Bonds

Munis underperform, pushing valuations higher on short end

Municipals improved Thursday while outflows from municipal bond mutual funds rose to more than $800 million. U.S. Treasuries were better on bonds five years and in and equities ended down as more news of troubled regional banks and the continued debt ceiling standoff in Washington hangs over markets.

Triple-A benchmarks were firmer, with yields falling one to five basis points, depending on the scale and UST yields falling up to nine basis points on bonds inside of five years.

Ratios rose on the short end. The two-year muni-Treasury ratio Thursday was at 72%, the three-year at 72%, the five-year at 71%, the 10-year at 69% and the 30-year at 90%, according to Refinitiv MMD’s 3 p.m. ET read. ICE Data Services had the two-year at 69%, the three-year at 70%, the five-year at 68%, the 10-year at 69% and the 30-year at 91% at 4 p.m.

“The muni market rarely moves rapidly on an FOMC meeting day, but Treasuries often do,” said R.J. Gallo, senior vice president and senior portfolio manager at Federated Hermes.

He noted Fed Chairman Jerome Powell has, at times, “been a market mover at the podium, in addition to what is in the FOMC committee statement.” However, this time, Gallo said “the markets didn’t necessarily get more volatile on Powell, who went up to the podium and reaffirmed the idea that inflation is still too high.”

This could be the end of the hiking cycle, but Powell didn’t commit to that, Gallo said. There was talk of a pause in the rate hiking cycle, but Powell said it was too early to determine.

“Markets are convinced that the Fed’s tightening cycle is on hold,” Peter Block, managing director of credit strategy at Ramirez & Co., said in a report Thursday.

“To the extent economic data comes in hot and yields rise there is risk this exacerbates problems with the economy,” he added.

Gallo also believes the change in the FOMC statement language suggests that this might be the last hiking in the cycle.

“Typically, bond markets rally fairly soon, around the last hiking of a cycle, so in that sense it could be a positive thing for the market,” he said.

One of the challenges last year, extraordinary interest rate volatility and a certain kind of volatility, namely yields sharply higher and prices sharply lower, wasn’t very good for fixed-income investors,” he said. “So if the Fed is, in fact, pausing, there’s a very high probability, that’s what we just saw today.”

Gallo said that opens the door for yields to stay in this range and likely go lower.

In the months ahead, he noted there’s a lot of uncertainty for any fixed-income investors, he noted.

The Fed is “now stuck trying to handle, on the one hand, inflation that’s still too high, and on the other hand, a financial system that has gone through significant stress linked to the rapid change in interest rates,” he said. “So they’re trying to sort of navigate between those two factors.”

If inflation is going to be sticky and not come down very rapidly, then the Fed won’t ease, he said. However, it inflation does come down more quickly, then the Fed could ease, according to Gallo.

He said the “one thing that is becoming less likely, is that the Fed’s going to hike rapidly from here, and as a result, that’s more positive for bond investors.”

Meanwhile, federal debt ceiling negotiations remain a significant tail risk for markets in May as the “X” date approaches, Block said.

Municipals should remain fully valued with tight municipal-to-Treasury ratios and spreads, at least through the 10-year spot, on constrained supply, accelerating reinvestment, and high absolute yields/safe-haven status, according to Block.

“Given this and the fact that forward Treasury rates have consistently implied a bull flattening within one year, we see value in curve positioning and structure while adhering to a high-quality credit bias,” he wrote. 

Block said there is value in the 11- to 20-year part of the curve versus the shorter duration. In addition, he favors discount coupons in a barbell posture to capture high short-term yields and lock-in long yields to capture potential positive convexity and enhanced roll-down.

For most of the year, he said the muni market “has been pretty well bid.”

“There was a couple of air pockets here and there when ratios got very rich, but that was short-lived,” he said. “And generally speaking, the much higher yield environment that we now face after the sharp Fed tightening and the big bond market selloff the last year, have taken yields back to levels where individual investors started to become interested again.”

More investors, he said, have moved into separately managed accounts and there are “more retail trades in terms of direct retail.”

“That tells you there’s a lot of investors in the muni market, who are not necessarily looking to buy a mutual fund, which is mark-to-market daily, giving you daily liquidity and a sort of total return,” Gallo said.

Many of these investors “are interested in owning their own bonds at much higher yields than they were able to get for 10 years,” he said.

The investors are “attracted by that higher yield level, and that’s where the demand has been coming from,” he said.

However, he said “when it comes to the mutual funds, it hasn’t been as readily apparent just yet.”

He believes the volatility in bond markets, which translates into volatility in muni mutual fund NAVs “causes people to maybe hesitate a little bit but ultimately, as the year goes on, and the economy slows, and inflation resumed its downward trend, there’s going to be more money coming into the muni mutual funds as well as to those other pockets of direct retail.”

Outflows from municipal bond mutual funds intensified as Refinitiv Lipper reported $846.116 million was pulled from them as of Wednesday after $92.055 million of outflows the week prior. 

In the primary market Thursday, the last of the week’s large new issues priced. BofA Securities priced for the Health and Educational Facilities Board of Johnson City, Tennessee, (/A-/A/) $185.525 million of Ballad Health hospital revenue bonds. The first series, $145.895 million of refunding bonds, Series 2023A, saw 5s of 7/2024 at 3.53%, 5s of 2028 at 3.16%, 5s of 2033 at 3.27% and 5s of 2034 at 3.35%, callable 7/1/2033.

The second tranche, $39.630 million of improvement bonds, Series 2023B, saw 5s of 7/2033 at 3.27%, noncall.

BofA Securities priced for the School Board of Lee County, Florida, (Aa3//AA-/) $131.970 million of certificates of participation, Series 2023A, with 5s of 8/2029 at 2.59%, 5s of 2033 at 2.73%, 5s of 2038 at 3.37%, 5s of 2043 at 3.72% and 4s of 2048 at 4.27%, callable 8/1/2033.

Secondary trading
NY Dorm PIT 5s of 2024 at 3.01% versus 3.10% on 4/26 and 3.02% on 4/24. Washington 5s of 2025 at 2.74%-2.72% versus 2.77% Tuesday and 2.79% on 4/27. Maryland 5s of 2026 at 2.51% versus 2.58%-2.55% on 4/26 and 2.55% on 4/25.

Washington 5s of 2028 at 2.41%. Massachusetts 5s of 2028 at 2.37% versus 2.41% Wednesday. California 5s of 2029 at 2.31% versus 2.41% on 4/25 and 2.08%-2.09% on 4/12.

Delaware 5s of 2032 at 2.25%. Union County, North Carolina, 5s of 2033 at 2.33%. DC 5s of 2034 at 2.59%-2.53%.

NYC TFA 5s of 2044 at 3.59% versus 3.59% Wednesday and 3.64% on 4/20. LA DWP 5s of 2052 at 3.63% versus 3.64%-3.63% on 4/26 and 3.55% on 4/17.

AAA scales
Refinitiv MMD’s scale was bumped three to five basis points: The one-year was at 2.97% (-3) and 2.66% (-3) in two years. The five-year was at 2.31% (-5), the 10-year at 2.31% (-5) and the 30-year at 3.36% (-3) at 3 p.m.

The ICE AAA yield curve was bumped four to five basis points: 2.99% (-4) in 2024 and 2.68% (-4) in 2025. The five-year was at 2.31% (-4), the 10-year was at 2.28% (-4) and the 30-year was at 3.35% (-4) at 4 p.m.

The IHS Markit municipal curve was bumped three to five basis points: 2.96% (-3) in 2024 and 2.66% (-3) in 2025. The five-year was at 2.31% (-5), the 10-year was at 2.30% (-5) and the 30-year yield was at 3.36% (-3), according to a 4 p.m. read.

Bloomberg BVAL was bumped one to four basis points: 2.80% (-1) in 2024 and 2.66% (-2) in 2025. The five-year at 2.31% (-3), the 10-year at 2.29% (-4) and the 30-year at 3.38% (-3) at 4 p.m.

Treasuries were firmer five years and in.

The two-year UST was yielding 3.768% (-9), the three-year was at 3.492% (-6), the five-year at 3.307% (-2), the 10-year at 3.368% (+2), the 20-year at 3.803% (+4) and the 30-year Treasury was yielding 3.731% (+5) at 4 p.m.

FOMC redux
As the Federal Reserve announced it 10th interest rate increase in a little over a year and hinted that the current tightening cycle is at an end, the municipal market was stable in the midst.

The decision was expected — and takes the fed funds rate to a target range of 5% to 5.25%.

A statement following the announcement omitted a sentence present in the central bank’s March comments saying that “the Committee anticipates that some additional policy firming may be appropriate” for the Fed to achieve its 2% inflation goal.

Analysts are watching the impact of the Fed’s latest actions for any risk in the municipal market.

“I actually can’t remember the last time there has been less movement in fixed income and equity markets around the statement and press conference,” said Christian Hoffmann, portfolio manager and managing director for Thornburg Investment Management. “Boring for us, but a success for the Fed.”

He does not believe “Powell offered a clean response to the question of tolerating inflation at 3%.” Powell “offered tea leaves that suggest the unspoken, uncomfortable reality that at some point the Fed may have to balance higher than desirable inflation to balance employment and economic stability goals,” according to Hoffmann.

“The presser toed the line of the policy statement, which we think was constructed to provide maximum flexibility in either pausing, hiking again or holding higher for longer,” said Marvin Loh, senior global macro strategist at State Street.

Based on limited market reaction and subsequent conversations, he believes Powell accomplished that goal.

“This leaves a market that is still aggressively pricing rate cuts beginning later this year, although it remains conceivable that data before the June meeting (two employment and two CPI reports) will prompt the Fed to tighten yet again,” he said. “We nonetheless continue to lean towards that this is the end of the hiking cycle and based on commentary from the Chair that we may be near or already at sufficiently restrictive levels, we suspect that the FOMC may also be leaning in this direction.”

Key to this view, Loh said, “would be the inherent tightening in financial conditions from banking stress and tightening lending conditions.”

“Powell freely cited results from the soon-to-be-released [Senior Loan Officer Survey] report would be consistent with more challenging conditions at small and mid-sized banks,” he said.

“The continued deep inversion of the curve will also not help banks until it can roll its assets into higher yielding (and performing) loans,” Loh said. “With our data showing strong interest in UST duration, we think that conditions are ripe for further deterioration in economic and financing conditions, heightening recessionary risk, and in our view, is something that is not priced into a multitude of risk assets.”

Overall, Christian Scherrmann, U.S. Economist at DWS Group, thinks “the Fed now starts lurking on the economy and might — if incoming data warrants this — be willing to adjust the current stance of monetary policy slightly to the up or downside.”

Given “the recent mixed data on inflation and labor markets we see risks of this somewhat tilted to the upside but caution that this situation might change quickly as a further tightening of credit conditions could change this assessment,” he said.

Crucially, Mickey Levy, chief economist for Americas and Asia at Berenberg Capital Markets, said “the Fed’s shift to a ‘wait-and-see’ posture reflects an acknowledgement — made in the policy statement — that credit conditions have tightened, which is expected to weigh on economic activity and labor markets.”

Powell believes “the Fed has come a long way in raising rates and monetary policy is now at or close to a sufficiently restrictive stance,” he said.

The decision to rate hikes further is “likely to hinge on the extent to which tighter credit transmits into real activity over the coming months, with the Fed acknowledging the wide bands of uncertainty regarding the extent of these effects,” Levy noted.

“While the shift in language [in the statement] suggests a pause, Chair Powell downplayed this by stating the Fed hadn’t discussed a pause during the May meeting, and tried to retain optionality by emphasizing that the Fed stood prepared to do more if required,” he said.

The Fed “signaled the threshold for justifying future rate increases is now higher than it was,” said James Knightley, ING chief international economist. “With lending conditions rapidly tightening in the wake of recent bank stresses, we think this will mark the peak for interest rates with recessionary forces set to prompt interest rate cuts later this year.”

Chair Powell “continued to play down the prospect of rate cuts this year, despite the market’s insistence on pricing them in,” said Emin Hajiyev, senior economist at Insight Investment.

The Fed Funds futures pricing “implied an almost 65% probability that the Fed will perform 75bp of rate cuts or more by year-end,” he said.

However, Hajiyev noted “this market view appears inconsistent with financial conditions indices, which still indicate relatively loose conditions.”

Rate cuts seem unlikely this year, he said, “barring a major retreat in inflation, which we see as unlikely as favorable base effects dissipate this summer.”

While the “overall job market conditions still are fairly robust, the data in the past few months point to a loosening of the labor market,” according to Hajiyev.

Meanwhile, he expects “the path to lower inflation to be protracted and bumpy,” believing “these factors justify maintaining a tight policy stance.”

“On the flip side, the magnitude of the Fed’s hikes and uncertainty around regional banks justifies a cautious approach over any potential further rate hikes,” Hajiyev said. “This could be the apex of the Fed’s hiking cycle, but we expect rates to stay on hold for some time.” 

Mutual fund details
Refinitiv Lipper reported $846.116 million of municipal bond mutual fund outflows for the week that ended Wednesday following $92.055 million of outflows the previous week.

Exchange-traded muni funds reported outflows of $81.864 million after inflows of $416.836 million in the previous week. Ex-ETFs muni funds saw outflows of $764.253 million after outflows of $508.890 million in the prior week.

Long-term muni bond funds had outflows of $442.708 million in the latest week after outflows of $100.401 million in the previous week. Intermediate-term funds had outflows of $149.306 million after inflows of $196.536 million in the prior week.

National funds had outflows of $697.743 million after outflows of $41.766 million the previous week while high-yield muni funds reported outflows of $343.820 million after outflows of $557.501 million the week prior.

Christine Albano contributed to this story.

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