Municipal market review: Second quarter rebound
Gregory A. Gizzi
Senior Portfolio Manager
Municipal bonds rebounded in the second quarter gaining .87 basis points, as measured by the Bloomberg Barclays Municipal Bond index, on the back of slightly lower rates in the front and long end of the municipal curve.
While US Treasury rates rose 26, 11 and 1 basis point in the 2, 10 and 30-year spots on the curve, municipals fell 1, rose 4 and fell 1 respectively outperforming treasuries across the curve.
The Bloomberg Barclays Municipal Bond Index now stands down .25 basis points heading into the 3rd quarter, after being down as much as 1.65% in late April. The municipal high yield sector continues to be the top performing sector as evidenced by the Bloomberg Barclays Municipal High Yield Index returning 3.06% for the quarter and now stands at a positive return of 3.66% heading into the 3rd quarter.
The quarter began with volatility as rates rose on inflationary concerns and fears of a potentially more aggressive Federal Reserve policy. By the end of the quarter, a clarification on policy directives by the Fed combined with a resurgence in geopolitical concerns out of Europe, a slowing Chinese economy, and the start of trade tariffs being initiated by the US and countered by the Chinese, all equated to a rate rally off the high in rates reached in April.
While US Treasury rates finished higher for the second quarter, municipal rates rallied on the back of continued strong market technicals.
Municipal supply decreased approximately 12% for the quarter, year over year, and now stands down roughly 21% year to date. The decrease can be attributed to a significant fall in refunding activity.
While new money issuance was up approximately 36% year over year for the quarter, refunding transactions were down 80%. Refunding activity is down 47% year to date, heading into the 3rd quarter.
As we expected, the elimination of advanced refundings has had a significant impact on the market. While issuance was subdued, investor demand, as evidenced by Lipper municipal mutual fund flows was slightly positive. According to Lipper, municipal mutual fund flows were up approximately $650 million during the quarter. This brings year to date fund flows to $7.12 billion.
This positive supply/demand technical that was a catalyst in the second quarter, should be a positive factor in the 3rd quarter as well as. Over the three-month period, the market is expecting significant negative net supply. This simply means that the amount of cash investors will have from calls, coupons interest and maturities will significantly exceed supply. Market estimates are as high as $80billion in negative net supply. This could provide a solid foundation for municipal market performance if rates behave.
From a curve perspective the best performing segment for the quarter was from 7 years on out with returns in the .90 to .97 basis range. The front end or 1-5 years, however, continues to be the best performing part of the municipal curve with positive returns for the year, while 7 years and longer continue to have negative returns. This outperformance can be attributed a consistent flow of money into the front end of the curve by individual investors and SMAs.
From a credit perspective the best performing segment continues to be the BBB category, returning 1.41% for the quarter. All credit tranches had positive returns for the quarter, but on a year to date basis heading into Q3, only BBBs have a positive return of .40 basis points while A-AAA remain negative anywhere from .18 basis points for As and .48 basis points for AAAs.
While the Federal Reserve will continue to have an influence on the rate markets, a measured approach to raising rates, and the potential increase in volatility in risk markets, should translate to a range bound rates for the second half of 2018. In this scenario, we believe the income component of total return will be the driver of performance in the second half, and remain very comfortable with our general overweight to the lower investment grade and high yield sectors in the portfolios.
Thanks for listening and good luck in the second half!