Is it just sheer exhaustion from last week’s extreme volatility? Or is it just the calm before the next bout of economic data-induced market convulsions? Perhaps market participants are already looking ahead to a weekend of backyard grilling? Whatever the reason, an eerie calm has settled on the fixed-income markets as we start this holiday-shortened week. As reported by Bloomberg, the Merrill Option Volatility Estimate (“MOVE”), a measure of volatility in Treasuries, has dropped to 97.13 by June 27th after peaking at an 18-month high of 110.98 on June 24th.
The yields on 10-year and 30-year Treasuries also appear to have found a temporary equilibrium around 2.50% and 3.50%, respectively. Renewed political turmoil in Egypt has also helped bring the flight-to-quality bid back to the market. As well, rising oil prices, now nearing the $100-per-barrel mark, are viewed as a potential dampener on economic growth.
Of course, this Zen-like state of mind could go right out the window on Friday, should Non-Farm Payrolls significantly exceed the current consensus of 160,000. This morning’s ADP private sector employment, already topped most estimates at 188,000, an ominous sign.
New Issue Market
In the tax-exempt market, yields have remained largely unchanged from Friday’s levels, with the new issue supply dropping to just under $1 billion for the week.
On the investment grade front, the only new issue of note was New York’s Metropolitan Transportation Authority (MTA), which priced for institutions $336 million of revenue bonds yesterday.
On the high yield side, Citigroup decided to take advantage of the light calendar to price $663 million of Louisiana Tobacco Settlement Financing Corp. refunding bonds, a holdover from last week. Fitch Ratings rated the bonds BBB-plus. Standard & Poor’s, who has a tiered rating policy based on maturity, gave the 2016 through 2023 maturities an A rating and the maturities from 2024 to 2033 an A-minus. Bonds maturing in 2035 were given a BBB-plus. The most controversial aspect of this deal was the State’s ability to skim off the first $114.37 million of any surplus monies and use it for general budget purposes, another instance of States using (and abusing) tobacco settlement proceeds for short-term budget purposes.
Pricing-wise, the 2035 maturities came at a 5 ¼% coupon to yield 5.30%, for a rather unenticing spread of +165 off AAA.
June and Second Quarter Recap
As we start the second half of the year, we thought it might be interesting to take another look at how various muni sectors fared during June’s historic selloff.
Two of the best-performing sectors over the past 12 months – Industrial Revenue and Hospital – suffered a reversal of fortune in June, with returns of -4.19%and -3.20%, respectively.
So how bad was June? “Abysmal” may come close to describing it. The total return for the Barclays Municipal Bond Index for the month came in at -2.83%, driven by a stunning 59 basis points increase in yield. This was the muni market’s worst performance since the financial crisis – September 2008 to be exact. Two of the best-performing sectors over the past 12 months, Industrial Revenue and Hospital, suffered a reversal of fortune in June, with returns of -4.19%and -3.20%, respectively. The Water & Sewer sector, the professed darling of investors who have grown wary of General Obligation bonds, was also one of the worst performers at -3.23%. We suspect the sector’s strong liquidity characteristics worked against it during last week’s selloff as it was probably the easiest sector to get a bid on.
Since June’s debacle also had elements of a “risk off” trade, it’s not surprising that Barclays’ Puerto Rico Index registered the biggest decline: -4.43%. However, because Puerto Rico bonds have been rebounding this year after a dismal showing in the second half of 2012, their year-to-date return still outshone the general market (-1.77% compared to -2.69% for the general Muni Bond Index).
Bonds with a much higher coupon than current market rates not only have a shorter duration (less raw exposure to interest rate risk) but may also benefit from positive convexity.
One of the most surprising aspects of the June selloff is that credit products underperformed. After all, if investors were concerned about interest rates rising as the economy rebounds, they should have favored credit risk while trying to reduce interest rate risk. Yet, high yield municipals underperformed investment grade paper during June’s selloff. The S&P Muni High Yield Index returned -4.73% in June, compared to -3.04% for the S&P National Non-AMT Index, a high grade index. This is rather uncharacteristic of the sector as fund managers have historically tend to liquidate their lower coupon high grade holdings first.
Part of this lackluster high yield performance probably had to do with coupon structure. Many of the recent “high yield” issues have come at par or only a slight discount. In technical terms, bonds trading near par suffer from what we call “negative convexity”. Before your eyes start to glaze over, all this means is that, mathematically, they have a tendency to decline faster in a rising rate environment than to appreciate when rates drop. Bonds with a much higher coupon than current market rates not only have a shorter duration (less raw exposure to interest rate risk) but may also benefit from positive convexity. Furthermore, as bonds start to trade at a deeper and deeper discount, “de minimis” considerations start to come into play, requiring additional yield penalties ranging from 20 to as much as 50 basis points (for a good primer on the “de minimis” rule, see LearnBonds.com “The DeMinimus Rule and How it Affects Taxes”).
Last but not least, let’s face it, all the lower-rated paper that came to market at sub-5% yields could hardly be called “high yield”, regardless of the prevailing rate environment. Earlier in the year, many investors were probably forced to reach for yield for all the wrong reasons, so it stands to reason they chose to sell that paper first when push comes to shove.
After all is said and done, however, on a year-to-date basis, the High Yield Index still edged out its High Grade counterpart: -1.50% for the former versus -2.88% for the latter.
This week marks the first anniversary of the publication of my book “Investing In The High Yield Municipal Market.” To commemorate this nefarious occasion, I’m giving out two signed copies to our readers who can most closely guess the July performance of the Barclays Municipal Bond Index. Please send your entries to firstname.lastname@example.org by July 14th.
Finally, as we head into a weekend of festivities, our thoughts and prayers go first and foremost to the families of the 19 firefighters who lost their lives in Arizona. Have a great Fourth and let’s find out together what the second half holds in store for the markets.
[Editor’s Note: Muni Bond Insights will not be published on Friday, July 5 due to the holiday, but will resume on Tuesday, July 9.]
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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