Municipal demand and prices so far in the New Year are being bolstered by market technicals, according to Jeffrey Lipton, managing director and head of municipal research and strategy at Oppenheimer.
Amid a continued negative tone for overseas and domestic equity markets – underscored by the Dow Jones Industrial Average's 500-point free fall in the last week -- the lack of municipal supply is driving mutual fund flows and demand for tax-exempt securities higher, Lipton said in a weekly municipal commentary dated Jan. 19.
"The risk-off trade is fully in place – for now – with quality asset classes positioned with open arms and a running meter for price appreciation," he wrote.
"As concerns mount over the state of China's economy, the markets grow more anxious over potential contagion implications for U.S. growth," he added.
But, in the fixed-income market, tax-exempt bond prices traded in a narrow range last week and actually underperformed the Treasury rally, according to Lipton. The 10 and 30-year Municipal Market Data benchmark triple-A yields finished last week just where they began – at 1.75% and 2.70% respectively. As of Jan. 19, those were at levels that were last available in February 2015, Lipton noted.
For the 15th consecutive week, municipal bond flows were positive, as per Lipper U.S. fund flow data, Lipton noted.
On Jan. 15, municipals rallied on weaker equity and commodity prices as 10 and 30-year U.S. Treasury yields were lower by 14 basis points and 15 basis points, respectively.
"Market technicals continue to support municipal bond prices," the strategist wrote. "January has been a relatively light issuance month, much as we expected given the January effect," he continued. "Lower supply and accelerating reallocation of cash stemming from calls and maturities have buoyed investors' appetite."
While the global volatility is contributing to increased demand for municipal bonds and providing strength, the municipal market it isn't free of concern.
Lipton remains cautious and wary of Chicago and Illinois – two market "outliers" that sold debt last week under supply and yield-starved conditions.
The city sold $550 million of general obligation refunding bonds, that after repricing to lower yields, offered a 5% term coupon priced to yield 4.875% in 2038 – which was 230 basis points over the benchmark triple-A, MMD scale, he noted.
The state, meanwhile, sold $480 million of GO bonds for critical infrastructure projects with a 2041 maturity carrying a 5% coupon to yield 4.27% -- 161 basis points to the MMD scale.
"Timing for both issues was likely supportive in terms of pricing given the lower supply environment, particularly for high-yield paper," he said in the report.
Illinois is rated Baa1 by Moody's Investors Service, A-minus by Standard & Poor's, and BBB-plus by Fitch Ratings, while Chicago is rated Ba1 by Moody's, and BBB-plus by the two other major rating agencies.
Although those new deals benefitted from good timing and aggressive pricing this time around, Lipton said they still face generally wider spreads as well as potential credit and liquidity issues going forward due to a combination of unsolved concerns, including structural imbalances, budgetary pressures, and unfunded pension liabilities.
"Both the state and the city have been subject to multiple downgrades largely due to quite onerous unfunded pension liabilities," Lipton wrote.
The city's deal, he said, came at tighter spreads compared to its prior two offerings last year. "More recent efforts to address the city's credit erosion and a general view that Chicago is not likely to follow the Chapter 9 path taken by Detroit, prevented the deal from coming at even wider spreads," Lipton noted.
"The city's implementation of a property tax increase to fund the public safety pension plans helped to soften market reception for Chicago's GOs," he added. "Nevertheless, the city's unfunded pension liability and surrounding litigation will likely keep trading levels at wider spreads until there is some clarity and improvement."
Lipton added that although the fiscal year 2015 budget resolved a significant deficit, subsequent budget gaps and overall structural imbalance "must be addressed in order to achieve credit stability," and "city officials must demonstrate progress with respect to structure and pension issues in order to prevent further downgrades."
Meanwhile, like the city, the state fared well when its newest deal priced, Lipton said.
"Given the credit erosion since the state last sold GOs in 2014, the result could have come with an even greater yield penalty," Lipton wrote.
This is especially true given that the state is facing its seventh month of the current fiscal year without a budget in place, which has led to a lack of progress on pension reform, the strategist noted.
"The temporary tax increases have expired and the Illinois State Supreme Court rendered an unfavorable ruling to the state that prevents cuts in pension payments," according to Lipton. "The loss of temporary tax revenue alone had a significant effect on fiscal year 2015 operations with an even greater impact expected for fiscal year 2016."
While Lipton said he does not envision a material likelihood of a state default, he thinks the boundaries of speculative grade ratings could be tested "without efforts to stabilize the credit trajectory."
"Illinois may very well display sufficient liquidity to fund debt service for the time being as well as possess appropriate credit fundamentals, but we call upon the state to end the gridlock and put a budget in place," he continued.
"We do think that the protracted budget debate will likely have longer term structural implications that will require even more difficult decisions," Lipton added. "There are likely to be legacy issues for the next governor and perhaps beyond."
Meanwhile, outside the municipal market, he said next week's Federal Open Market Committee will focus around the conditions of the U.S. and global economies.
"We suspect that recent developments for the New Year will be part of the active dialogue when the FOMC next meets," Lipton advised. The two-day meeting is scheduled for Jan. 26 and Jan. 27.
"A rate action is not expected with this meeting and severe global market volatility only reduces the likelihood of a March rate hike," he wrote.
"While most would agree that 'lift-off' came and went with little fanfare, the challenge before the Fed is to assess just how impactful the latest volatility will be upon the U.S. economy," Lipton added. "Further rate hikes will be heavily data-dependent and will likely be tied to overriding evidence of economic growth that may turn around training inflation," he said.
Christine Albano is an investing reporter for The Bond Buyer.
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