Ohio Water Development Authority Set to Add to Mounting Supply

Municipal bond investors will generally continue to contend with interest rate risk in the week ahead, amid uncertainties over U.S.-China trade negotiations, as well as the near-term path of monetary policy.

While Chinese officials prepare to meet later this week with their U.S. counterparts in Washington to hammer out a potential trade deal, it appears discussion points may be fewer than initially expected — as industrial policy reform and government subsidies have been reportedly cleared off the table.

Market participants have generally attributed some softening in U.S. economic data, as well as the ongoing impeachment inquiry against President Donald Trump, as support for strengthening China’s hand in the upcoming trade talks.

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Any agreement between the two nations that would help to resolve, or at least dial-back, the escalating feud would undoubtedly help to calm the pervasive backdrop of global market volatility.

However, the recent reports of China exploiting U.S. economic weakness, political divisions, and potential leadership change, has added to an already long list of turbulent headlines, filled with intensified violence in Hong Kong, gloomy data out of Germany and the eurozone, as well as heightened fears about Brexit, as the UK’s October 31st deadline approaches with little progress towards agreement with the EU.

As a reflection of the tumult, the Cboe volatility index (VIX) was up around 6.22% intraday Monday to trade at around US$18.10, according to the IBKR Trader Workstation.

Prices of U.S. Treasuries have also been benefiting from the recent flight to safe-haven assets, with the yield on the 10-year note last hovering at around 1.539%. The level represents a drop of a little more than 36 basis points since September 13, when China reportedly said it would exclude certain agricultural imports from its tariffs list, including soybeans and pork.

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Flocking from Overseas

Meanwhile easing policies among several global central banks, including the Federal Reserve’s Federal Open Market Committee (FOMC), the European Central Bank (ECB) and the Reserve Bank of Australia (RBA), have been helping to keep interest rates low – notably in the short-end of the yield curve.

Brian Nick, the chief investment strategist at Nuveen, noted that when central banks “load up their balance sheets with high-quality bonds, there are fewer left for other investors at a time when the premium on safety has risen sharply.

“This inadequate supply of government bonds relative to demand — even allowing for the roughly $1 trillion in new U.S. Treasury issuance over the past year — is predictably leading to higher prices and thus lower yields.”

The entire German yield curve, for example, remains in negative territory, with the yield on the 10-year Bund last around -0.59%. In fact, several European countries’ 10-year notes reside with negative yields, including France (-0.29%), Sweden (-0.36%), the Netherlands (-0.45%) and Switzerland (-0.82%).

Against this backdrop, Nick added that municipal bonds are “benefiting from historically strong investor demand, including from overseas investors who value yield despite being ineligible for the tax benefits; the municipal yield curve remains upward sloping and rates are strongly positive.”

Indeed, for the week ended October 2, Thomson Reuters/Lipper U.S. Fund Flows posted net inflows into muni bond funds (for the 39th straight week) of around US$906m, albeit down from last week’s US$1.36bn, and below their weekly average of US$1.154bn 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 9.86% and 7.77%, respectively, since their most recent 52-week lows set in early November 2018.

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Furthermore, analysts at Janney Montgomery observed that tax-free yields finished last week lower by 11-12bps across the curve, with the recent bull flattening trend pushing the ‘AAA’ 3-year tax-free benchmark yield within a few basis points of the multi-decade low established in late August.

The 10-year muni / Treasury ratio edged higher from the prior week and was last quoted at around 89%.

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Among the offerings last week, the City of New York priced US$850m worth of tax-exempt, and US$130m of federally taxable, general obligation bonds; and the Maryland Community Development Administration sold US$323m of housing revenue bonds at yields of around 1.3% to 3.0%.

Fed Watch

Market participants will also likely be tuned-into Fed speeches this week, including from chair Jerome Powell, in the lead-up to the FOMC’s conclusion to its two-day meeting on October 30, for any indications of the central bank’s near-term monetary policy direction.

The minutes to the committee’s September 17-18 meeting are also slated to be released Wednesday, and investors have generally been weighing recent downbeat manufacturing data against a still-strong labor market against divided perspectives within the Fed when forming their views on the Fed’s potential path forward.

Economists at Jefferies recently noted, for instance, that September’s employment report does not provide “compelling evidence to support either the hawk or dove camps on the FOMC for the upcoming FOMC meeting; one survey is tepid, but not disturbing, and the other survey is robust. Payroll growth has decelerated while household employment has surged.”

Jefferies added that it is “likely that the outcome of the December FOMC meeting depends significantly on the ability of the administration to get a meaningful trade deal done with China.

“If the tariffs are peeled back, both U.S. growth and inflation will accelerate, and eliminate the perceived need for another rate cut. If there is no trade deal, the probability of a December rate cut will increase, however. Timing would also influence the decision.”

The implied probability Monday of a 25bp rate cut by the Fed on its October meeting was around 72%, with a December cut close to 89%.

The Supply Side

Against this landscape, investors may find yields on municipal bonds more alluring than U.S. Treasuries, as ratios approach their cheapest point to fair value in recent history.

Barclays strategists highlighted heavy supply as yet another factor helping to keep prices of munis low.

According to Barclays, October may wind up as the third nearly US$40bn supply month in a row; “although a big portion of issuance is taxable, tax-exempt supply will remain heavy even after subtracting it.” Moreover, the 30-day visible supply is close to the highest level for the year, and “issuance will remain robust in the next one to two months.”

Barclays calculates that with last week’s roughly US$10bn of new deals, the year-to-date tally rose to US$277bn, while another US$8bn is poised to price in the week ahead. The 30-day visible supply was around US$17bn as of October 3, higher than the US$10bn year-to-date average. 

OWDA and Other Issuers Ahead

Among the near-term transactions on the radar, the Ohio Water Development Authority (OWDA) is on tap with US$300m worth of Water Pollution Control Loan Fund (WPCLF) refunding revenue and revenue bonds, Series 2019B.

The issuer intends to peg the proceeds from the sale of the notes in part to refund existing WPCLF-related debt, as well as to raise money for the sole benefit of the WPCLF.

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The deal, which has received ‘AAA’ credit ratings from S&P Global and Moody’s Investors Service, is being co-lead managed by Bank of America Merrill Lynch and Huntington Capital Markets.

Moody’s analyst Omar Ouzidane attributed the agency’s pristine ‘Aaa’ credit rating on the proposed bonds in large part to “the strong security provided by the size, diversity and credit quality of the combined program loan pools (loan pool), the pledge of substantial funds and reserves that results in a very high default tolerance, OWDA’s established track record of successful management of this and other programs, and the cross-collateralization” between the WPCLF and the Drinking Water Assistance Fund (DWAF).

The WPCLF was created as a stand-alone, self-sufficient financing program in 1989, with a 50-year track record of managing loan programs for communities throughout the State of Ohio.

As of July 31, 2019, there were 338 government agencies with 1,185 projects financed through the WPCLF. A total of US$7.62bn in principal amount of loans has been made through the program, with a principal balance of US$5.55bn outstanding.

To date, the OWDA has around US$524.415m worth of Water Quality bonds and US$2.112bn of WPCLF revenue notes outstanding.

The latest WPCLF bond, Series 2019B, are set to price Wednesday, October 16.

In the meantime, other deals on the near-term horizon include more than US$550m of notes from the University of Nebraska; over US$500m of revenue and revenue refunding bonds from the District of Columbia Water and Sewer Authority; US$325m of single-family mortgage revenue bonds from the Michigan State Housing Development Authority; and around US$550m of taxable refunding notes from the Massachusetts Water Resources Authority.