A post-recession yield climate that has bolstered demand for municipals should persist awhile longer, even though the Federal Reserve has started to raise interest rates.
The low tax-exempt yields and the strong supply-demand imbalance that have bolstered municipal-to-Treasury ratios since the Great Recession should remain in place until the flight to safety triggered by global market fears dissipates, municipal pros say, or until the current supply-demand imbalance for munis abates, investment strategists say.
"A lack of leveraged buyers and general low yield environment are the two main drivers behind municipal-to-Treasury yield ratios remaining high relative to pre-recession levels," Anthony Valeri, fixed income and investment strategist at LPL Financial told The Bond Buyer this week.
"When yields are low, muni ratios are generally higher and yields are still near historic lows," he said, pointing to the Bond Buyer 20 index of general obligation bonds, which shows municipal yields at or near 50-year lows.
This yield climate has provided fertile terrain for municipals to outperform other asset classes so far this year, analysts said.
"Muni-to-Treasury yield ratios have increased so far in 2016 in response to the flight-to-safety in U.S. Treasuries," Valeri said. "Munis usually lag Treasuries during bouts of safe haven buying, but munis are still up nearly 2% year-to-date."
The yield ratio of 10-year municipals to Treasuries is currently 98.1% for the three month period ending Feb. 23, versus a three-month average of 88.2% and a one-year average of 96.8%, according to Thomson Reuters.
The ratio of 30-year municipals to Treasuries is currently 107.1% for the same time period, which compares to a three-month average of 98.2% and a one-year average of 105%.
Before the financial crisis, the ratios were noticeably lower.
The 10-year ratio of municipal yield to Treasuries was 79.5% as of Feb. 23, 2007, compared with the three month average of 79.3% and the one-year average of 79.8%, both ending on the same day.
The ratio of 30-year municipal yield to Treasuries was 84.4%, versus the three-month average of 85%, and the one-year average of 87.5%, all as of a Feb. 23, 2007, according to Thomson data.
Peter Block, managing director of credit strategy at Ramirez & Co. agreed that the ratios should generally remain at the current, post-recession levels as global markets remain fragile, and the supply-and-demand imbalance will keep yields generally range-bound.
However, he said there has been greater volatility in recent years, now that ratios have reverted toward a historical trend of stronger correlation since the 2008 financial crisis.
"Today's market is clearly not your father's muni market," he wrote in a Feb. 1 municipal market outlook on issuance and ratios. "Munis are now a credit market, similar to early 1990s, heavily tied to the rates market and cross-asset flows."
He said the 2008 financial crisis was a "game changer" for munis, causing the muni-U.S. Treasury relationship to deteriorate significantly. "There was virtually no relationship between munis and U.S. Treasuries during any window of time during the 2008 period," he said in an interview.
Volatility has gradually decreased since then and is now close to historical levels as alternative risk assets, most notably equities and corporate bonds, have sold off and investors piled into munis and Treasuries, he said.
But the presence of more volatility, especially that seen in 2012 and 2013, shows that credit turmoil – in the form of bankruptcies in Detroit and Jefferson County, Ala., – can "dislocate the municipal market in terms of rates and ratios," Block said.
"The credit turmoil during that time period changed muni market psychology insofar as potential systemic credit risk in the muni market, duration, and risk premiums," he continued. "The notable and ongoing credit stress of New Jersey, Illinois, and Chicago, are adding some fuel to that fire, but these are clearly idiosyncratic events and have not had knock-on effects across the market."
Valeri agreed that yield volatility means investors have to be more discerning on specific bonds given the transition of the ratio relationship in recent years.
The Ramirez report found that the strongest relationship between 10-year U.S. Treasury yields and Moody's Investors Service general obligation 10-year index was between 2003 and 2007.
Subsequently, there was a breakdown in the relationship between Treasury and muni rates, following a period of high correlation which coincided with the height of bond insurance.
"The relationship disappears during years immediately following the 2008-2009 recession, and continues through the series of municipal bankruptcies beginning in 2012," the analysts wrote.
It "accelerated further during the two major periods of muni market stress in late 2011 and again in 2013," around the time of Detroit's bankruptcy, Block said in an interview.
The average spreads between 10-year yields for U.S. Treasuries and Moody's double-A GO municipal index was 114.6 basis points between Dec. 1987 and Dec. 2007, while there was an average spread of negative 28.6 basis points between Dec. 2007 and Dec. 2015, the report showed.
A 10 basis-point movement in the U.S. Treasury 10-year yield corresponds to a six to eight basis point movement in Moody's double-A general obligation 10-year index yield, according to the data in the report.
Valeri of LPL said there was a brief period in late 2015 when ratios fell to levels not seen in a few years due to the presence of limited supply and prospects for limited future growth.
That pattern could reappear and gradually bring ratios back to historic levels with the arrival of higher interest rates and disappearance of the flight to safety, he said.
However, Valeri said that process could take several years.
Ratios could, however, be impacted at different points across the curve, by investors' duration preferences given their perceptions of the likelihood of short-term rate increases by the Federal Reserve Board, according to Block.
For instance, "in the last few weeks we have seen a steepening of the muni curve and muni ratio decreases in the front-end of the curve as investors park cash in both asset classes due the global fears," Block said.
"The strong correlation of munis to U.S. Treasuries will last until such time as there is another event or series of credit or market events -- probably idiosyncratic -- which causes muni investors to re-think bedrock assumptions previously considered sacrosanct," Block said.
That was the case with the Detroit bankruptcy, he said.
"Investors were forced to question the sanctity of the GO pledge," and that "caused many investors to re-examine their basic assumptions about credit and risk premiums," Block said.
He said the firm avoids making ratio or interest-rate predictions for 2016, but forecasted that gross supply will be approximately $370 billion and that net supply will again be negative as it was in 2015.
"The negative net supply combined with continued strong demand from investors, retail in particular, will keep ratios, in general, fairly range-bound," Block said.
While Valeri said there is potential for near-term weakness in recent municipal strength due to the low yields and a seasonal slowdown from tax-related selling ahead of the April 15 deadline, any weakness should be limited, Valeri warns in a Feb. 23 report.
"Recent Treasury strength, prompted by a flight to safety at the beginning of 2016, has left municipal bonds looking attractive on a relative basis," he wrote.
At the same time, he said the market is not growing and there are limited options for investors seeking tax-exempt income – both of which should fuel demand and further limit the weakness, he said.
"Municipal investors are no longer deterred, other than by low yields, and demand is likely to increase in coming years," Valeri said.
