Performance in the tax-exempt municipal market was positive in May, with the long end taking the lead as investors continued to travel further out on the curve in search of yield enhancement. Despite the positive absolute results, munis underperformed Treasuries amid a dramatic investor flight to quality that sent 10-year Treasury yields to new all-time lows. The investor response was led by renewed angst over the financial turmoil in Europe and continued signs of weakness in the domestic economy.
The yield decline (and price increase) in the tax-exempt municipal market was sparked by these same factors, but was much less pronounced than in the taxable space. The price underperformance led to attractive muni-to-Treasury yield ratios, which ended the month well above 100% across all maturities. In essence, the market is not pricing in the tax benefit that the asset class offers investors. The appealing relative value should continue to capture the interest of non-traditional and crossover buyers and also help to limit volatility as we enter June, which typically is not overly friendly to muni performance as states negotiate their budgets and issuance picks up.
New issuance was $37 billion in May and nearly $150 billion year-to-date, an increase of 76% versus one year ago. The pick-up in supply has been met by continued strong demand. Municipal bond mutual funds saw inflows each week of May, with the majority targeting the higher-yielding long-term and high yield funds. ICI reports $23.5 billion in total inflows so far this year. Overall, tax-exempt munis continue to offer yield, safety and income in an environment where each is highly prized by investors.
State and local governments continued to reduce payrolls in May, albeit at a slower pace than in recent years. With 8,000 jobs eliminated in May, employment of state workers is down 2.5% from the peak, while local government employment is down 3.6%.
Key headlines were seen in Alabama, where the state legislature refused a measure that would allow bankrupt Jefferson County to impose taxes to close its budget shortfall. Alabama’s bondholder-unfriendly ways contrast policies in Rhode Island, which has been supportive in terms of providing local governments the flexibility to navigate fiscal distress.
In California, Governor Jerry Brown issued a revised budget proposal to address a $15.7 billion deficit. The linchpin in closing the gap is a November ballot initiative to raise taxes on high- income residents. The legislature can approve this budget by a majority vote and has a June 15 deadline, but proposed cuts to health and social safety net programs will be difficult to pass.
The S&P Municipal Bond Index returned 0.88% in May and 4.17% year-to-date. Returns were positive across the curve, with the greatest strength among longer maturities. Credit spreads (high yield vs. general obligation bonds) tightened by 18 basis points (bps) on the month. High yield outperformed the main index by 7 bps in May and 494 bps year-to-date. In terms of sectors, the land- backed index was the standout for the month, outpacing the main index by 55 bps, while the pre-refunded index lagged by 61 bps.
We maintain a neutral duration stance given the backdrop of low absolute rates and compressed spreads. New issuance still presents opportunities to enter the market at attractive levels, particularly relative to the secondary market. This theme is typical during the first two to three weeks of June given elevated supply as municipalities craft their budgets.
We expect tax-exempts to continue taking cues from the Treasury market, although heightened headline noise is likely throughout budget season. We are attuned to discussions around tax reform, but do not expect any meaningful market impact until late in the year. Overall, in an environment of low absolute rates, municipal performance is likely to be driven by yield curve positioning, trading the maturity ranges, taking advantage of supply/ demand imbalances and security selection.