Market Outlook

Last Friday, a chunk of space rock large enough to wipe out civilization sailed past our planet harmlessly. Its name? Asteroid 1998 QE2 (It’s true; you just cannot make this stuff up). It was a fitting end to a week which saw the bond market experiencing its own close call with a QE2 disaster, or more precisely, QE2’s potential “tapering.”

It was indeed a disastrous month for the fixed-income market. May went out with the 10-year Treasury yield at 2.16%, up exactly 50 basis points for the month, a significant move by any measure. Thirty-year Treasuries closed at 3.30%, up 47 basis points from the previous month.

Given the violence of the recent rate move, we believe a period of market consolidation is in the offing. At least for the time being, there should be a self-regulating aspect to this process: another rate spike will almost certainly lead to a significant stock market selloff, which in turn will bring investors back into bonds and lead to lower yields again.

In the meantime, traders will certainly be scrutinizing tomorrow’s ADP report for clues to the all-important employment number on Friday. In all likelihood, by Friday morning, the market will be set up for a “buy the rumor, sell the news” type of response and a post-number relief bond rally cannot be ruled out.

The tax-exempt market uncharacteristically underperformed Treasuries during last week’s selloff. For the week, 10-year and 30-year muni yields were 17 basis points and 14 basis points higher to reach 2.07% and 3.22%, respectively. Perhaps more importantly, according to Barclays, the muni-to-Treasury ratios cheapened to 98%, both on the 10-year and 30-year parts of the curve.

To add insult to injury, mutual fund flows also turned negative during the week, with weekly-reporting funds showing about $150 MM in outflows after three consecutive weeks of positive, albeit anemic inflows.

The Prairie State now joins the Golden State at the bottom scale of all state ratings. In contrast to Illinois, however, California’s credit looks to be on the upswing.

For an additional perspective, the bellwether high grade muni ETF, the iShares S&P National AMT-Free Muni Bond (MUB), has now declined by 5.8% from its 52-week high. The fund’s value peaked right after last November’s election and now stands just off its one-year low. On the high yield side, the Van Eck Market Vectors High-Yield Muni ETF (HYD) is only down 2.4% from its high, also reached last December. As we’ve discussed in past columns, high yield paper should hold up better than high grade paper during the initial stage of a bond selloff due to their shorter duration and other technical factors, and this has in fact been the case.

New Issues

Municipals underperformed during a holiday-shortened week where new issue supply was only about $4 billion, well below the year-to-date average of about $6.5 billion. This week’s calendar will be closer to the norm, with about $6.4 billion slated to be priced. On the negotiated side, the largest offering will be a $1.115 billion G.O. issue from the Commonwealth of Massachusetts, notable for the fact that it will include $100 million of new money “green bonds” for environmentally sensitive infrastructure projects, with potential appeal to socially-responsible investors. Los Angeles County will also be on deck to float $1 billion in short-term notes to kick-start the summer note borrowing season.

Illinois Pension Reform Fails – Again

As you may have heard by now, the Illinois legislature adjourned this weekend without reaching a compromise solution on pension reform. There is now little doubt that further downgrades will be forthcoming from the rating agencies. On Monday, Fitch didn’t waste any time in lowering Illinois’ rating from “A” to “A-”, with a negative outlook. The Prairie State now joins the Golden State at the bottom scale of all state ratings. In contrast to Illinois, however, California’s credit looks to be on the upswing.

Credit spreads for Illinois paper have started to tighten in recent weeks in anticipation of some kind of pension reform. Given the latest development, this improvement may prove short-lived. The timing couldn’t be worse: with bond yields already on the rise, any spread widening may result in real mark-to-market losses, not just opportunity costs, to Illinois bondholders.

Needless to say, for Illinois citizens, the cost of pension reform failure will be all too real: the State will need to come to market with up to $1 billion worth of bonds in the next few weeks and nothing short of  a legislative miracle will prevent it from incurring higher interest costs.

Having said that, we believe the current spread of about +140 off the MMD AAA scale for 10-year Illinois paper is already more reflective of a “BBB” credit than even a weak “A” State G.O. Illinois G.O. bonds do enjoy relatively strong legal protection so buy-and-hold investors need not worry at this point, as long as they can put up with the short-term headline risk.

Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.

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