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Written by: John Albomonte | Advisor Asset Management
As inflation trends continue upward, the Federal Reserve is determined to combat inflation by raising interest rates. The Fed’s goal would be to slow the economy down just enough to maneuver into a “soft landing.” The goal of a “soft landing” is to slow the economy down enough so that it does not lead into a recession. This maneuver is never an easy task.
Overall, prices rose 1.3% in May. According to the data released by the Labor Department on July 13, 2022, this percentage is greater than the 1.1% the survey reported.
Source: Bloomberg
According to the data released by the Labor Department on July 13, 2022, year-over-year CPI climbed to 9.1%, greater than the 8.8% survey.
Source: Bloomberg
As prices of goods and services continue to climb, the Federal Reserve had no choice but to raise rates to help curb inflation. As expected, on July 27, 2022, the Federal Reserve Target Rate increased 0.75 basis points to 2.50%. The Federal Reserve has tightened four times in 2022.
Source: Bloomberg
As the Fed continues to fight inflation by raising the Target Discount Rate, how will higher rates effect supply in the Municipal Bond Market?
According to a report on June 13, 2022, by Hilltop Securities, the 2022 Municipal Bond Issuance forecast was revised lower to 410 billion, a change of 85 billion in 2022.
The drop in issuance is the result of rising interest rates and lack of refunding activity by issuers. Additionally, higher interest rates have recently had the greatest effect on the high yield municipal market.
On Nov. 12, 2021, a Bloomberg article by Danielle Moran suggested Junk Municipals were set to beat the market benchmarks highest return since 2012.
Source: Bloomberg
More recently, however, the chart below suggests High Yield Municipal sales are expected to slow as investors switch to investment grade issues. This switch offers decent yields, less risk, and shorter durations.
Source: Bloomberg
With our economy at risk of a recession, why wouldn’t investors shift their municipal investments from lower quality, high yield issues to higher quality municipals?
Why take on more risk when you can capture better quality and higher yields in today’s Municipal Market environment? One year ago, investors were willing to buy a BB @ 1.45% Yield-to-Call (YTC) with a Yield-to-Maturity (YTM) of 5.25%. Today, investors can get a shorter maturity, AAA-rated issue at 3.54% YTC and a yield of 3.70% YTM. The YTC pickup from one year ago is approximately 209 basis points.
With the fear of an even greater recession ahead, and better yields in today’s environment, investors would most likely reduce holdings of the lower quality high yield municipal bonds and add higher quality municipals to their portfolios.
What will lower municipal bond issuance mean for the secondary municipal market?
For now, all eyes are on the New Issue Municipal Market. As municipal deals are printed, offerings in the secondary market have the potential to become cheap to the new deals or more expensive.
There are many factors that drive the secondary market. As mentioned previously, the New Issue Municipal Market offerings will drive secondary levels. Municipal new issue supply, monthly municipal bond redemptions and reinvestment will be key factors driving the secondary market.
In most cases, if reinvestment is greater than the supply, bumps to the Municipal Market Data (MMD) curve will drive municipal secondary yields lower. Based on a supply forecast by Parametric, reinvestment for July will exceed issuance by 20 to 30 billion. (Parametric Municipal Market Insight 07.06.22)
There is no doubt volatility will continue in the Fixed Income Markets. Fixed income investors will continue to ask themselves if the Federal Reserve has done enough to combat inflation and guide the economy into a soft landing. Most likely, speculation will continue as to whether raising rates in the coming months to further slow down inflation will be necessary.
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