Municipal bond demand is likely to rebound with the arrival of the fiscal year-end, according to a new report by BlackRock Inc.
Once state and local municipalities settle budgetary issues at quarter end, demand should increase through the summer months, after waning in May amid interest rate volatility, analysts Peter Hayes, James Schwartz and Sean Carney wrote in a June 11 municipal market update.
Demand slumped last month when municipal bond mutual funds experienced $503 million in outflows, mostly in the high yield sector, on the heels of healthy inflows in the first four months of the year.
The S&P Municipal Bond Index returned negative 0.21% in May, according to data in the report from S&P Indices.
Bonds maturing in 20 years and beyond posted negative returns of 0.07% for the month, yet were positive year to date at 0.55%. The high-yield sector outperformed the broader market in May, returning 0.98%, and 1.80% year to date, according to performance data from S&P Indices.
Intermediate maturities due between three and 14 years were also negative for the month, posting returns of minus-0.40%, but positive at 0.28% year to date.
"Demand in the muni market tends to cue off of recent past performance and volatility measures, so May's $503 million in outflows is not necessarily a surprise," given the combination of mixed economic data and evolving rhetoric about the Federal Reserve Board's interest-rate hike, the analysts said in the report.
In addition, the concentration of the outflows particularly in the high-yield sector was "not entirely unexpected," given credit concerns and Moody's Investors Service's downgrade of Chicago to below investment grade at Ba1 on May 12.
"The downgrade was particularly surprising since Moody's has discounted any options Chicago may have in dealing with its budget and pension situation, threatening the city's liquidity position in the process," the analysts wrote.
Other municipalities with pension problems continue to see negative press, ratings pressure, and wider credit spreads as the fiscal year-end approaches, the analysts noted.
"The upside to a third down month is that the correction has created levels - higher yields and ratios - not seen in many months," the analysts wrote in the report.
Rates were higher and the muni-to-Treasury ratios were elevated -- closer to their one-year maximum than to their one-year average, the analysts said. The five year triple-A municipal yield ended on May 31 at 1.41%. That compared with the five-year Treasury yield of 1.49%. The 30-year triple-A municipal yield was 3.16% at the end of May, while the comparable Treasury yield ended the month at 2.88%.
"The recent correction in rates and muni-to-Treasury ratios has re-introduced value in the market, and we expect both retail and crossover buyers will take notice," according to the analysts.
BlackRock Municipals Group had $114 billion of asset under management as of March 31, according to the report. It currently maintains a neutral duration and favors a barbell approach, focusing on the two-year-and-under and 15- to 20-year portions of the yield curve.
The holdings are overweight relative to a benchmark index in state tax-backed and essential service bonds, particularly in the Southwest, the Plaines, and Southeast regions, as well as school districts, and dedicated tax bonds.
It is underweight in land-secured and senior living bonds, Puerto Rico and its authorities, and local tax-backed issues, particularly in Alabama, Nevada, Michigan and Illinois.
Before demand rebounds, the market has to weather a "potentially contentious state and local budget season and quarter end pressures that will likely bring less demand and lower dealer support" in the remainder of June.
Once that pressure passes, the "attractive taxable/tax-exempt ratio" should capture investor interest and support the market, they said.
Hayes is the managing director and head of the municipal bonds group, Schwartz is a managing director and head of municipal credit research, while Carney is director and head of municipal strategy.
"We remain optimistic that the recent turbulence in the market will soon be an opportunity and the asset class will revert back to positive performance," they said.
