Restrained volume and record demand sums up first half

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Municipal bond volume is 2% ahead of last year, as volume sans advance refundings is starting to level out and normalize.

Halfway through the year, total volume stands at $168.99 billion over 4,901 deals, compared with $165.68 billion in 4,812 transactions, according to data from Refinitiv.

"The first half of 2019 was strong for municipals as a record pace of inflows to mutual funds and ETFs drove M/T ratios to the lowest levels in a decade," said Alan Schankel, managing director at Janney Montgomery Scott. "While municipal credit conditions were generally strong in the first half, the March ruling by a federal appeals court related to the treatment of Puerto Rico Highway and Transportation Authority special revenues in bankruptcy has broad market implications, triggering rating agency criteria revisions and probably future rating reductions."

Volume did, for the most part, continue to pick up and normalize with more distance from the commencement of the new tax laws. Issuance in January totaled $21.50 billion, then fell to $17.86 billion in February, rose to $26.02 billion in March, climbed again to $31.37 billion in April, then rose higher still to $35.95 billion in May, before dipping to $32.98 billion in June and ending with $25.31 billion in July.

"The market has played out to what we thought, in terms of issuance," Wesly Pate, PM, Income Research + Management said. "We didn't expect any legislative change that would bring back advance refundings. We thought issuance would be similar to 2018 and it is playing out that way."

First quarter volume was 19.3% higher to $78.21 billion from $65.56 billion and second quarter issuance was 9.3% lower to $90.79 billion from $100.11 billion.

"Hobbled by restrictions on advance refundings included in the 2017 tax reform legislation, municipal new issue supply fell last year, and has continued at the slower pace so far in 2019," Schankel said. "Through July, the $197 billion total of new muni deals is about 8.5% below the average first 7-month volume of the previous 10 years."

New-money deals were down 2.3% to $115.51 billion in 3,781 deals, compared to $118.22 billion in 3,762 issues.

Pate said that infrastructure needs will be what drives incremental issuance going forward. "And while we haven't seen an uptick in ballot approval for bonds, yearly volume will stay in the $325-$340 range," he said.

"What would drive issuance at the corporate level, such as NPVs and IRRs, doesn't necessarily occur at the local level," he said. "It is much more need-driven as opposed to the cost of finance-driven. Absent of refundings, infrastructure spending doesn't correlate with what we see in rates."

Refunding deals were up 9.9% to $28.44 million from $25.89 billion.

Other than restrained volume, the other story of the year in municipals is the strength and consistently of demand for the asset class.

"The inflow momentum we have seen, approaching 30 consecutive weeks, is a little bit surprising coupled with current valuations. It highlights a flight to safety," Pate said.

Schankel added that the underlying story of strong demand and modest supply that has characterized the municipal market so far this year continued unabated into the summer.

"Investors have added $53 billion to muni mutual funds plus almost $5 billion to muni ETFs so far in 2019," Schankel said. "In theory the $58B total of new 2019 cash is enough to absorb more than a third of the first six months of municipal new-issue volume ($166.8B). This illustrates the shifting trend in how investors seeking tax free income are participating in the municipal market, with vehicles such as mutual funds and ETFs attracting a gradually growing share of the individual tax free investor pie."

Schankel also noted the first half of 2019 was good for municipal bond investors. The Bloomberg Barclays Municipal bond index registered a 5.09% total year-to-date return through June 30th; credit conditions have generally improved, with upgrades from all three rating agencies exceeding downgrades; and favorable supply and demand dynamics have been supportive of municipal outperformance relative to Treasuries.

"The 10-year municipal to Treasury ratio, a key measure of municipal bond relative value (AAA tax free yield divided by same maturity Treasury yield), began the year at 87.6%, dropped to a record low point of 71.6% just before Memorial Day (based on Bloomberg data beginning in 2001), and moved higher in recent weeks. Through six months, new-issue supply has been flat compared to 2018, which in turn was the lowest in 4 years."

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