Market Outlook
Global financial markets are starting to get cold feet as the start of Fed tapering efforts draws near.
It certainly doesn’t help that recent economic data have been quite firm. Housing starts, for instance, have yet to be affected by higher interest rates as they increased 5.9% to a seasonally adjusted annual rate of 896,000 in July, up from a revised 846,000 for June. Initial unemployment claims for the week ending August 10th were also reported down 15,000 to 320,000, their lowest since October 2007.
Even the European economy has shown signs of stabilizing, leading to a worldwide bond sell-off. According to the Wall Street Journal, “both the 10-year Treasury and the 10-year U.K. government bond yields hit two-year highs, as the 10-year German government bond yield touched the highest level since March 2012”.
The yield on the U.S. Treasury’s 10-year note jumped 20 basis points this week, to 2.79%, its highest level since July 28, 2011. The yield on the Treasury’s 30-year bond gained 15 basis points this week, to 3.82%, also its highest since July 28, 2011. Although the recent volatility could certainly be explained by late summer market illiquidity, the longer the 10-year Treasury stays above 2.75%, the more likely the new trading range will shift from 2.50-2.75% to say 2.75-3.00%.
… the tax-exempt market seems stuck in this vicious circle of fund redemptions leading to negative fund performance, which in turn leads to further redemptions.
In other news, we are now entering the 25th week of the latest hostage crisis. The hostage in this case is the muni industry, which has been held captive for quite a while now by continuing mutual fund outflows. For the week ended August 14th, long-term muni bond funds that report on a weekly basis again experienced redemptions of $903 million, according to Lipper, capping 24 straight weeks of outflows. High-yield muni funds also recorded outflows at $217 million. Total outflows for all weekly reporting funds are once again back above $1 billion, $1.21 billion to be exact.
It will be hard for tax-exempt yield levels to stabilize until fund outflows moderate, particularly if the new issue supply picks up after Labor Day. Until then, the tax-exempt market seems stuck in this vicious circle of fund redemptions leading to negative fund performance, which in turn leads to further redemptions. You can blame it on a market driven by retail investors who can only look in the rear view mirror.
Not surprisingly, tax-exempt yield indices are retesting levels not seen in at least two-years. The weekly average yield to maturity of the Bond Buyer Municipal Bond Index rose 4 basis points this week, to 5.15%, its highest level since the week ended July 28, 2011 (107 weeks ago). The Revenue Bond Index spiked by 13 basis points this week to 5.18%, its highest level since Aug. 4, 2011 (106 weeks ago).
In spite of the prevailing doom and gloom in the industry, we do believe the muni market is fast becoming one of the best, if not the best, relative value among all fixed-income asset classes. We will try to flesh out our argument in next week’s column.
Puerto Rico’s FY2014 Budget: Less than Meets the Eyes?
In case you’re wondering how the recent PREPA deal has been trading in the secondary market, it’s fair to say it’s kept up with the market but hasn’t really outperformed. The 2043 maturity came at a 7.12% yield, or +290 versus AAA, and last traded in institutional size at 7.22% or +288. Institutional size blocks of the 2036 maturity last traded at 7.15% or +296, only 1 basis point wider than the original spread. Of course, since the overall market has been slipping this week, all the original buyers of this issue are now stuck with modest paper losses.
Muni market participants will also be holding their breath as they watch how closely the first Padilla budget will track economic reality this year.
Last night, the Commonwealth of Puerto Rico did post its latest General Fund (GF) revenue estimates on EMMA. GF total revenues for FY2013 are now estimated at $8.5 billion, down 1.8% from FY2012. A 12% decline in corporate income taxes was the main driver behind the revenue drop.
To put things in the proper perspective, last year’s budget (FY2012) did benefit from a 6.1% jump in GF revenues, driven primarily by an Act 154 excise tax increase, or rather, the reversal of scheduled rate decreases by the previous administration.
The new disclosure document also gives us a preview of the FY2014 approved budget. As usual, the new budget relies on very optimistic economic assumptions and even more tax increases. Interestingly, FY2014 General Fund resources will include “$245 million in deficit financing to be provided by GDB or third party lenders!”
On the economic front, the Padilla administration is projecting a 0.2% increase in gross national product in FY2014, an assumption that flies in the face of the recently reported 1.7% decline in the island’s economic activity index for the second quarter of 2013.
Economic growth won’t be helped by the more than $1 billion in revenue enhancement measures built into the budget: $775 million in new corporate taxes, $342million in additional sales and use taxes through tax base expansion, just to name a few.
Predictably, the rating agencies are viewing the new budget with a certain amount of skepticism. Standard & Poor’s commented rather pointedly: “Although it’s budgeting for a smaller deficit in this 2014 fiscal year, Puerto Rico has a track record of ending fiscal years with worse-than-budgeted results, as it did in fiscal 2013. With this in mind, Standard & Poor’s Ratings Services will evaluate the credit impact of the commonwealth’s fiscal 2014 budget by comparing actual results against budget projections as the year progresses (…)”
Needless to say, muni market participants will also be holding their breath as they watch how closely the first Padilla budget will track economic reality this year.
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