Fixed Income Strategy Municipal Bond Market Weekly Bottom Line: U.S Treasury yields fall for a second consecutive week on risk aversion to Brexit with lower real yields and lower inflation breakevens there will be no Fed rate hike this week and there is potential for yield (and equity market) volatility given ample meaningful economic data and central bank meetings. Municipal yields caught-up come with the previous week s labor report rally. Illinois downgrade at Moody s to Baa2 and S&P to BBB+. Lottery revenues becoming a smaller contributor to state revenues. Muni funds had a 36 th consecutive week of net inflows. Puerto Rico: o U.S. House passes Puerto Rico oversight plan off to the Senate o U.S. Supreme Court strikes down public corporation restructuring law passed in 2014 o S&P Puerto Rico Total Return Index was 2.8% last week; 4.4% YTD. What Happened in the Bond Markets Last Week? Last week, Treasury yields fell for a second consecutive week. Economic data were not a meaningful contributor to the rally but rather it was heightened risk aversion and tracking to other developed market global yields. The risk aversion fulcrum rests on the upcoming Brexit vote on June 23 rd, which has been polling with much uncertainty as to the outcome. Global safe-sovereign developed market yields have continued to decline; in fact, the German 10-yr yield nearly hit 0.0% and Japan s 10yr hit record lows of -0.16%. Inflation breakevens also contributed, to a lesser degree, to the decline in nominal yields. The notion of a live meeting in June is silly (still) at a 0% implied probability priced into Fed Funds Futures July, as it stands now, seems like a stretch too. However, probabilities could reverse quickly if a Bremain is voted for). Along with some meaningful economic data this week (Retail Sales, CPI, PPI, Industrial Production) and several central bank meetings (FOMC, BOJ, BOE), there is ample opportunity to see some yield (and equity) volatility. Municipal yields caught up some with the previous week s big labor-report Friday. The resulting 10-yr AAA GO ratio to Treasuries fell. Yields (Figure 1). For the week ending 6/10/16 Treasury yields declined; 2-year Treasury Note yields -4.1 bps to 0.73%, 5-year Notes yields were -5.7 bps to 1.17%, 10-year Notes yields were -5.5 bps to 1.64% and 30-year bonds yields were -4.9 bps to 2.46%. Bloomberg Municipal Index curve yields were also fell: AAA-rated GO yields; 2-year bonds were -4 bps to 0.67%, 5-year bond yields were -6 bps at 1.01%, 10-year bond yields were -7 bps to 1.51% and 30-year bonds were -13 bps to 2.32%. The Ratio of 10-year AAA GO debt to 10-year Treasury yields fell to 92.1 from 93.3 last week. The year-to-date average is 92.0 and the 12-month average is 96.2. David N. Violette, CFA Sr. Fixed Income Analyst Vice President dviolette@rwbaird.com 414-298-7688 1 o
Figure 1 - Yield Curve and Muni Curve Changes Data Source: Bloomberg One can observe these changes by looking at how rates have changed along the curve for both the Treasury curve and for the AAA-rated G.O. Index since last week. The top panel shows four yield curves; two for the Treasury curve (in red) - one for the most current date and one from last week and two for the AAA-rated G.O. (in blue) - current and last week. The bottom panel of the graph shows changes in the rates along both curves for the week for both Treasuries and the AAA G.O. Index. 2 o
Figure 2 - Muni Ratio Data Source: Bloomberg AAA 10-Year G.O. Muni Ratio to Treasury 110.0 105.0 Ratio (%) 100.0 95.0 90.0 92.1 85.0 Mid Price SMAVG (50) Bond Buyer Indexes (Table 1 and Figure 3): Last week, Bond Buyer Indices yields fell significantly; the 20-GO Index declined by -8 bps to 3.3.18% and 25-Revenue Index fell -10 bps to 3.38%. Table 1 - Bond Buyer Indexes Source: Bloomberg Index Yield % Yield Last Week 1 Week Change (bps) Yield 1 Month Ago 1 Month Change (bps) Bond Buyer 20 Gen'l Obligation Index 3.18 3.26-8.0 3.32-14.0 Bond Buyer 11 Gen'l Obligation Index 2.70 2.78-8.0 2.84-14.0 Bond Buyer 25 Revenue Index 3.38 3.48-10.0 3.54-16.0 Figure 3- Bond Buyer Indexes - 1 Year; Data Source: Bloomberg 3 o
What Are Market Participants Talking/Writing About? Supply (Figure 4) Bloomberg 30-Day Visible Supply currently stands at $9.9 billion; down from the $18 billion level. Supply had risen sharply the previous week after the holiday-shortened week. Figure 4- Bloomberg 30-Day Visible Supply - 1 Year; Data Source: Bloomberg Articles of Interest Municipal Fund Flows: According to Lipper FMI, municipal bond funds reported net inflows for the 36 th straight week in the amount of $852.5 million after net inflows of $473.2 during the previous week. The four-week moving average is $880.3 million. High-yield funds also continued to see net inflows last week. Illinois Downgraded: Moody s downgraded the State of Illinois GO rating to Baa2 from Baa1. Other associated downgrades include; Build Illinois bonds downgraded to Baa2 (from Baa1), Convention Center expansion bonds sold by Metropolitan Pier and Exposition Authority were downgraded to Baa3 (from Baa2). The rationale for the downgrade is the political impasse on how to deal with lost tax revenues (since Jan. 2015) and the state s 15% structural budget imbalance. Aside from the political standoff, Moody s cites as credit challenges: severe and growing pension underfunded status, consistent payment deferrals to manage cash. Offsetting, Moody s cites as credit positives: sovereign spending and revenue power, large and diverse economy and statutory debt service priority. Further downgrades could occur if the structural imbalance grows creating a liquidity constraint, failure to pass legislation and continuingly rising underfunded pension balances. S&P also dropped ratings of Illinois debt one step to BBB+ Both rating agencies have negative outlooks. S&P s BBB+ rating is its lowest on any state since it had a BBB rating on California in 2004. Lotteries Becoming Less Important to State Finances Moody s: Moody s issued an In-Depth sector report on state s changing reliance on lottery revenues. States have traditionally used lottery revenue to offset tax-funded spending particularly for school districts. Some of Moody s points of emphasis include: 1) Delaware, Oregon, South Carolina, South Dakota and West Virginia have been the states with reliant lottery revenues however, lottery revenue growth in these states has fallen -6.5% between 2006 and 2014. For these states, lottery revenue accounted for 5.9% of total state revenue down from 7.6% in 2006. 2) net lottery revenues has accounted for, on average, 2.5% of state operating revenue across the 43 states that transfer revenues to the state they have grown by 2.2% between 2006 4 o
and 2014. 3) Given the slow-moving nature of lottery revenues, even the states with the greatest dependency have adequate means and credit positioning to suitably accommodate fluctuations and shortfalls. Puerto Rico: o o o U.S. House Passes PR Debt Oversight Plan: Last week the U.S. House passed a bipartisan plan to help Puerto Rico deal with their debt crisis. The plan would establish a seven member federal financial oversight board which would manage a restructuring of the island s debt. The Senate must still pass the bill and be signed by President Obama. There is a race to try to pass the bill before July 1 st debt obligation deadlines although organization of such would still be difficult within this timeframe. Puerto Rico has been concurrently negotiating with creditors and insurers over restructuring debt. Supreme Court Voids Public Corporation Restructuring Law: The U.S. Supreme Court struck down the Recovery Act law which would have allowed the island s public utilities (PRASA, PREPA and PRHTA) to restructure $20 billion of debt, similar to a bankruptcy. Post-decision, some utility bond prices have reacted favorably in the belief that a negotiated restructuring would be more favorable to their recoveries. The S&P Municipal Bond Puerto Rico Index finished at 165.2 on Friday vs. 160.7 at the end of the previous week, +2.8%. Year-to-date the index is +4.4%. S&P Municipal Bond Puerto Rico Index Level (1-year) 5 o
Relative Value by Maturity Table 2 - AAA Muni Ratios and Spreads by Maturity - Data Source: Bloomberg 6/13/2016 Yield-to-Maturity (%) 0% Tax Rate 35% Tax Equivalent Maturity (yrs.) AAA Gen. Oblig. Treasury Spread (bps) Ratio (%) Spread (bps) Ratio (%) 1 0.55 0.53 1.1 102.0 30.4 156.9 2 0.67 0.72-4.8 93.3 31.5 143.6 3 0.80 0.86-6.1 92.9 37.1 143.0 4 0.93 1.04-11.3 89.1 38.6 137.1 5 1.02 1.15-13.4 88.3 41.4 135.9 7 1.23 1.43-19.7 86.2 46.8 132.7 10 1.51 1.63-12.0 92.7 69.6 142.6 15 1.84 1.80 3.6 102.0 102.6 156.9 20 2.07 1.98 8.7 104.4 120.0 160.6 25 2.21 2.21-1.0 99.6 117.8 153.2 30 2.33 2.45-12.3 95.0 113.0 146.1 Figure 5 AAA General Obligation Ratios and Spreads Data Source: Bloomberg 6 o
Relative Value by Rating Figure 6 Muni Index Yield Curve by Credit Rating Data Source: Bloomberg 3.50 3.00 Muni Yields by Rating 2.50 Yield (%) 2.00 1.50 1.00 0.50 0.00 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 Treasury AAA AA A Figure 7 Muni Index Ratios by Maturity and by Credit Rating Data Source: Bloomberg 165 Muni Ratios by Rating 145 Ratio (%) 125 105 85 65 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 AAA AA A 7 o
Figure 8 Muni Index Spread to Treasuries by Maturity and by Credit Rating Data Source: Bloomberg 100.00 Muni Spread (bps) by Rating 80.00 60.00 Spread (bps) 40.00 20.00 0.00-20.00-40.00 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 AAA AA A For more information please contact your Financial Advisor. 8 o
Appendix Important Disclosures Some of the potential risks associated with fixed income investments include call risk, reinvestment risk, default risk and inflation risk. Additionally, it is important that an investor is familiar with the inverse relationship between a bond s price and its yield. Bond prices will fall as interest rates rise and vice versa. When considering a potential investment, investors should compare the credit qualities of available bond issues before they invest. The two most recognized rating agencies that assign credit ratings to bond issuers are Moody's Investors Service ( Moody s ) and Standard & Poor's Corporation ( S&P ). Moody s lowest investment-grade rating for a bond is Baa3 and S&P s lowest investment-grade rating for a bond is BBB-. The Bond Buyer 20-Bond Index consists of 20 general obligation bonds that mature in 20 years. The average rating of the 20 bonds is roughly equivalent to Moody's Investors Service's Aa2 rating and Standard & Poor's Corp.'s AA. The Bond Buyer 11-Bond Index uses a select group of 11 bonds in the 20-Bond Index. The average rating of the 11 bonds is roughly equivalent to Moody's Aa1 and S&P's AA-plus. The Bond Buyer Revenue Bond Index consists of 25 various revenue bonds that mature in 30 years. The average rating is roughly equivalent to Moody's A1 and S&P's A-plus. The indexes represent theoretical yields rather than actual price or yield quotations. Municipal bond traders are asked to estimate what a current-coupon bond for each issuer in the indexes would yield if the bond was sold at par value. The indexes are simple averages of the average estimated yields of the bonds, are unmanaged and a direct investment cannot be made in them. This is not a complete analysis of every material fact regarding any sector, municipality or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates. The alternative minimum tax (AMT) may be applicable, even for securities identified as tax-exempt. It is strongly recommended that an investor discuss with their financial professional all materially important information such as risks, ratings and tax implications prior to making an investment. Past performance is not a guarantee of future results. This report does not provide recipients with information or advice that is sufficient on which to base an investment decision. This report does not take into account the specific investment objectives, financial situation, or need of any particular client and may not be suitable for all types of investors. Recipients should consider the contents of this report as a single factor in making an investment decision. Additional fundamental and other analyses would be required to make an investment decision about any individual security identified in this report. ADDITIONAL INFORMATION ON SECURITIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST BY CONTACTING YOUR BAIRD INVESTMENT PROFESSIONAL. Copyright 2016 Robert W. Baird & Co. Incorporated. 9 o