How plummeting taxable issuance has hit volume expectations

Taxable municipal issuance has plummeted this year as the shock of rising interest rates made the financing vehicle less enticing for issuers, both economically and psychologically. 

From becoming a replacement for tax-exempt advance refundings lost to 2017 tax law changes to broadening the investor base for munis, taxables have played a larger role in the market since mid-2019, topping 30% of all issuance in 2020, and helping to grow overall issuance since then.

Overall market volatility in 2022, though, has kept many issuers on the sidelines, and particularly stymied refunding and taxable volumes. 

The nearly 50% drop in 2022 will very likely lead to a much smaller-than-anticipated overall issuance year, with total issuance for the first half of 2022 down 15% from 2021. Year-to-date, issuance sits at $235.199 billion with taxables accounting for $35.561 billion, or about 15% of the total. Issuance in 2022 will likely fall short of 2021’s and 2020’s record-breaking numbers

“It’s really two things: sticker shock and uncertainty/volatility due to the Fed’s hawkish stance and rate increases through 2022,” said Peter Block, managing director of credit strategy at Ramirez & Co.

The relative cost of taxables versus tax-exempts is lower today at about 150% of 10-year AAAs versus 170% of 10-year AAAs in 2020 and 2021, “but the absolute Treasury rates are almost 200% higher today and likely headed higher,” Block said. 

“Combine this setup to a deal timeline that is several months in the making and you have depressed taxable muni issuance.” 

This has prompted several firms to revise their taxable projections, along with their total issuance forecasts for the year. BofA Global Research strategists Yingchen Li and Ian Rogow lowered their projections for taxables to $80 million from $120 million in June, while CreditSights decreased its estimates from $118 billion to $67 billion.

Citigroup Global Markets Inc. revised their issuance projections down to $495 billion from $550 billion, the entire amount coming from taxables. 

Barclays PLC sees taxable issuance sinking to $75 billion from $110 billion. 

This is all primarily rate-driven, analysts say.

“We are not going to see a substantial increase in taxable refundings at this level of UST rates,” BofA’s Li said. “We have to see sub-2% 10-year UST rates.”

“If rates decline, taxable refundings will come back,” Barclays’ strategist Mikhail Foux said. “This is mostly bond economics; we do expect more taxable issuance but probably not until 2023 if rates decline.” 

Sticker shock
“Everyone was used to sub-1.5% 10-year Treasury rates for three years, and we’ve had such a dramatic back up in rates; it’s a tough adjustment psychologically,” Block said. 

He outlined the numbers. When taxable munis were 30% of the total market in 2020 (the high water mark) the 10-year UST averaged 0.88%. In 2021, when they were about 25% of the market, the 10-year UST averaged 1.43%. 

The 10-year today is at 2.80%, for a price increase of 200%, and that is only for AAA muni rates in 10 years (i.e., if you’re a lower-rated issuer, the yields will be much higher).

Block noted that spreads have also backed up by 50-plus basis points in many cases, even for high-grade issuers in the taxable space. 

“In terms of making sense, even with the rates backup, present-value savings for taxable advance refundings still make sense in many cases — meaning that the savings are within threshold tolerances for an issuer,” said Peter Block of Ramirez & Co.

The state of Washington earlier this month sold $843 million of exempt and taxable GOs. Of that, $140 million were taxable, with 3.34s of 2027 priced at par. 

In July 2021, the state sold taxable munis priced to yield 1% in the 2027 maturity.

Jason Richter, deputy treasurer of debt management for Washington, said the state generally does new-money transactions twice a year with a taxable component in the summer months to fund six months of its capital budget.

The capital budget, he said, usually has some amount of taxable expenditures for projects that don’t meet the requirements of tax-exempt bonds.

“People who need to issue taxable bonds for projects will continue to do so. Most municipal projects are tax-exempt, so [taxable] represents a minority of the issuance,” Richter said. “With rates elevated from where they had been six months to a year ago, I would anticipate a drop off from what we had been seeing for taxable advanced refundings.” 

Foux said there is a need and an appetite for advance refundings and the only viable option for issuers is to issue taxables.

“We still expect taxable refundings, but at a much slower pace than last year,” Foux said. “To offset some of the loss in taxable municipal issuance due to slower refunding activity, more new-money deals are beginning to come to market and will likely remain the driving force for taxable issuance unless muni yields decline meaningfully.”

With Treasury rates up substantially this year, and many bonds with coupons of 4% and below trading at or below par, only bonds with coupons of 5% or higher would provide enough savings to issuers to make financial sense as refundings, Foux said. This leaves a much smaller refundable universe, although still sizable.

“In terms of making sense, even with the rate backup, present-value savings for taxable advance refundings still make sense in many cases — meaning that the savings are within threshold tolerances for an issuer,” Block said.

“But with the Fed committed to vanquishing inflation with super-aggressive rate hikes, fewer issuers versus the recent past want to take the risk,” Block said. “Most want to wait until the dust settles on this hawkish Fed.”

Taxable performance
Taxable municipals have performed the worst in 2022. While returns for all municipals are in the black for July, taxables included, year-to-date performance is deep in the red.

The Bloomberg Municipal Index shows positive 2% month to date and in the red at 7.16% year-to-date. High-yield is at positive 2.87% for July and negative 9.23% in 2022. Bloomberg’s Impact Index is at positive 2.30% for July with losses of 9.65% year-to-date.

Taxables are in the black at 1.09% in July but have lost 13.03% in 2022.

“Taxable muni spreads have started widening in the past couple of weeks, but only marginally and mostly in sympathy with corporates,” Foux noted in a July 22 Barclays report. “However, IG corporates have been tightening as of late, and the spread differential between taxables and corporates have started to shrink.” 

Foux noted double-A taxables are at their cheapest level compared with corporates in more than a year.

In general, the lower supply has helped the market overall during the volatility of the first half of 2022. 

“Lower taxable supply compared with our initial projections should also provide additional support for the market,” he said. “Although we are cautious on taxable muni spreads in 2H22, we selectively see attractive opportunities in higher-rated taxables. This rating bucket is especially attractive for life insurers, and we might see them becoming a bit more aggressive in the secondary market, with primary supply meaningfully declining year-over-year.”

Although the correlation between taxables and corporate spreads is relatively high (80% over the past 10 years), “the former typically outperform during times of market stress,” Foux said.

“That might be even more true this time around, as municipal credit is in a good shape and there should be substantially less taxable supply (as taxable advance refundings make a lot less sense for issuers in the current rate regime), which would also support the taxable muni market,” he added.

Li said the taxable market is “quite sizable” since the market lost exempt advance refundings and if rates can come down, this market is going to be larger.

There is demand for taxables, particularly among foreign investors. 

“Traditionally we had not spoken to foreign investors but in the past few years, because of booming taxable bonds, our interaction with foreign investors has been regularly occurring,” Li said, noting interest from South Korea, Japan, and Europe, via insurance companies and hedge funds. 

“The Fed has surprised everyone; even the bears,” Li said. “Rates have risen too much and that is responsible for everything that happened in the first half.”

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