Munis hold steady; Is inflation a problem?

Bonds

Municipal yields were little changed Wednesday as several new issues priced in the competitive market and U.S. Treasuries pared back earlier losses.

Markets were mostly unmoved in either direction as the U.S. House of Representatives was preparing to vote to impeach President Trump, a week after a mob took over the Capitol.

Strong technicals continue as the Investment Company Institute reported $2.67 billion of inflows in the latest reporting week.

On Wednesday, the municipal to Treasury ratios rose to 72% in 10 years and 80% in 30 years, according to Refinitiv MMD. Ratios rose to 71% in 10 years and 82% in 30 years, according to ICE Data Services.

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In the primary, Barclays Capital priced $250 million of electric system general revenue notes for the Long Island Power Authority (A2/A/A/). Bonds mature in 2025 with a 1% coupon and yield 0.50%, callable in September 2023.

Morgan Stanley & Co. bought $130.4 million of general obligation limited tax school improvement bonds from Washoe County School District, Nevada (Aa3/AA//). Bonds in 2022 with a 5% coupon yield 0.20%, 5s of 2026 0.50%, 5s of 2031 1.16%, 2s of 2036 at 1.80%, 2s of 2041 at 2.10% and 2.25s of 2046 at 2.28%.

Fremont, California, Unified School District (Aa2/AA-//) sold $126.5 million of general obligation bonds to Mesirow. Bonds in 2021 with a 3% coupon yield 0.09%, 4s of 2029 yield 0.65%, 3s of 2031 1.00%, 2s of 2036 at 1.75%, 2s of 2041 2.06% and 2s of 2043 2.14%.

Mesirow bought $88 million of general obligation bonds from South Carolina (Aaa/AA+/AAA). Bonds in 2022 with a 5% coupon yield 0.14%, 5s of 2026 at 0.31%, 5s of 2031 0.84%, 5s of 2036 at 1.11%, 3s of 2040 at 1.47%, priced to the call on April 2031.

Hilltop Securities won $84 million of South Carolina GOs. Bonds in 2022 with a 5% coupon yield 0.12%, 5s of 2023 at 0.15%, 5s of 2024 at 0.17% and 5s of 2025 at 0.22%.

The growing demand for tax-exempt bonds with attractive yields that began in 2020, continues to be a theme into the early part of the new year on the buy side of the municipal market.

“The entire story year to date is the continued vibrant demand for bonds with yield,” Tom Doe, president of Municipal Market Analytics, said on Wednesday. “Credit concerns have been pushed aside, presumably because of optimism for a return to normal with vaccine rollout and the support from the Biden relief packages.”

But, while some investors are putting yield ahead of credit concerns, others are focused on how credit will be impacted by market technicals in the coming year.

As municipals continue to exhibit resilience amid the COVID-19 crisis, some key credit-related issues warrant attention in 2021 and beyond, according to a quarterly credit commentary from Cumberland Advisors.

Pensions, cyber-security, internet access issues, tax rates, and environmental, social and governance-related issuance, are among the top credit concerns, Patricia M. Healy, senior vice president of research and portfolio manager, wrote in the Jan. 11 report.

“The prospects for municipal credits in the coming year depend on the shape and speed of the recovery,” she wrote. “Some are very long-tailed risks, such as pensions or population declines, which will challenge management to reinvent the raising of revenues and the provision of services to municipalities.”

“The lingering risk of short-term shocks, such as COVID-19 or, for smaller municipalities, the loss of a major employer will fully challenge management.”

Pension funding remains one of the biggest risks to municipal credit, according to Healy.

“COVID-19 has had shocking effects on revenues and expenses, and municipalities may be tempted to reduce payments to pension plans, but that choice could lead to bigger problems down the road,” she warned.

The management of this will warrant close monitoring by market participants, Healy said, adding that although the stock market has performed well in the past couple of years, assumed rates of return in projecting pension funding remain above actualized levels.

“Of concern is the news of very underfunded pensions or growing unfunded pension liabilities, which could crowd out services and in the longer run could take priority over bondholders,” Healy wrote.

She said another issue for pensions is shifting demographics, as evidenced by the recent census results that show the Northeast and other regions are losing population to southern states and states with lower tax rates.

Some pension underfunding stems from population moves, some from technological advances, and some from longer lifespans, which is the most concerning issue for pensions, she noted.

“If it is not addressed, it will reduce budgetary flexibility,” she wrote, noting that this is one reason Cumberland has avoided the debt of entities such as New Jersey and Illinois, which have little budgetary flexibility and have experienced numerous downgrades.

Pension obligation bonds are sometimes issued to add funds to a plan, Healy pointed out. This strategy, she said, can reduce the annually required contribution, though debt service on the POBs still has to be repaid.

“A decline in pension fund market value shortly after investing the proceeds of the POBs could result in the need for higher annual contributions than hoped for,” she said.

Cybersecurity and internet access issues remain important for municipalities, especially with increased usage since the pandemic began, Healy said.

“COVID-19 accelerated many trends that were in place, such as remote learning and working,” she said, pointing to a survey of mayors that indicated expanding broadband was one of the most important ongoing capital investments for municipalities.

Municipalities were made vulnerable to cybercrime, so individuals, businesses, and governments “cannot afford not to invest in cybersecurity.”

“This issue has and will continue to be an area of focus for municipalities,” and some have appointed a chief cybersecurity officer or other layers of management dedicated to cybersecurity issues, Healy wrote.

Increasing tax rates and fees anticipated over the next few years will likely make tax-exempt bonds more “desirable,” according to Healy, who said this is a key concern on her radar.

Meanwhile, the firm will also keep a watchful eye on the demand for impact investing, which has grown in the wake of COVID-19 and the economic shutdown, and could potentially make a difference in returns. Social issues, such as income inequality, home affordability, and access to healthcare, as well as environmental risks, such as hurricanes and wildfires all helped boost the desire for impact investing, Healy said.

“The increase in the use of taxable municipal bonds has attracted crossover buyers, such as sovereign wealth fund pension plans, which have for years been concerned about impact,” she said. “Thus ESG-related credits could see more demand and possibly better performance because of these buyers,” including the potential for more attractive returns.

“Better [artificial intelligence] and other tools are being developed to measure impact and returns, so ESG is an area to watch,” she added.

Economic indicators
The consumer price index came in as expected in December, with the headline number up 0.4% and the core 0.1% higher, while year-over-year CPI rose 1.4% (compared to a 1.3% expectation) and the core increased 1.6%.

Since the Federal Reserve wants inflation of 2%, the year-over-year core number suggests “there is more work to be done in terms of monetary accommodation to reach their long-term target,” said Jeff MacDonald, head of Fixed-Income Strategies at Fiduciary Trust International.

While CPI should stay soft through the first quarter at least, he said, expectations for future inflation should be considered, and they “have accelerated meaningfully in recent months, largely based on election-related hopes for more stimulus and active rollout of the vaccine.”

TIPS breakeven spread, which he called “a good market-based indicator of future inflation expectations,” gained 25 to 50 basis points in the latest quarter, suggesting average inflation in the five- to 10-year range “in excess of 2%.”

MacDonald attributes the rising inflation expectations to “a combination of increased stimulus, normalization of the global economy in late 2021, and a release of pent up demand which should all put upward pressure on prices in the wake of the COVID experience.”

While gas prices grew in the latest CPI report, they’re still off 15% year-over-year. Energy prices rose seven consecutive months, he said, but are still 7% lower than year ago levels.

Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle, says, “Stop worrying about inflation.”

Because of the “very significant disinflationary shock in March and April 2020 … we may see slightly higher prices on a year-in-year basis in March and April 2021. But the structural story for inflation is one of stability: in the U.S., core inflation is anchored at around 1.5%.”

Also, since the Fed will let inflation run a little hotter to compensate for the downside misses of the past decade, Al-Hussainy said, “higher inflation does not automatically translate to higher rates because the Fed wants to see some inflation. As a result, we believe that investors should not be focused on hedging against inflation in 2021. But it’s OK: inflation hedges like gold and TIPS don’t work very well anyway.”

The Beige Book, released Wednesday, indicated modest increases in activity in most districts, but two regions reported little or no change, and two districts (New York and Philadelphia) reporting a drop in economic activity.

Prices rose modestly in most districts, the report said, with “prices for construction and building materials, steel products, and shipping services” having the largest increases. Several regions reported respondents were able to pass price hikes to customers, “especially in the retail, wholesale trade, and manufacturing sectors, and some cited plans to increase selling prices in coming months.”

Spending varied, with retail sales and leisure and hospitality sectors the hardest hit as the number of coronavirus cases rose. More people turned to online shopping for the holidays, according to the report.

Auto sales declined, while manufacturing “continued to recover in almost all districts, despite increasing reports of supply chain challenges.”

Respondents generally said employment was rising slowly and the recovery remained incomplete. However, a growing number of districts reported a drop in employment levels relative to the previous reporting period.”

Manufacturing, transportation and construction saw the strongest demand for workers.

ICI: Muni bond funds see $3.18B inflow
Long-term municipal bond funds and exchange-traded funds saw combined inflows of $3.180 billion in the week ended Jan. 6, the Investment Company Institute reported Wednesday.

In the previous week, muni funds saw a revised inflow of $3.482 billion, originally reported as a $3.472 billion inflow, ICI said.

Long-term muni funds alone had an inflow of $2.670 billion in the latest reporting week after an inflow of $2.959 billion in the prior week, originally reported as a $2.949 billion inflow.

ETF muni funds alone saw an inflow of $510 million after an inflow of $523 million in the prior week.

Taxable bond funds saw combined inflows of $19.527 billion in the latest reporting week after a revised inflow of $8.347 billion in the prior week, originally reported as a $10.843 billion inflow.

ICI said the total combined estimated inflows from all long-term mutual funds and ETFs were $23.877 billion after a revised inflow of $18.378 billion in the previous week, originally reported as a $17.554 billion inflow.

Secondary market
High-grade municipals were steady, according to final readings on Refinitiv MMD’s AAA benchmark scale. Short yields were steady at 0.13% in 2022 and 0.14% in 2023. The 10-year remained at 0.78% and the 30-year at 1.47%.

The ICE AAA municipal yield curve showed short maturities at 0.14% in 2022 and at 0.17% in 2023. The 10-year was a basis point higher at 0.77% while the 30-year yield rose to 1.50%.

The IHS Markit municipal analytics AAA curve showed yields at 0.15% in 2022 and 0.16% in 2023 while the 10-year rose to 0.77% and the 30-year yield at 1.46%.

The three-month Treasury note was yielding 0.09%, the 10-year Treasury was yielding 1.09% and the 30-year Treasury was yielding 1.82%. The Dow rose 29 points, the S&P 500 rose 0.34% and the Nasdaq rose 0.74%.

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