Hello this is Natalie Baker, vice president of marketing here at Breckinridge, and welcome to the Breckinridge podcast. Today we will be providing an update of market events for the month of June. I'm joined by Eric Haase, a member of our portfolio management team. So Eric, market volatility picked up in May largely because of economic data and geopolitical concerns. How did this carry over into June?
Well, U.S. Treasury rates continue to be primarily influenced by macroeconomic policy, the Fed funds rate, and economic data. The largest macro or geopolitical headlines for June were concerns regarding the beginning of a trade war as we saw continued escalation of tariff talks, primarily with China, as well as the summit between the U.S. and North Korea in Singapore. On the economic front, U.S. economic data remain strong and the Federal Reserve Bank increased the Fed funds rate to the range of 1.75% to 2% as expected.
What economic data stood out and will the Federal Reserve Bank continue to raise rates?
Well employment remains strong as U.S. initial jobless claims registered within the 215,000 to 235,000 range for the month. Unemployment remains at 4% which is near the 18-year lows. Additionally core CPI and core PCE from May clocked in at 2.2% and 2% respectively, both in the range of the Fed’s target of 2%. The first quarter GDP came in at an annualized 2%. So, based on this positive data, this should allow the Fed to continue raising the Fed funds rate at least one more time in 2018 and possibly two more times. That would be a total of three or four hikes in 2018.
Well how did U.S. Treasury rates react to all of this?
Through all this the ten-year U.S. Treasury bond remained within a tight range and the yield curve continued to flatten as short rates increased more than longer rates. As the Fed raised rates, the two-year increased by 13 basis points and the 10-year ended the month unchanged of 2.85%. At 32 basis points, the additional yield earned by investing in the 10-year over the 2-year U.S. Treasury is at the lowest value in a decade. On the quarter, the U.S. Treasury curve flattened as yields in the short end of the curve increased the most. The 2-year ended higher by 26 basis points while the 10-year only increased by 11. The 30-year remained essentially unchanged over the quarter ending at 2.99%.
So switching now from Treasuries to munis, did the municipal curve move in a similar fashion?
Municipal bonds also traded in a tight range in June with the short end out-performing the rest of the curve. The curve steepened with yields on short maturities dropping more than longer maturities, as the 2-year dropped by 11 basis points in yield, to finish the month at 1.64%. The rest of the curve ended flat or up single digits in yield. The 5- and 10-year yields ended at 1.99% and 2.46% respectively.
Well, based on movement in the short maturities for municipal and Treasury bonds, how has the relative value changed?
So on a relative value basis, municipal bonds with shorter maturities out-performed similar maturity U.S. Treasuries. We compare the yield of an AAA-rated tax-exempt municipal bond to the yield of a similar maturity U.S. Treasury to analyze the security’s relative value. This yield ratio for bonds maturing in the 1 to 2-year range ended at 68% while the 5-year part of the curve ended at 73%. The 10- to 30-year ratios are hovering close to both 3-month and 1-year averages of 85 and 98% respectively.
Well, are you seeing relative value opportunities?
As a result of this movement the shorter end of the tax-exempt municipal curve has become less attractive as compared to taxable municipal bonds. Although more attractive, we are still only seeing some selective opportunities in the taxable municipal space for bonds maturing within 5 years.
Well, let's switch gears and talk about the supply and demand balance in June and the second quarter. Did supply remain constrained?
Yes, the turn in supply continued through the second quarter so June’s issuance was nearly 20% lower on a year-over-year basis, while year-to-date supply clocked in at around $160 billion, which is also lower by approximately 20%. On an annualized basis, gross supply of roughly $320 billion would be the lowest since 2011.
So are you still able to find opportunities outside the new issue market?
We are. So the increase in selling from bank balance sheets as well as the elevated level of dealer inventories did continue through June. The daily average dealer inventory ticked up in the month of June by nearly $1 billion, month over month, holding the year-to-date average at approximately $14 billion. Likewise, the daily average amount of municipal bonds for sale ticked up $150 million month-over-month to $880. The year-to-date average stands at nearly $830 million.
And what about demand? Did demand remain strong for municipals over the month and the quarter?
Mutual funds have continued to benefit from strong demand with 8 consecutive weeks of inflows and posting of $421 million of inflows for the week ending June 28th. That puts the 4-week moving average up to $427 million and the year-to-date aggregate inflows of over $7 billion.
As a result of these factors, how did municipal bonds perform over the month of June and in the second quarter?
The Bloomberg Barclays Municipal 1 – 10-year blend index posted positive returns of 24 basis points in June bringing the performance up to 0.10% for the year. The best performing sectors in June included leasing, electric, and resource recovery. BBB-rated bonds out-performed higher-rated bonds over the second quarter, boosted by strong performance from Illinois state geo-debt. BBB-rated bonds have posted a positive 0.4% year-to-date while AAA-rated bonds posted negative returns of -0.48%. Over the quarter, 7-year and longer bonds performed the best with the 7-year municipal index of 0.97% and the long bond municipal index up 0.92%. The 1-year fared the worst with the return of 0.59%.
Last month we discussed the expected negative net supply over the summer meaning more bonds coming due for maturities and calls and pre-refundings, than what is available in the new issue market. Are there any updates regarding supply data?
Sure. So J.P. Morgan estimates that there will be -$59 billion of negative net supply over the course of July and August. In 2017, over the same period, that value was -$43 billion and the trailing 5-year average is -$32 billion.
So, how does all this impact your return expectations?
Well, as we stand right now, while we are entering this year’s cycle with significantly less supply, we also start with a lower relative value to Treasuries, potentially dampening further out-performance. The returns for the remainder of the year could be driven more by yield.
Has anything drastically changed in your credit outlook?
Our big picture outlook remains consistent. Municipal credit quality remains stable and we will continue to see how tax reform ripples through the market. Additionally we do feel the credit cycle is continuing to move forward and that our higher-quality bias should benefit us if credit spreads begin to widen.
Okay, thanks Eric. We hope that you in the field have found this informative, and we look forward to you joining us on our next podcast. Thank you.
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