U.S. Muni Market: Fed Rate Cut Could Fuel Further Surge In Taxable Supply

Broward County, FL On Tap With Water and Sewer Revenue Bonds

Optimism about U.S.-China trade talks appeared Monday to outweigh signs of heightened downside risks to the domestic and global economy, reigniting the upbeat risk-taking mood in the financial markets.

The specter of a so-called ‘Phase One’ trade deal – a partial resolution to the ongoing trade conflict – seemed to overshadow more fundamental concerns about slowing global growth, amid deteriorating manufacturing conditions and faltering business expectations.

The yield on the 10-year U.S. Treasury note was bid at around 1.778% intraday Monday, a climb of almost 31 basis points from its multi-year trough of 1.47% at the start of September.

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Municipal bonds had also witnessed a sell-off along with U.S. government debt, as market participants had generally rotated out of fixed-income and into stocks.

The tax-free yield curve had steepened further on Friday, with the yield on the 2-year benchmark note falling about 2.5bps to roughly 1.15%, while the 30-year ended 1.5bps higher at about 2.14%.

Nuveen analysts Bill Martin and John Miller recently noted that while investors had been motivated to sell both municipal bonds and U.S. Treasuries, the activity mainly reflected an “unwinding of ‘panic buying’ over the last couple of months, due to fears of potential recession and consequently much lower rates.”

However, Martin and Miller continue to think municipal bonds remain an “attractive” investment opportunity, despite the selloff, as investors “will likely take advantage of higher yields and a higher new issue calendar through the end of the year,” amid rates that “will stay lower for longer.”

Indeed, the market’s implied probability the Federal Reserve’s Federal Open Market Committee(FOMC) will elect to cut interest rates by another 25bps at the conclusion to its two-day monetary policy meeting on October 30 rose Monday to nearly 90%, a jump of around 20% over the past two weeks.

The chances the FOMC would reduce rates were further boosted by Fed vice chair Richard Clarida’s speech at the CFA Institute’s conference on fixed-income management ahead of the weekend.

Clarida highlighted that business fixed investment in the U.S. has “slowed notably since last year, exports are contracting on a year-over-year basis, and indicators of manufacturing activity are weakening.” Moreover, global growth estimates “continue to be marked down, and global disinflationary pressures cloud the outlook for U.S. inflation,” which at its current course remains muted.

The FOMC at both its July and September meetings voted to lower the target range for the federal funds rate by 25bps, to what is now 1.75% to 2%.

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Clarida’s rhetoric about the downside risks to the domestic economy was further fueled Friday by The Conference Board’s Leading Economic Index (LE), which fell 0.1% in September after a 0.2% decline in the prior month.

Ataman Ozyildirim, senior director of economic research at The Conference Board, attributed the latest fall to manufacturing sector weaknesses, as well as the interest rate spread, which were only “partially offset by rising stock prices and a positive contribution from the Leading Credit Index.”

Ozyildirim added that the LEI reflects “uncertainty in the outlook and falling business expectations, brought on by the downturn in the industrial sector and trade disputes.”

Muni Market Health Check

Against this backdrop, demand for municipal bonds, ex-exchange-traded funds (ETFs), continues to remain healthy, according to the latest flow of funds data.

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For the week ended October 16, Thomson Reuters/Lipper U.S. Fund Flows posted net inflows into muni bond funds (for the 41st straight week) of around US$1.09bn, down only slightly from the prior week’s US$1.14bn and just south of their weekly average of US$1.15bn since August 7, 2019.

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Also, prices of certain exchange-traded funds (ETFs), such as the iShares National Muni Bond fund (NYSEARCA: MUB) and the Vanguard Tax-Exempt Bond fund (NYSEARCA: VTEB), have risen roughly 9.5% and 7.3%, respectively, since their most recent 52-week lows set in early November 2018. However, prices of these ETFs have been trending somewhat lower in recent weeks, in line with the sell-off in U.S. Treasuries.

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Deals that priced this past week included close to US$2.5bn worth of New York State Thruway Authority general revenue bonds at yields of 1.12% and 3.5%; more than US$1bn of taxable California State general obligation bonds at yields of 1.69% to 3.18%; and almost US$714m of Ascension Health System hospital revenue bonds at yields of 1.17% to 1.71%.

Sales Continue to Surge

According to analysts at Janney Montgomery, the municipal market absorbed a “sizeable” new issue calendar last week, and this week appears to be “more of the same,” with about US$12.5bn worth of fresh offerings teed up for sale.

Janney observed that taxable bonds will account for “a large slice” of the coming week’s offerings – as was the case last week – including US$621m of ‘AA’-rated Wisconsin annual appropriation bonds, as well as Pennsylvania Turnpike Commission’s planned sale of three series worth of taxable refunding bonds.

Also, on the near-term radar, Broward County, Florida is on tap to sell around US$226m of water and sewer utility revenue bonds, Series 2019A, as well as roughly US$204m worth of taxable water and sewer utility revenue refunding bonds, Series 2019B.

The county intends to peg the proceeds from the Series 2019A bonds in large part to fund various water and sewer projects, while the intake from the Series 2019B bonds is expected to help refund existing municipal debt.

Broward has a five-year, US$381m capital program in place from the fiscal year 2019 to 2023, with a budget about on par to meet its plan. The county anticipates financing around 60% of the program with debt and the remainder with cash on hand.

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The offering rated ‘AA+’ by Fitch Ratings and ‘Aa1’ by Moody’s Investors Service, is being lead-managed by Bank of America Merrill Lynch and is slated to be sold in the week of November 5th.

Moody’s analyst Valentina Gomez noted that the agency’s credit rating reflects “stable coverage levels, healthy liquidity, a large and diverse customer base, and an above-average debt burden.” She also said the rating is further supported by wholesale customers, which pay around 39% of debt service (post-issuance), based on reserved capacity.

The county’s water and wastewater system provides service to an estimated 57k retail water customers, 51k retail sewer customers, and 11 wholesale users.

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The latest bond issuance is secured by net revenues of the combined water and sewer system, as well as legally available impact fees.

Fitch Ratings also noted that the issuer’s financial performance “remains stable with debt service coverage (DSC) at about 1.9x the last two fiscal years,” adding that strong liquidity and “affordable rates provide financial flexibility.” These strengths are also likely to help mitigate an expected decline in DSC to around 1.6x in fiscal 2020.

Meanwhile, the taxable Series 2019B bonds will contribute to a growing mountain of taxable issuance as rates remain low.

Strategists at Barclays recently noted that while taxable muni spreads have “widened marginally, in general, taxable supply has been absorbed quite well thus far, as low corporate issuance due to earnings blackouts has definitely been a positive for the market.” Barclays expects taxable supply to remain heavy, “but only if rates stay low.”

Taxable supply in August, for example, had surged, but only after yields fell about 60bps, according to Barclays. “If taxable muni yields start moving higher from current levels (by 25- 40bp), it would make much less sense to issue taxable bonds as well as advance refund taxable bonds with tax-exempts,” they said.

Barclays added that it anticipates more than US$45bn in total muni issuance in October, which is typically a busy month, with up to US$12bn-15bn in taxable muni supply. 

To date in 2019, almost US$300bn worth of fresh muni bond issuance priced, with the Bond Buyer’s U.S. 30-day visible supply signaling another US$15.5bn intraday Monday, according to Bloomberg.