Municipal market review: A solid fourth quarter
January 8, 2019
Municipals ended 2018 with a solid gain of 1.69% in the fourth quarter, which saw a distinct return of volatility in both bond and equity markets. A rate rally in the last two months of the quarter led to solid gains. This strong performance came against the backdrop of a shift in the outlook for US fiscal and monetary policy, and lower Treasury yields and negative equity returns, as geopolitical and global growth concerns drove the markets. Learn more about performance in the fourth quarter, in this brief video with Greg Gizzi, senior portfolio manager.
Municipals ended the year with a solid gain of 1.69% in the fourth quarter despite a distinct return of volatility in both bond and equity markets.
The fourth quarter started with US Treasury rates rising particularly in the intermediate and longer portion of the curve, on what was perceived as hawkish Federal Reserve commentary when Chairman Powell characterized rates as “a long way from the neutral rate” or the rate that neither induces or impedes economic growth. The market sold off 15 to 20 basis points and municipal rates followed but underperformed Treasury rates, selling off an additional 2 to 5 basis points. Since late September, municipal markets continued to see pressure from outflows in tax-exempt funds and selling in ETFs, but bond market sentiment appeared to turn in mid-October as equity markets began to sell off amid trade tensions and geopolitical concerns.
Through November, municipal rates rallied with yields falling 22 basis points in 10 years and 16 basis points in 30 years. Municipals outperformed Treasurys as US Treasury rates fell 8 to 14 basis points in the intermediate and long portion of the curve. Despite continued outflows from tax-exempt bond funds, the municipal market benefitted from lower issuance and the relative attractiveness of municipals, particularly in the longer end of the curve.
In December, rates continued to rally as equity markets continued to sell off. US Treasury rates fell 31 to 33 basis points while municipals fell 14 to 23 basis points. Outflows persisted until late December when tax-exempt bond funds experienced inflows for the first time in 12 weeks. As anticipated, the Federal Open Market Committee did raise rates for the fourth time in 2018 but Fed commentary suggested that the Fed was now “just below” neutral, and that the Fed was looking at the “economic effects of the gradual rate increases.” For the first time in two years, the Fed was no longer on a pre-set rate path that could lead to increased volatility in markets during 2019.
Technicals were not supportive of performance in Q4. While overall issuance was down 44% for the quarter year over year, the outflows and tax-loss related selling overwhelmed the positive supply factor. According to Lipper, heading into Q4 year to date, flows were positive $10.9 billion, but the fourth quarter erased these flows and ended with outflows of -$1.35 billion from tax-exempt mutual funds for the year.
Overall 2018 was a year in which credit worked for municipal investors but the long end of the curve, or 17 years and longer, underperformed. Banks continued to sell throughout the year and relative value under a new tax code made corporate participation minimal.
The strong performance in Q4 gave municipals a positive return of 1.28% for 2018. The Bloomberg Barclays Municipal High Yield Index finished the year with a return of 4.76% — making municipal high yield and investment grade municipals the top two performing indices of all the major Bloomberg Barclays indices as illustrated by the chart.
||Bloomberg Barclays Municipal Bond Index
||Bloomberg Barclays Municipal High Yield index
||Bloomberg Barclays U.S. Treasury Index
||Bloomberg Barclays U.S. Aggregate Index
||Bloomberg Barclays U.S. Government/Credit Index
||Bloomberg Barclays U.S. Corporate High-Yield Index
||Dow Jones Industrial Average
||S&P 500® Index
Data as of Dec. 31, 2018.
Past performance is not a reliable indicator of future results.
Looking ahead to 2019, ultimately Treasury rates and mutual fund flows, which will largely be driven by Fed policy, will be the key for municipal performance, in our view. We believe the asset class will once again post positive returns, the magnitude of which will depend on whether US rates markets have reached cycle highs in early November. We believe municipal investor should earn the coupon +/- depending on the magnitude of rate movements.
Thank you for listening, and good luck in 2019!
Sources: Bloomberg, Bloomberg Barclays Indices, The Federal Reserve, and Lipper
The views expressed represent the Manager's assessment of the market environment as of January 2019, 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.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
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.
HQLA 2B designated assets refer to high-quality liquid assets that consist of Level 2A assets (including certain government securities, covered bonds, and corporate debt) and Level 2B assets (including lower-rated corporate bonds, residential mortgage-backed securities, and certain equities).
The Bloomberg Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.
The Bloomberg Barclays High-Yield Municipal Bond Index measures the total return performance of the long-term, non-investment-grade tax-exempt bond market.
The Bloomberg Barclays US Aggregate Index is a broad composite that tracks the investment grade domestic bond market.
The Bloomberg Barclays US Government/Credit Index is composed of investment grade corporate and US government debt securities with at least one year to maturity.
The Bloomberg Barclays US Treasury Index measures the performance of US Treasury bonds and notes that have at least one year to maturity.
The Bloomberg Barclays US Corporate High-Yield Index is composed of US dollar-denominated, non-investment-grade corporate bonds for which the middle rating among Moody’s Investors Service, Inc., Fitch, Inc., and Standard & Poor’s is Ba1/BB+/BB+ or below.
The Dow Jones Industrial Average® is an often-quoted market indicator that comprises 30 widely held US blue-chip stocks.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.
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Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index.