The fixed-income sector remains under pressure this week, despite a relative scarcity of market-moving data. After a volatile session yesterday, Treasury yields are once again nearing a two month high. Should market participants detect further “tapering” signals in Chairman Bernanke’s speech on Thursday, 10- year and 30-year Treasuries may retest the highs from March 11, 2.07% and 3.26%, respectively.
For now, the municipal market is taking some degree of comfort in the projected $60 billion in re-investment flows coming in May and June.
Tax-exempt yields are also drifting up about 3 basis points in sympathy with the taxable market. The combination of the upcoming long holiday weekend and school graduation season certainly does not bode well for the level of trading activity this week. A relatively meager new issue calendar totaling about $5 billion, comprised mainly of bread-and-butter issues such as New York City G.O.s ($800 MM) and Los Angeles Department of Water & Power ($452 MM), will do little to stir traders out of their torpor.
One credit that appears to enjoy fairly active secondary trading due to its sheer size is the Iowa Fertilizer issue, which we discussed back on April 30 (See Muni Bond Insights, “A Record-Breaking Fertilizer Deal That Doesn’t Stink … Yet”.) The 2025 maturity was reportedly the most actively traded last week and its yield has compressed by an astonishing 56 basis points since issuance. A potentially competing $1.8 billion fertilizer bond issue in Indiana has run into political problems with the State over its affiliation with a Pakistan-based company who has been tied to explosives used against Americans in Afghanistan and in the Middle East.
Credit spreads on Puerto Rico paper have also stabilized in recent weeks as investors have grown increasingly confident, rightly or wrongly, that the Padilla Administration will be able to address the fiscal challenges confronting the island. The Commonwealth also hosted its annual Investor Conference last week and its candid discussions of the fragile financial status of key agencies such as PRASA and PREPA went a long way toward providing some short-term reassurance to its bondholders. According to a recent report from the Wall Street Journal, Puerto Rico also appears to quite serious in its efforts to gain statehood this time around, in spite of the fact that the November referendum’s results remain wide open to interpretation.
Credit spreads on Puerto Rico paper have also stabilized in recent weeks as investors have grown increasingly confident, rightly or wrongly, that the Padilla Administration will be able to address the fiscal challenges confronting the island.
For now, the municipal market is taking some degree of comfort in the projected $60 billion in re-investment flows coming in May and June. There is no guarantee, of course, that all that cash will find its way back into munis, given all the tax reform talk on Capitol Hill and increasing competition from a record-setting stock market. Already, the Bond Buyer is reporting a sharp drop in interest from direct retail investors. Another sign of investor reluctance could be seen in the shrinking premiums to net asset values for the larger muni closed-end funds and ETFs.
Of course, on the flip side to this argument, municipals now look quite attractive from a relative value standpoint, particularly compared to corporates.
Corporate “junk” indices now yield less than 5.00% on a taxable basis, yet the Van Eck High Yield Municipal Index ETF (HYD) currently displays a tax-exempt SEC yield of 4.54%, or a taxable-equivalent yield of 7.52% for investors in the top 39.6% federal tax bracket. Another ETF devoted to the high yield muni sector, the SPDR® Nuveen S&P High Yield Municipal Bond ETF (HYMB), reports a current SEC yield and top bracket taxable-equivalent yield of 4.08% and 6.75%, respectively.
At the end of April, the Barclays Muni High Yield Index (again a tax-exempt index) stood at 101.8% of its Corporate High Yield counterpart. Over the past decade, every time this ratio has exceeded 90%, a powerful rally would ensue to take it back down to the 75% level or lower. Of course, this time around, any potential decline in this ratio will probably occur in a rising rate environment, with high yield municipals significantly outperforming high yield corporates in most sell-off scenarios. In our view, this suggests a “crossover” trade opportunity whereby an investor would short a corporate high yield ETF and go long a muni high yield ETF. Of course, this is best done on a duration-neutral basis to avoid any directional interest rate risk.
In summary, assuming one is comfortable with the outlook for bonds in general (and this is a major assumption), muni investors are currently getting the tax exemption for essentially nothing – and then some.
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