Taxable Fixed Income Markets
While the Federal Reserve was busy increasing short-term interest rates in both March and June, the bond market was equally busy lowering long-term interest rates. The result was a much flatter yield curve and a new emerging bond conundrum. While we are not yet close to the dreaded inverted yield curve that often signals an impending recession, it is quite remarkable that long term rates continued to fall during the initial stages of a Federal Reserve rate hiking cycle. The Federal Reserve forecasts a strengthening economy and the likelihood of rising inflation, meanwhile; markets remain skeptical with hopes fading of imminent and meaningful tax reform, or anticipated fiscal stimulus from infrastructure spending.
The second quarter saw the 10 Year AAA Municipal yield moved gradually lower. The most startling takeaway from the quarter was the disappearance of any volatility as the downward movement in yields continued. One likely reason for this, according to our municipal bond analysts, was an unusually high net negative supply. Over the quarter the municipal bond market shrank by as much as $80 billion as new supply was outweighed by maturing and called bonds. This negative net supply seemed apparent as municipal valuation ratios fell in conjunction with rates. Political initiatives or lack thereof were also supportive of the market and lower volatility.
- Rates & Ratios: The 10-year AAA rated municipal bond yield fell from 2.25% to 1.96%. Lows for the quarter were 1.82%, and we would have ended at these levels if not for a bit of a selloff during the last couple days of the quarter. This 1.96% yield level represents 86% of the 10 Year U.S. Treasury yield, down from 95% at previous quarter end.
- Fund Flows: Flows in the municipal market were strong for the quarter as political (tax) initiatives were delayed and performance was positive. Lipper reports inflows to municipal bond funds of $5.3B, or a 0.8% increase in total municipal fund assets.
- Credit: We remain positive on municipal credit. Slow and steady growth since the recession ended 9 years ago has increased municipal revenues. At the highest level, we continue to remain more bullish on revenue bonds and issuers who have limited exposure to long-term liabilities such as pensions.
- The state of Illinois was downgraded within one notch of “junk bond” status by ratings agencies. We are entering uncharted waters as this would be the first instance where a U.S. state was rated below investment grade. States, unlike nearly all other municipal entities, do not have the ability to enter bankruptcy. Illinois may be the first state to challenge this legal concept, as laws can always be rewritten and the state certainly appears to need debt restructuring.
- The state of Connecticut was also downgraded by multiple credit agencies in the quarter. This may come as a surprise as it has one of the highest earnings-per-capita among U.S. states. It is just another example of how years and years of underfunding pensions and other long term liabilities can stack up and eventually reach a tipping point.