WEALTH SOLUTIONS GROUP Muni Fortnightly Treasury curve bear-flattens on tax policy advancement and Flynn plea. Munis generally underperform. David N Violette, CFA Senior Fixed Income Analyst December 4, 2017 Bottom Line: Treasury yields were volatile on tax plan progress and the Friday-Flynn-Flattener. On the week, yields bear-flattened. Munis had the worst month in a year as a rush to issuance before new tax policy may roll back benefits to issuers. The 10yr AAA GO Ratio stabilized after a brisk move higher. Moody s Q3 upgrades outnumbered downgrades but notional downgrades exceeded upgrades. Moody s sector outlooks include Stable outlooks for community colleges, toll roads and positive for airports. S&P Puerto Rico Total Return Index was -0.7% two weeks; -17.4% YTD. What Happened in the Bond Markets Last Week? Treasury yields ended slightly higher and the curve continued to flatten as domestic and global equities ripped through more milestones. Yields were driven by two domestic things. 1) The expectation and eventuality of the Senate tax overhaul plan. This had the effect of lifting risky assets along with shorter and belly yields. 2) A sizeable rally and flattening hit the curve on Friday on the Flynn admission to guilt and plea bargain. However, yields came off their lowest levels on Friday. The componentry of the yield changes were for an offsetting rise in real-yields and offsetting declines of inflation breakevens on the front end of the curve and higher breakevens on the long-end the inflation breakeven curve effectively steepened. Bitcoin was not a third thing that happened to Treasuries. Municipal yields underperformed Treasuries again. As was mentioned a few weeks ago, the municipal market is still trying to digest the probability and magnitude of tax changes on the municipal market and is currently digesting a late-year rush of municipal bond sales. Yields (Figure 1): For the week ending 12/1/17 Treasury yields traded higher and flatter; 2-year Treasury Note yields were +3.0 bps to 1.77%, 5-year Notes yields were +5.4 bps at 2.12%, 10-year Notes yields were +2.3 bps to 2.37% and 30-year bonds yields were flat bps at 2.76%. Bloomberg Municipal Index curve yields were mostly higher and the curve flatter, AAA-rated GO yields; 2- year bonds were +19 bps to 1.50%, 5-year bond yields were +9 bps to 1.73%, 10-year bond yields were +4 bps bps to 2.14% and 30-year bonds were -7 bps to 2.76%. Robert W. Baird & Co. Incorporated Page 1 of 7
The Ratio of 10-year AAA GO debt to 10-year Treasury yields rose off week-ago levels to 90.9 from 90.0 last week. The year-to-date average is 89.3 and the 12-month average is 90.0.. 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. Robert W. Baird & Co. Incorporated Page 2 of 7
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 85.0 90.9 80.0 Mid Price SMAVG (50) Supply (Figure 3) Bloomberg 30-Day Visible Supply currently stands at $26.0 billion up from $22.3 billion this time last week. The YTD average visible supply is $11.6 billion and the 12-mo average is $11.5 billion. This week s expected volume exceeds the entire volume of last December. Figure 3- Bloomberg 30-Day Visible Supply - 1 Year; Data Source: Bloomberg Bloomberg 30-Day Visible Supply U.S. Total 35,000 30,000 25,000 $ Million 20,000 15,000 10,000 5,000 0 Robert W. Baird & Co. Incorporated Page 3 of 7
Articles of Interest Municipal Fund Flows: According to Lipper data muni funds had net inflows of $100.4 million after $659.2 million of net inflows during the previous week. The four-week moving average was $410.1 million of inflows. High-yield funds had net inflows. Moody s Q3 Ratings: During Q3 2017 Moody s rating revisions resulted in upgrades outnumbering downgrades (122 to 104) reversing the previous quarter s performance. The notional dollar amount downgraded was greater than that upgraded ($28.2 B to $23.5B) with the biggest downgrades in PREPA (to Ca) and the Commonwealth of Kentucky (to Aa3). The largest upgrade was for the State of Wisconsin (to Aa1). Pension funding was a contributor to both KY s and WI s rating changes. Moody s 2018 Sector Outlooks: Airports: Moody s has a positive outlook for the airport sector. Some highlights of their outlook: 1) Moody s expects economic growth to result in 3.7% enplanement growth. They expect smaller airports to have the strongest enplanement growth 2) Moody s expects seat capacity to grow between 4.5% and 5.7% in 2018. 3) Airport parking-related revenues will be kept in check by passengers turning to services such as Uber and Lyft. Toll-roads: Moody s has a stable outlook for the government-owned toll road sector. Some highlights of their outlook: 1) Moody s expects 2-3% traffic growth for toll roads in 2018. 2) They expect too rate increases particularly those that are indexed to inflation to support revenue gains of 3-4%. 3) Economic growth and stable gas prices will support growth in traffic (1.7% growth in 2017). 4) Start-up roads in urban areas (Austin, Atlanta, and Orlando) will experience greatest growth. Community colleges: Moody s has a stable outlook for community colleges that issue revenue-backed debt. The highlights of their outlook: 1) Modest revenue growth of 1.5-2.5% on stabilization of aggregate enrollment, after declining for several years. Tuition increases will help stabilize revenues also. 2) Growth in local tax revenues and level state funding will support revenues. 3) Expense flexibility in labor and facilities remain a sector strength. Puerto Rico: o o o The federal oversight board (PROMESA) is set to meet this week to begin a revised fiscal plan by the end of the year. The University of Puerto Rico reportedly made its interest payment last week, avoiding default as of now. The university would like to restructure its debt by extending maturities, suspend and reduce debt-service payments. The S&P Municipal Bond Puerto Rico Index finished at 145.9 on Friday vs. 147.0 at the end of two weeks ago, -0.7%%. Year-to-date the index is -17.4%. Robert W. Baird & Co. Incorporated Page 4 of 7
S&P Municipal Bond Puerto Rico Index Level (1-year) Relative Value by Maturity 12/4/2017 Table 1 - AAA Muni Ratios and Spreads by Maturity - Data Source: Bloomberg Yield-to-worst (%) 0% Tax Rate 35% Tax Equivalent Maturity (yrs.) AAA Gen. Oblig. Treasury Spread (bps) Ratio (%) Spread (bps) Ratio (%) 1 1.30 1.62-31.3 80.6 38.9 124.0 2 1.50 1.80-30.1 83.3 50.7 128.1 3 1.58 1.92-34.3 82.1 50.6 126.4 4 1.64 2.07-43.4 79.0 44.7 121.6 5 1.74 2.15-41.1 80.9 52.4 124.4 7 1.91 2.30-39.0 83.1 64.0 127.8 10 2.15 2.40-24.7 89.7 90.9 138.0 15 2.47 2.45 1.9 100.8 134.6 155.0 20 2.63 2.57 5.6 102.2 147.0 157.2 25 2.71 2.68 2.8 101.0 148.5 155.4 30 2.76 2.79-2.6 99.1 146.2 152.4 Robert W. Baird & Co. Incorporated Page 5 of 7
Figure 4 AAA General Obligation Ratios and Spreads Data Source: Bloomberg AAA G.O. Muni Ratio and Spreads (0% Tax Convention) Ratio % 105.00 100.00 95.00 90.00 85.00 80.00 75.00 70.00 65.00 60.00 1 3 5 10 20 30 Maturity (yrs.) 10.0 0.0-10.0-20.0-30.0-40.0-50.0 Spread (bps) Ratio (%) (Left) Spread (bps) Right Relative Value by Rating Figure 5 Muni Index Yield Curve by Credit Rating Data Source: Bloomberg 4.00 3.50 Muni Yields by Rating Yield (%) 3.00 2.50 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 For more information please contact your Financial Advisor. Robert W. Baird & Co. Incorporated Page 6 of 7
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-. Ratings are measured on a scale that ranges from AAA or Aaa (highest) to D or C (lowest). 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 2017 Robert W. Baird & Co. Incorporated. Robert W. Baird & Co. Incorporated Page 7 of 7