Dangerous curves: Yield inversion can’t be ignored by muni market any longer

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As municipal bond buyers prepared Monday to see almost $7 billion of volume head their way, geopolitical trade worries, weak U.S. economic data and stock market volatility all combined to cast a gloomy pall over the start of the new work week.

Inverted Treasury yield curve warrants attention
As the yield on the 10-year U.S. Treasury falls under 2.10%, the three-month to 10-year yield curve remains inverted, with the spread now at its most negative level since 2007.

“Given the spate of poor macroeconomic news as well as unsettling developments in global trade, we believe investors need to pay attention to the yield curve’s role as a forecaster of recessions,” according to a Monday market comment from Morgan Stanley. “The key to its efficacy is the duration of the inversion. This episode began on May 22 and history shows that inversions of one month or longer have predicted all seven of the recessions in the last 50 years with a lead time of 12 to 14 months.”

Lisa Shalett, Morgan Stanley Wealth Management CIO, said inversions tend to occur when investors anticipate Federal Reserve rate cuts in response to economic slowing and deflationary conditions. With economic fundamentals surprising to the downside and headwinds from trade intensifying, she said they were encourage clients to be cautious and reflect on the rising odds of a recession that extended inversion tends to predict.

“When the yield curve inverted in late March, the episode lasted only five days and we cautioned not to read it as harbinger of recession, especially because the economic data was still strong,” Shalett said. “The curve inverted again on May 22, but the backdrop is much different — disappointing retail sales, weak durable goods orders and the worst purchasing managers reports since 2016; in addition, financial conditions are rapidly tightening and are back to last November’s level.”

According to Kimberly Olsan, senior vice president at FTN Financial, May’s impressive muni gains certainly stand out for the market’s endurance at current yields.

“Notwithstanding 20 basis-point moves in intermediate and long munis, the force of funds (approaching $40 billion) coming into the asset class are presenting new challenges for inquiry looking for options,” she said in a Monday market comment.

She said that as the last month of the second quarter kicks off, investors should keep several things in mind.

“Returns to date for 2019 are approaching 5% in generic indices. That pace hasn’t been seen since 2014, when a comparable level of supply drew firmer secondary demand,” she said. “Only if the market sees a measurable pickup in supply through the final month of Q2 are muni yields likely to succumb to any real pressure.”

Looking at Treasuries and municipals, she noted that the inversion in the taxable market and overall nominal slope offered some opportunity in munis.

“Short-duration inquiry is incented with some extension reward. Witness the prevalence of short-calls and lower-rated bonds as the salve in the wound to otherwise low absolute yields,” she said.

Olsan said the taxable-equivalent yield component was striking, and even more so in highly rated bonds.

“Using the top federal bracket and a 5% state income tax assumption for a combined 42% liability, TEYs compare favorably to USTs at current implied AAA yields. Short munis net a 2.50% TEY, intermediates are near a 3% TEY and 20-year AAAs offer a 3.75% TEY. These levels can be further enhanced with lower-rated credits or bonds subject to AMT.”

Looking at taxable munis, their performance has been stellar so far this year, said Patrick Luby, senior municipal strategist at CreditSight.

"May new-issue volume this year was down 16% versus last year, but year to date it is up 7% over last year," Luby said. "But since 2018 supply was distorted by the acceleration of new issues from early 2018 into December of 2017 — in order to get ahead of the then-expected restrictions from the Tax Cuts and Jobs Act, we also compare this year's volume to the average year to date volume of the prior five years and this year's total is 12% lower than the average year to date volume over that time."

He added that if all of the bonds on this week's new-issue calendar come to market, it would be the supply week since late March.

"In addition to a full slate of long-term deals, the short-term calendar this week totals $1.7 billion and $4.5 billion for next week," he said. "Far succeeding the year-to-date weekly average of $510 million, through the end of last week." He noted that June marks the beginning of the summer redemption season, with $131 billion in principal expected to be returned to investors — $46.2 billion of it just in June, starting with $20.2 billion on June 1.

Luby also said that the ICE BofaML Municipal Bond Index earned 1.48% in May — the seventh consecutive month of positive returns. "For the month, the Municipal Index lagged the U.S. Treasury Index, but beat out the return of the Corporate Bond Index," he said. "Year to date, the Municipal Index has outperformed the U.S. Treasury Index, but is well behind the Corporate Bond Index."

However, the Taxable Municipal Bond Index returned an eye-popping 4.19% in May and has earned 9.19% for the year, leading both the U.S. Treasury and Corporate Bond Indices, according to Luby. "It was the best one-month performance since January of 2015 when it earned 4.39%, which was the best month of the year, as the Index returned -0.004% for the full year. "

Last week's actively traded issues
Revenue bonds made up 49.49% of total new issuance in the week ended May 31, down from 50.73% in the prior week, according to IHS Markit. General obligation bonds were 45.93%, up from 44.95%, while taxable bonds accounted for 4.58%, up from 4.32%.
Some of the most actively traded munis by type in the week were from New York, Iowa and Puerto Rico issuers.

In the GO bond sector, the New York City zeros of 2047 traded 28 times. In the revenue bond sector, the PEFA Inc. of Iowa 5s of 2049 traded 35 times. In the taxable bond sector, the Puerto Rico Sales Tax Finance Corp. 4.55s of 2040 traded 40 times.

Primary market
Weekly supply is forecast at $6.99 billion, composed of $4.36 billion of negotiated deals and $2.63 billion of competitive sales.

On Monday, Morgan Stanley priced the New York State Housing Financing Agency (Aa2/NR/NR) $129.975 million of Series 2019H affordable housing revenue climate bond certified and/or sustainability bonds for retail investors.

The NYS HFA has changed its ESG designation from green bonds to Sustainability Bonds to pair the environmental attributes with the social benefits of its funded affordable housing projects.

"When NYS HFA first launched its Climate Bonds Certified/Green Bonds designated bond issuance, ESG and green bonds were just starting to gel in the market," said a source familiar with the deal. "Now, certain standards and certifications and general guidelines have been established including the ICMA principles and guidelines and the United Nations Sustainable Development Goals."

Today, ESG investors have certain criteria and checklists that they go through.

"The NYS HFA Sustainability Bonds designation seeks to provide investors with details about how and where money is going, showing environmental and social programs associated with the financed projects," he said. "The NYS HFA financing is the first municipal issuance to include disclosure on alignment with the ICMA Sustainability Bond Guidelines and United Nations SDGs."

The deal will be priced for institutions on Tuesday.

On Tuesday, Jefferies is expected to price the Metropolitan Washington Airports Authority (Aa3/AA-AA-) $398.81 million of airport system revenue and refunding bonds. The issue is composed of Series 2019A bonds budget to the alternative minimum tax and Series 2019B non-AMT bonds.

BofA Securities is set to price the New Jersey Higher Education Student Assistance Authority’s $286.37 million of student loan revenue bonds consisting of Series 2019A and Series 2019B (Aa1/NR/NR) and Series 2019C (A2/NR/NR) subordinate bonds on Tuesday.

Citigroup is expected to price the Maricopa County Industrial Development Authority, Arizona, (NR/AA-AA-) $246.82 million of Series 2019B, C and D revenue bonds for Banner Health.

In the competitive arena on Tuesday, Arlington County, Virginia, (Aaa/AAA/AAA) is selling $169.48 million of Series 2019 general obligation public improvement bonds.

Proceeds will be used to finance various public improvements. PFM Financial Advisors is the financial advisor; McGuire Woods is the bond counsel.

The county last competitively sold comparable bonds was on June 6, 2018 when Wells Fargo Securities won $153.555 million of Series 2018 GOs with a true interest cost of 2.99%.

Travis County, Texas, (NR/AAA/NR) is selling $153.96 million of securities on Tuesday consisting of $113.29 million of Series 2019B limited tax certificates of obligation $26.12 million of Series 2019 limited tax permanent improvement bonds and $14.55 million of Series 2019 unlimited tax GO road bonds.

Proceeds of the certificates will be used to pay for civil and criminal justice facilities and jail facilities, various capital improvements and buying vehicles and heavy equipment. Proceeds of the permanent improvement bonds will be used to finance various capital improvements while proceeds of the road bonds will be used to pay for roads and turnpikes, road drainage, bike lanes, sidewalks and shared use paths and replacement and improvement of road bridges and culverts.

PFM Financial Advisors is the financial advisor; Bracewell is the bond counsel.

Secondary market
Munis were stronger on the MBIS benchmark scale on Monday, which showed yields falling by less than one basis point in the 10-year maturity and by one basis point in the 30-year maturity. High-grade munis were mixed on MBIS’ AAA scale.

On Refinitiv Municipal Market Data’s AAA benchmark scale, the yield on the 10-year GO fell two basis points to 1.63% while the yield on the 30-year muni decreased one basis points to 2.31%.

“The ICE Muni Yield Curve is one basis point lower as the market lags Treasuries today,” ICE Data Services said in a Monday market comment. “High-yield and tobaccos are down one basis point as well. Taxable spreads are down by as much as four basis points for the five-year.”

The 10-year muni-to-Treasury ratio was calculated at 78.0% while the 30-year muni-to-Treasury ratio stood at 90.7%, according to MMD.

Treasuries were stronger as stock prices remained volatile. The Treasury three-month was yielding 2.330%, the two-year was yielding 1.860%, the five-year was yielding 1.860%, the 10-year was yielding 2.098% and the 30-year was yielding 2.553%.

Previous session's activity
The MSRB reported 32,191 trades Friday on volume of $12.33 billion. The 30-day average trade summary showed on a par amount basis of $12.36 million that customers bought $6.12 million, customers sold $4.04 million and interdealer trades totaled $2.19 million.

California, Texas and New York were most traded, with the Golden State taking 15.196% of the market, the Lone Star State taking 14.565% of the market, and the Empire State taking 9.495%.

The most actively traded security was the Puerto Rico public improvement Series 2012A refunding GO 5s of 2041, which traded 15 times on volume of $25.82 million.

Treasury auctions discount rate bills
Tender rates for the Treasury Department's latest 91-day and 182-day discount bills were lower, as the $36 billion of three-months incurred a 2.300% high rate, down from 2.310% the prior week, and the $36 billion of six-months incurred a 2.255% high rate, off from 2.320% the week before.

Coupon equivalents were 2.352% and 2.319%, respectively. The price for the 91s was 99.418611 and that for the 182s was 98.859972.

The median bid on the 91s was 2.265%. The low bid was 2.200%. Tenders at the high rate were allotted 76.23%. The bid-to-cover ratio was 2.59.

The median bid for the 182s was 2.220%. The low bid was 2.190%. Tenders at the high rate were allotted 68.70%. The bid-to-cover ratio was 2.70.

Gary E. Siegel contributed to this report.

Data appearing in this article from Municipal Bond Information Services, including the MBIS municipal bond index, is available on The Bond Buyer Data Workstation. Click here for a brief tour of the Workstation, or contact Ziad Saba at 212-803-6079 for more information.

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Secondary bond market Primary bond market State of California State of New York State of Texas Commonwealth of Puerto Rico City of New York, NY Puerto Rico Sales Tax Financing Corp (COFINA) Metropolitan Washington Airports Authority New Jersey Higher Education Student Assistance Authority Maricopa County Industrial Development Authority, AZ County of Arlington, VA