Municipal market review: Positive technicals ahead

After a difficult start to 2018 that underwent pressure from rising rates and other factors, the municipal fixed income market expects positive technical conditions as the year ends. In this brief video, Senior Portfolio Manager Greg Gizzi looks at how these conditions developed in the third quarter.

The municipal market experienced negative returns for the 3rd quarter as yields rose across the curve. The Bloomberg Barclays Municipal Bond Index returned -0.15% for the quarter against a backdrop of rising treasury yields and positive equity returns. Year to date the Index is down -.40 basis points. The Bloomberg Barclays High Yield Index continued its streak putting up a +.76 basis points for the quarter and is now up +4.45% for the year. Both the investment grade and high yield municipal indices continue to outperform all major fixed income indices except for corporate high yield which is the best performing fixed income asset class in 2018.

From a return perspective for the first 3 quarters, the best performing part of the curve in the Bloomberg Barclays Municipal Bond index has been inside of 5 years with positive returns of .10-.95 basis points depending on maturity. From a credit perspective the only positive returning segment is the BBB category returning .61 basis points for the year.

In Q3 municipal rates rose across the curve with AAA GO rates up .21, .12, and .25 basis points respectively in the 5,10, and 30-year segments of the curve. This compared to UST rates that also rose .21 basis points in 5 years but rose .20 basis points in 10 and 30-year segments. This lead to municipal ratios, or AAA GO MMD rates over UST rates, to widen approximately 2 ratios in 5 years, tighten approximately 1.75 ratios in 10 years and widen 1.7 ratios in 30 years. Muni ratios ended the quarter at 84.6% in 10 years and 100% in 30 years.

The long end of the municipal curve continues to trade at elevated ratios due to demand factors which have impacted what would appear to be a positive technical condition in the municipal market. Supply for the quarter was down approximately 9% year over year, and flows into tax -exempt bond funds were positive $3.5B in Q3. This puts aggregate municipal supply down approximately 15% for the year while tax-exempt bond fund flows have been about $11B, yet 30-year ratios have widened over 7 full ratios on the year.

There are two key factors that have superseded the positive technical in the market. First, the most recent Federal Reserve data indicates that banks, the largest component of corporate demand for municipal bonds continued to sell municipal bonds due to new accounting treatment for certain structures and a lower corporate tax rate. Bank holdings of municipal bonds fell by $10.9B during the 2nd quarter and are now down 4.7% for the year. This has added supply to the longer end of the curve but more importantly has removed the largest component of corporate demand for municipal bonds from the market.

Second, retail investors continue to be absent on the long end of curve and remain focused on the front end, inside 10 years, despite attractive opportunities out longer. The majority of municipal strategists continue to recommend investors shorten duration and upgrade credit which has helped to curtail demand in the longer end of the market.

The fourth quarter begins with a positive technical condition as expected supply of $25-35B should be significantly less than the $40B returned to investors. This will result in a market with negative net supply to start out the quarter. We continue to favor credits that generate higher income which typically outperform during periods of orderly rate rises. The markets did get the third rate hike from the FOMC at the end of the quarter and is expecting a fourth most likely in December if the economy continues its current trajectory.

Good luck in Q4 and thanks for listening.


Sources: Municipal Market Data, Citibank, Bloomberg.

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, noninvestment grade tax-exempt bond market.

The views expressed represent the Manager’s assessment of the market environment as of September 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.

Other than Macquarie Bank Limited (MBL), none of the entities noted are authorized deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities, unless noted otherwise.

Macquarie Investment Management (MIM) is the marketing name for certain companies comprising the asset management division of Macquarie Group. Investment products and advisory services are distributed and offered by and referred through affiliates which include Delaware Distributors, L.P., a registered broker/dealer and member of FINRA; and Macquarie Investment Management Business Trust (MIMBT) and Delaware Capital Management Advisers, Inc., each of which are SEC-registered investment advisors. Investment advisory services are provided by the series of MIMBT. Macquarie Group refers to Macquarie Group Limited and its subsidiaries and affiliates worldwide. Delaware Funds by Macquarie refers to certain investment solutions that MIM distributes, offers, refers or advises.

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