While expectations for municipal bond demand are high, the forecast calls for frustration for investors in the second half of the year.
Municipal experts predict the technical imbalance will continue to plague the tax-exempt market through year-end. If there is a pickup in supply between July and December, it won't be enough to compensate for the 25% year over year supply slump in the first half of 2018 — or satisfy the growing demand, said Dan Heckman, senior fixed income strategist at U.S. Bank, in a June 19 interview.
As of June 29, year-to-date bond issuance totaled $161.05 billion, compared with $436.34 billion in all of 2017, according to Bond Buyer data.
“We’re seeing good inflows into the market by investors,” Heckman said. “Couple that with maturities and calls occurring in July, and we think there’s plenty of money around to get invested and more than soak up any additional supply that may occur.”
Tom Kozlik, managing director and municipal strategist at PNC, sees no signs indicating that volume is likely to accelerate from the first half of 2018, with credit partly to blame.
“Across almost every sector there are indicators that some issuers are still struggling, even though we are in the ninth year of an economic expansion,” Kozlik said. “Issuers are still mindfully repairing their balance sheets, changing their missions or strategies, and pension requirements are crowding out other spending.”
He said it is difficult for some issuers to think about upgrading infrastructure, while their day-to-day missions or strategies are being questioned or adjusted.
Heckman pointed to several factors that will pressure performance as a result of the scarcity and create pent-up demand for historically attractive tax-exempt securities.
“We still see a lot of demand for this market,” Heckman said.
On Thursday, the triple-A generic general obligation bonds in 10 and 30 years were yielding 2.47% and 2.94% respectively, compared with 1.98% and 2.55% back on Jan. 2, and 1.92% and 2.74%, respectively, as of June 27, 2017, according to Municipal Market Data.
“With the tax reform, the market may have misjudged things and thought the demand for munis would diminish, but we are not seeing that,” Heckman said.
Demand has been strong year to date, according to Heckman, and he doesn’t expect that to change with the calendar. Nor does he expect to see volume ramp up significantly through year-end.
“Supply was so huge in 2017 — especially in late November and December — plus municipalities are flush with cash and perhaps may want to finance some projects without coming to market,” he explained. “Rates are a little higher, so it’s a little less attractive” for them to issue debt, he said.
In addition, the loss of advance refundings under the tax reform bill will further strain supply for the rest of 2018, according to municipal sources.
Heckman called the loss of advanced refundings a “significant drag” on supply over time.
“Although we are seeing new-money bonds coming at plus 18% year to date, that is roughly consistent with the previous past two years, and doesn’t fully offset the loss of refunding supply,” Reid Smith, director of ZCM Fixed Income Strategies, a subsidiary of Ziegler Capital Management LLC, in New York, told The Bond Buyer in a June 18 interview. “We don’t expect this to accelerate into the end of 2018,” Smith said. His prediction is that municipal supply ends the year at $325 billion.
Kozlik, meanwhile, said his 2018 volume forecast calls for close to $295 billion.
Second-half hurdles
Heckman and Smith said there are other obstacles to volume growth this year such as seasonal supply patterns and political uncertainty.
For instance, potential improvement in visible supply will likely reverse course, according to Heckman, given the overall seasonal supply constraints facing the market, like the summer doldrums through August.
“We still see the year ending with net issuance lower than 2017,” he said.
After the summer, any bond measures included in the November elections won’t do much to boost municipal volume in 2018 as they will likely be delayed to market, Heckman said. “Even if there is voter-approved funding, we think that tilts into 2019 and doesn’t impact the 2018 calendar since there’s always a lag time.”
Another “wild card” preventing an increase in volume, is the potential $1 trillion Trump Administration infrastructure plan, which Smith said remains “cloudy.”
“We believe this has slowed down the market issuance for new or revitalized infrastructure investment” as potential projects from issuers remain sidelined, Smith said.
Kevin Dunphy, managing director and head of public finance at MUFG Bank, said critical infrastructure projects are currently underfunded as the Trump infrastructure plan continues to be discussed, and that is not helping to relieve the supply shortage.
“We need new revenue sources and funding for transportation needs,” including major projects at transportation hubs around the country, such as LaGuardia Airport in New York, he said in a roundtable discussion with Bond Buyer reporters and editors on Thursday.
Dunphy suggested that Public-Private Partnerships (P3s) are “becoming more popular” as the infrastructure plan evolves at a time when municipal issuers have capital needs.
“The combination of a long-term investment horizon required for project capital investment with poor visibility into the future of infrastructure support from the federal government is cooling the potential for development,” Smith said.
If a strong Federal government infrastructure initiative utilizing municipal financing surfaces, then a significant pick up in new-issue supply could surpass previous years’ volume, according to Smith. “However, at this point any dramatic pickup will be pushed into 2019,” he said.
Taxable municipal volume, on the other hand, may increase in the second half, according to Heckman. Such deals, which are federally taxable but can be exempt from state or local taxes, are applicable to a broader base of investors and remain relatively attractive for high net worth individuals, he said.
Secondary strategies and structure
Although he is keeping a sharp eye on the new issue market heading into the second half, Heckman said he has been more active in the secondary market lately, due to the presence of significant bid wanted lists. He is finding the most relative value between seven and nine years, with the long end being less attractive.
“We think investors make a mistake, from a total return standpoint, by concentrating [only] in the short end,” under seven years, he said. “We expect yields to rise very, very gradually to the point where we think pressure will be greater on short-term rates.
"They will move up at a greater rate than longer term bonds, and we don’t think they will have the same total return opportunity” he said.
Since the curve has gotten more attractive lately, he said bond laddering and barbell structures both make sense through year-end depending on investors’ goals. A year ago the short end wasn’t at all attractive, he said.
Going forward in the second half, the barbell approach — utilizing some short and some long maturities — is most effective for investors who need a little higher level of income and predictability, Heckman explained. He said that structure works well for those who have a greater income need, but want to reduce the risk of having an overly longer-term portfolio structure.
While the uncertainty surrounding the supply-demand dynamic will continue to surface in the second half, rising interest rates will have an impact on investor demand and strategy going forward, as it did in the first half, according to Smith.
“Currently, individual investor demand is piling into the shorter maturities,” Smith said in a June 18 interview, adding that he has observed the strongest demand for bonds due in three years or less.
“There is weaker demand for longer bonds and dealers are taking down unsold intermediate offerings,” he said. “As [the yields on] shorter maturities have moved higher with the Federal Reserve tightening, investors are finally being paid to buy lower duration risk,” Smith continued.
“Traditional corporate intermediate buyers remain on the sidelines, with the reduction in tax rates and long-end mutual fund flows are anemic,” which bodes for a steeper curve in the second half of the year. “It feels like demand is matching supply — except in shorter maturities where it remains a food fight,” Smith said.
Ratios and remainder of the year
In addition to supply and interest rate concerns, Heckman believes the second half of the year will also see continued tightening ratios, especially in 10 years, where they have become more expensive in recent weeks compared with the long end, where the yield curve is flatter.
According to MMD, the 10-year and 30-year benchmark triple-A GOs are yielding 86.8% and 98.8% of the comparable Treasury yield, respectively.
“We feel like we can see a scenario where most investors are duration light,” Heckman said. “We could see further rallies on the long end when the market realizes that the Fed tightening has slowed down, and it has slowed the economy,” he added, suggesting the potential for an increased flattening of the municipal yield curve 10 years and beyond.
Overall, despite the supply and other market challenges, the remainder of the year should progress with continued strong demand for an asset class that is still attractive, contrary to the expectations that the newly enacted tax reform would reduce municipal demand.
“As people go about doing their taxes on an individual basis we will see more heightened interest in the muni market in 2019 as they see the full impact of tax reform in terms of deductions,” Heckman said.
“Investors don’t have a lot of alternatives to reduce their income — munis are one of the only sources to do so — so we are not buying into that notion,” Heckman said. “We think they will maintain strong demand.”
