.32% and 4.25s of 2053 at 4.37%, callable 2/15/2033.

June performance recap
June’s volume was “readily absorbed by investors as a portion of the $44 billion reinvestment on the month was recycled into the market,” for a net supply of negative $5.6 billion, said Peter Block, managing director of credit strategy of Ramirez & Co.

The resulting “depth and breadth of accounts involved in the primary market was significant, leading to yield/spread reductions on pricings for solid credits,” he said.

He expects there to be net negative supply to be $8.5 billion and $14.8 billion in July and August, respectively, “which all else equal, should be price supportive.”

September, he noted, “is a different story as reinvestment falls off the proverbial cliff.”

For the first half of the year, supply was at $174.8 billion, down 20% year-over-year. This includes the “surprise surge” of $34.4 billion in June, which is up 32.1% month-over-month.

Given this, Ramirez & Co.’s initial forecast for total volume in 2023 of $350 billion “appears reasonable and attainable” with an implied expectation of an average of around $30 billion month per month through December and a total of negative $11 billion of net supply.

Fund flows ended up being positive for June at $212.573 billion but negative for the year at negative $7.111 billion, according to Refinitiv Lipper, driven by the higher rate environment, he said.

Bids wanted in competition and trading volume only negative 2% below average in June, he noted.

“Dealer inventory of fixed coupon bonds is only slightly elevated,” he said.

The Refinitiv MMD curve was bumped by an average of 11 basis points for the month, including 15 basis points in two years, “outperforming Treasuries by an average of -8 ratios across the curve,” he said.

“SIFMA was higher by 45 bps in June to 4.01% as dealer inventories of VRDOs averaged a slightly elevated $4.7 billion,” Block said.

Muni outperformance in June has left muni-UST ratios “mostly rich heading into July, which along with only fairly valued credit spreads, indicates that the muni market is bereft of any significant value at this time,” he said,

Munis should continue to outperform USTs through August on strong reinvestment demand, Block said.

“Given these factors, look for better relative value and absolute entry points beginning in September when reinvestment falls off the cliff,” he said.

Secondary trading
NYC 5s of 2024 at 3.10%. California 5s of 2024 at 2.95%-2.94%. Georgia 5s of 2025 at 3.02%.

Connecticut 5s of 2028 at 2.83%. LA DWP 5s of 2029 at 2.56%-2.50% versus 2.50%-2.49% on 6/28. NYC 5s of 2029 at 2.82% versus 2.81% Wednesday and 2.84% on 6/27.

Massachusetts 5s of 2033 at 2.73% versus 2.75% on 6/30 and 2.76% original on 6/29. Triborough Bridge and Tunnel Authority 5s of 2033 at 2.85%-2.90% versus 2.84%-2.86% Wednesday and 2.84%-2.86% Monday. Battery Park City Authority, New York, 5s of 2034 at 2.70% versus 2.70% Wednesday and 2.81% original on 6/30.

Raleigh Combined Enterprise System, North Carolina, 5s of 2048 at 3.66% versus 3.58% on 6/28. Huntsville, Alabama, 5s of 2053 at 3.83% versus 3.75%-3.65% on 6/22.

AAA scales
Refinitiv MMD’s scale was cut four to five basis points: The one-year was at 3.09% (+4) and 2.97% (+5) in two years. The five-year was at 2.67% (+5), the 10-year at 2.61% (+5) and the 30-year at 3.54% (+5) at 3 p.m.

The ICE AAA yield curve was cut five to six basis points: 3.07% (+5) in 2024 and 2.99% (+5) in 2025. The five-year was at 2.64% (+5), the 10-year was at 2.61% (+5) and the 30-year was at 3.60% (+5) at 4 p.m.

The IHS Markit municipal curve was cut four to five basis points: 3.09% (+4) in 2024 and 2.98% (+5) in 2025. The five-year was at 2.67% (+5), the 10-year was at 2.61% (+5) and the 30-year yield was at 3.54% (+5), according to a 3 p.m. read.

Bloomberg BVAL was cut three to five basis points: 3.03% (+3) in 2024 and 2.94% (+4) in 2025. The five-year at 2.64% (+4), the 10-year at 2.58% (+5) and the 30-year at 3.55% (+4) at 4 p.m.

Treasuries were weaker.

The two-year UST was yielding 4.995% (+6), the three-year was at 4.686% (+8), the five-year at 4.362% (+12), the 10-year at 4.041% (+11), the 20-year at 4.242% (+8) and the 30-year Treasury was yielding 4.007% (+7) near the close.

Mutual fund details

Refinitiv Lipper reported $855.719 million of outflows from municipal bond mutual funds for the week that ended Wednesday following $25.331 million of outflows the week prior.

Exchange-traded muni funds reported inflows of $200.867 million after inflows of $80.804 million in the previous week. Ex-ETFs muni funds saw outflows of $654.852 million after outflows of $106.135 million in the prior week.

Long-term muni bond funds had outflows of $602.577 million in the latest week after inflows of $417.409 million in the previous week. Intermediate-term funds had $53.963 million of outflows after outflows of $72.004 million in the prior week.

National funds had outflows of $720.647 million after inflows of $24.768 million the previous week while high-yield muni funds reported outflows of $306.587 million after inflows of $220.752 million the week prior.

June FOMC meeting minutes redux
The minutes from the June FOMC meeting where the Fed decided to skip a rate hike “point to what will likely be strong support around the FOMC for a 25bp rate hike at the Fed’s July 25-26 meeting,” said Mickey Levy and Mahmoud Abu Ghzalah of Berenberg Capital Markets.

“‘Almost all’ Fed members were in favor of additional rate hikes later this year given inflation is well above the Fed’s 2% target and labor markets remain ‘very tight,'” they said.

The near-unanimous agreement that the “more rate hikes will be required was reflected in the June dot plot, in which just two Fed members thought it would be appropriate to leave the policy unchanged, with the median Fed member in favor of at least two more 25bp rate hikes,” they said.

The minutes also show Fed Chair Jerome Powell’s role “as a consensus builder on the committee,” Levy and Ghzalah said.

The decision to ‘pause’ in June “likely marks an agreement — brokered by Powell — between the hawks and doves on the FOMC,” they noted.

“‘Some participants’ signaled openness to or pushed outright for a June hike, citing ‘few clear signs that inflation was on a path to return to … 2% … over time’ and resilient economic and labor market data,” they said

While not all participants “judged it appropriate or acceptable” to pause in June, they said, “there were no dissents, with Chair Powell and the Fed keen to present a united front despite clear internal divisions on the current and future path of policy.”

An underlying theme through the FOMC meeting minutes has been uncertainty and “that was no different in June,” they said.

Fed members remain “uncertain about the economic outlook, the effect of bank stresses in late March on credit intermediation, and the extent to which they will need to raise rates,” Levy and Ghzalah noted.

These uncertainties and “the desire to avoid tipping the economy into recession via excessive policy tightening, underscored the Fed’s decision to pause in June and emphasize the distinction between the pace of rate hikes and the eventual level of the terminal policy rate,” they said.

“Meeting participants ‘noted a higher degree of uncertainty regarding the cumulative effects on the economy” of the 500bp of tightening since March 2022, with the ‘full effects of monetary tightening … likely yet to be observed,'” they said.

These uncertainties and “downside risks may lead the Fed to settle on a terminal rate lower than the 5.6% the median FOMC member thought appropriate at the time of the June meeting, particularly if declining inflation and modest softening in labor markets bring risks surrounding the Fed’s employment and inflation mandates into better balance later this year,” according to Levy and Ghzalah.