Municipal market review: A challenging first quarter
April 9, 2018
With a combination of factors leading to rising rates, fixed income experienced a difficult first quarter of 2018. In this brief video, Senior Portfolio Manager Greg Gizzi looks at the effects on the municipal bond market, including a discussion of index curve and credit components, new-issue supply, and flows into tax-exempt bond funds.
Gregory A. Gizzi
Senior Portfolio Manager
It was a challenging first quarter for fixed income as rates rose aggressively on the back of strong economic data and expectations of a Federal Reserve rate hike, accompanied by more hawkish commentary. The 10- and 30-year US Treasury spots were up 33 and 24 basis points, while AAA municipals underperformed Treasurys and rose 44 and 41 basis points, respectively. These rate moves were off the high points of the quarter, which occurred during February. Municipals experienced their worst first-quarter performance since 1996, finishing down 1.11% as measured by the Bloomberg Barclays Municipal Bond Index.
Municipals did outperform every major fixed income asset class in the Bloomberg Barclays Aggregate Index except for high yield, which lost 86 basis points. Municipal high yield, however, did outperform taxable high yield, by gaining 58 basis points for the quarter.
If we examine the individual credit and curve components of the Bloomberg Barclays Municipal Bond Index, curve played the critical role. The front end significantly outperformed the long end of the curve, while credit returns were fairly flat as BBBs, the best-performing segment, outperformed AAAs, the worst-performing segment, by returning -1.00% versus -1.19%.
The first quarter technical conditions were impacted by the record $62.5 billion in supply that was pulled forward and priced ahead of the passage of the Tax Cuts and Jobs Act in December. The pull forward led to a Q1 new-issue total of $63 billion, down roughly 32% from last year, according to the Bond Buyer. It is very interesting when we examine the composition of the supply. New money issuance was up 5% for the year, while the refunding portion was down 68%. As expected, the elimination of advanced refundings has had a significant impact on supply.
Fund flows into the tax-exempt bond funds were positive for the quarter, increasing approximately $6.5 billion, according to Lipper. On the surface, positive flows and lower supply suggests a solid technical backdrop for the market, but a combination of bloated dealer inventories (taken into balance sheets from the supply in December), the rising rate environment, and some select selling by corporate entities, all contributed to the down quarter in the asset class. Banks were selling specific bond structures that faced an accounting change by FASB, which makes holding those structures less appealing to the banks. While the new FASB standard does not become effective until this December, some entities were being proactive in selling their holdings during the quarter.
As I mentioned, municipal rates rose more aggressively than Treasury rates, causing municipal ratios (AAA GOs versus US Treasurys) to widen 6-plus ratios in the quarter. Given the significant rate rise and relative attractiveness of municipal bonds, individual investors have an attractive entry point to add to municipal holdings, particularly as the supply picks up in the second quarter.
Lastly, from a philosophical standpoint, we believe municipal bond investors that seek tax-exempt income would prefer not to pay capital gains tax. This rate rise has been an opportunity for us to book losses by executing tax swaps and eliminating gains, which generally have accrued during the rate rally over the last few years. We are taking advantage of the opportunity that exists, something which hasn’t been that frequent.
Thanks for listening, and good luck in the second quarter.
The views expressed represent the Manager's assessment of the market environment as of April 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions.
Bond funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
Funds that invest primarily in one state may be more susceptible to the economic, regulatory, and other factors of that state than funds that invest more broadly.
Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to state or local taxes and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.
The Bloomberg Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.
The Bloomberg Barclays US Aggregate Index is a broad composite that tracks the investment grade domestic bond market.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
FASB denotes the Financial Accounting Standards Board.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 877 693-3546. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.