Technically speaking, analysts see value in munis
Supply scarcity and pent-up demand have helped municipal bonds outperform most fixed- income securities so far in 2018.
As the second half of the year approaches, two municipal analysts said in separate reports this week that the asset class continues offer relative attractiveness and opportunity thanks to these technical factors, along with the Federal Reserve's comments on interest rates and inflation earlier this month.
“The overall better total return of munis in 2018 is reflective of low new issue and net supply — driven in part by lack of advance refunding activity— countered by continued good demand driven by the continued attractiveness of muni’s after-tax returns,” Peter Block, managing director of credit strategy at Ramirez & Co., said in his May 21 weekly municipal report.
Much of the upward movement in bond yields throughout May can be attributed to the pronouncement by the Federal Reserve Board that inflation is on the cusp of the Central Bank’s 2% target, Jeffrey Lipton, head of municipal research and strategy and fixed-income research at Oppenheimer & Co. wrote in his municipal report for the same week.
In 2018, triple-A-rated municipals in two and five years tracked by Municipal Market Data have outperformed Treasuries by 9.4 and 3.5 ratios, respectively, and are fairly valued at about 72%, according to Block's data as of May 18. Meanwhile, 10-year municipals have underperformed Treasuries by 2.1 ratios, but are richly valued at 83%, while 30-year municipals have underperformed by 4.6 ratios and are fairly valued at 96% as of the same time frame, Block reported.
Despite the fair-to-rich valuations in benchmark maturities along the curve, Block said municipals overall have outperformed Treasuries — and all fixed-income assets excluding high-yield corporates — on a total return basis year to date.
While municipals lost 36 basis points in the week ending May 18 and are down 96 basis points year to date, Treasuries lost 40 basis points over the same weekly period, yet 249 basis points year to date, he noted.
Only high-yield corporates fared better on a total return basis — down just 19 basis points last week and 21 basis points in 2018.
Relative value ratios have been recognizing the current outperformance of tax-exempts, with the 10-year benchmark at 81.3% late last week, according to Bloomberg Intelligence (BI) data reported by Lipton in his report.
“Quite possibly, we can see muni prices growing even more expensive relative to UST as new tax-exempt issuance declines and Treasury bond sales rise to accommodate growing federal deficits,” Lipton wrote.
So far this year, municipal supply has contracted, creating opportunity along the way, the analysts said.
Gross supply is down $114 billion, or 19%, year to date, while net supply over the next 30 days is up 73% from last week’s negative $8.3 billion — driven by $17 billion of maturities — and it currently stands at negative $14.37 billion, Block said in his report.
“We expect June to be the highest 30-day negative net supply month,” with the three-year average of net supply in June at $41 billion over the prior three years, he wrote.
Lipton of Oppenheimer said scarcity value may be supportive of outperformance over the coming months.
“For now, relative value ratios are more likely to be driven by a new set of technical factors and we are not expecting mean reversion anytime soon,” Lipton wrote.
Investors pumping cash into mutual funds has helped buoy the municipal sector, Block said.
“The strong mutual fund inflows at $3 billion year to date are indicative of the strong underlying demand, which was reinforced by the 2017 tax reform act that cemented munis as one of the last legitimate tax havens for high-income taxpayers,” Block wrote.
Aside from moving in sympathy with U.S. Treasuries, the municipal bond market remains captive to the effects of the Tax Cuts and Jobs Act, Lipton added.
While he believes selling activity from banks and property and casualty insurance companies has caused intermittent downward pressure on municipal bond prices, he noted that the changes being made on the institutional buyer side are not necessarily fully tied to tax reform “given that a sense of apathy amid declining bond prices has taken hold.”
Lipton advised investors to follow relative value relationships, as any appreciable underperformance by municipals can elevate ratios and provide more compelling entry points.
“Much of this portfolio realignment took place during the first quarter and we would expect the investment rationale to stabilize more noticeably beyond Q2,” Lipton added.