Expectations were virtually sealed this past week for the Fed to cut its target rate by 25 basis points on Wednesday afternoon. Economic data supported this narrative but raised the specter of more pe...
Bond Markets
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4 min read
The municipal bond market took a wild ride in the first half of the year to near-historic levels of richness versus Treasuries that is rarely seen, and the environment is ripe for the second half of the year to take it even further. The outperformance of municipals in the first half can be attributed to many factors, such as inflation, rising tax rates and an imbalance of supply and demand. I believe these factors will continue in the second half setting up another favorable period for the municipal bond market.
According to Bloomberg market data, municipal bond yields have traded at approximately 100% of Treasury yields for the last two decades with two notable exceptions in late 2008 to early 2009 and then again in 2020, when long-term municipal bond yields traded significantly higher than long term treasury yields. The first half of 2021 saw municipal yields fall from approximately 90% of treasuries to 70% of treasuries which lead to municipal bonds outperforming treasuries by approximately 400 basis points. The Barclays U.S. Treasury index returned -3.44% versus Barclays municipal bond index return of 0.65%.
The main factor in the second half of the year that should help municipal performance is that the market is starved for supply. Demand has far outstripped supply so far this year, and I expect that to continue. Cash inflows into municipal bonds has been approximately $50 Billion in the first half with approximately $350 Billion in bonds being called or maturing. According to Ramirez and Co., the $350 Billion being called or maturing is more than the expected total tax-exempt issuance for the year of $331 Billion. Add in a very strong interest payment season during June, July, and August and I find it very difficult for the municipal bond market not to do well in the second half of the year.
The specter of higher tax rates and the continuation of people looking for any way to avoid higher taxes should continue to bolster the municipal market in the second half and add to the outperformance of municipals versus other taxable fixed income securities. There has also been talk in congress of reviving Build America Bonds, which are taxable and subsidized by the Federal government to pay for an infrastructure plan. BABs as they are known in the industry are taxable and would most likely decrease the issuance of tax-exempt bonds in favor of taxable municipals, leading to a more uneven demand/supply issue than we already have.
Inflation will continue to be a concern in the Treasury market as both input prices and output prices are increasing. The supply chain from chickens to computer chips is also a contributing factor with shortages being reported daily. Treasury yields will also fight a surge in issuance to cover the financing of trillions of dollars in relief packages, which should also weigh on Treasury yields for the rest of the year. The last piece of bad news for Treasury yields that should be mentioned is the potential of the Federal Reserve tapering its market purchases, pulling a strong level of support from the market. One positive I expect in the Treasury market is that I don’t expect the Federal Reserve to raise short term rates this year.
Municipals should be able to avoid the shortfalls seen in the Treasury market this second half as the demand seams unrelenting and the supply is very limited Even with the possibility of higher Treasury rates in the second half of 2021, investors are willing to accept lower tax-exempt rates If it means not having to give the government more money than they already do.
Definitions:
An index is unmanaged and not available for direct investment. Definitions sourced from Bloomberg.
- The Bloomberg Barclays Global Aggregate Negative Yielding Debt Market Value Index represents the portion of the Bloomberg Barclays Global Aggregate Index that measures the aggregate value of global debt with a negative yield.
- The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
- The NASDAQ Composite Index is a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market. The index was developed with a base level of 100 as of February 5, 1971.
- The Cboe Volatility Index® (VIX) is a calculation designed to produce a measure of constant, 30-day expected volatility of the US stock market, derived from real-time, mid-quote prices of weekly S&P 500® Index (SPX) call and put options with a range of 23 to 37 days to expiration.
- The ICE BofA MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of implied volatilities on the CT2 (Current 2 Year Government Note), CT5 (Current 5 Year Government Note), CT10 (Current 10 Year Government Note), and CT30 (Current 30 Year Government Note), with weights 0.2/0.2/0.4/0.2 respectively.
- The Markit CDX North America Investment Grade Index is composed of 125 equally weighted credit default swaps on investment grade entities, distributed among 6 sub-indices: High Volatility, Consumer, Energy, Financial, Industrial, and Technology, Media & Tele-communications. Markit CDX indices roll every 6 months in March & September.
- The Markit CDX North America High Yield Index is composed of 100 non-investment grade entities, distributed among 2 sub-indices: B, BB. All entities are domiciled in North America. Markit CDX indices roll every 6 months in March & September.
- The U.S. Dollar Index (USDX) indicates the general international value of the USD. The USDX does this by averaging the exchange rates between the USD and major world currencies. Intercontinental Exchange (ICE) US computes this by using the rates supplied by some 500 banks.
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