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U.S. Muni Market: 2020 Rate Outlooks Trigger Taxable Supply Uncertainties; Issuance Likely to Skyrocket in Week Ahead


Senior Market Analyst at Interactive Brokers

A host of global geopolitical and economic headwinds has generally spurred lower U.S. interest rates, driving an increasing number of municipal bond issuers and investors towards taxable transactions.

In fact, the volume of new taxable deals has soared nearly 107% to date in 2019 over the prior year to a little more than US$44.7bn, according to data compiled by the Securities Industry and Financial Markets Association (SIFMA).

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One reason for the uptick is likely due to the termination of tax-exempt advance refunding bonds in 2018, when many investors looked to similar, taxable transactions to fill the void.

Strategists at Barclays, for example, noted that over the span of just a few months, taxable advance refundings accounted for almost 40% of the taxable muni supply in 2019 – “boosting taxable’s supply share of total issuance, as well as making 2019 the largest taxable muni supply year since 2010.”

Barclays noted that the resurgence of taxable muni supply has been “one of the main stories in 2019 and probably the largest variable going into next year,” depending on the direction of U.S. interest rates.

As they anticipate U.S. Treasury rates will remain in a relatively narrow trading range for most of 2020, they foresee total issuance amounting to around US$410bn to U$420bn, an increase of about 4-5% year-on-year. However, should government bond yields rise, they would negatively affect tax-exempt issuance, with an even larger impact on taxable supply.

Indeed, within the months of August, September and October, yields on the 10-year U.S. Treasury note toggled within a 43-basis point range, from a trough of 1.47% to a peak of 1.90%. The note was last bid at around 1.76% intraday Wednesday.

Diverging Growth Outlooks

Market participants generally expect a protracted period of low interest rates, amid continued U.S.-China trade tensions, slowing global growth, weak domestic fixed investment and sluggish inflation.

These conditions had mainly served as the catalysts for the Federal Open Market Committee (FOMC) to cut its target range for the federal funds rate by 25bps three times in 2019 to 1.50%-1.75%.

Nuveen analysts Bill Martin and John Miller noted that while the U.S. economy remains strong, it is “not strong enough to stoke fears of inflation.”

Nuveen expects two additional weeks of outsized municipal new issuance in 2019, “then new issue should be effectively finished for the year.”

They observed that institutional investors are using this supply to invest portfolios to meet the target durations of their mandates, adding that rates “should remain lower for longer, so investors may see this supply as a buying opportunity.”

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While some signals suggest the domestic economy could continue to be hampered by a general deceleration of global economic expansion – underscored by the International Monetary Fund’s (IMF) recent lowering of its global growth outlook to 3.0% for 2019, its lowest level since 2008–09 – some analysts remain optimistic about the strength of the U.S. consumer, as well as its labor and housing markets.

Speaking at the New York Association for Business Economics in New York Tuesday, Federal Reserve governor Lael Brainard said there are “good reasons to expect the economy to grow at a pace modestly above potential over the next year or so, supported by strong consumers and a healthy job market, despite persistent uncertainty about trade conflict and disappointing foreign growth.”

The latest data from the U.S. Bureau of Labor Statistics (BLS) showed a total of 128k jobs were added in October – far more than expected – with another 95k in total upward revisions for the prior two months.

Among other updates for the U.S. employment situation in October, the unemployment rate held near a 50-year low at 3.6%, the participation rate climbed 0.1% from the prior month to 63.3% — its highest level since June 2013 – and average hourly earnings (AHE) for private sector workers notched-up by 0.2% over September for a 3.0% year-on-year gain.

Brainard added that although business investment “remains downbeat, restrained by weak growth abroad and trade conflict,” there is “little sign so far that the softness in trade, manufacturing, and business investment is affecting consumer spending, and the effect on services has been limited.”

The Bureau of Economic Analysis (BEA) Wednesday said real gross domestic product (GDP) grew by 2.1% in its second estimate for the third quarter of 2019, upwardly revised from 1.9% in its initial report.

Jefferies economists Ward McCarthy and Thomas Simons said that after 18 months of a slowdown in the U.S. economy – underpinned by trade tensions and other related uncertainties – they think that the deceleration has “hit bottom.” They added that not only is the worst over for manufacturing activity, but “housing activity has come back to life and the consumer is cruising along with a tailwind from a strong labor market, stock market and housing market.” 

Municipal Bonds Maintain Their Luster

Meanwhile, investors generally continue to find municipal bonds attractive.

For the week ended November 20, Thomson Reuters/Lipper U.S. Fund Flows posted net inflows into muni bond funds (for the 46th straight week) of around US$1.6bn, about on par with the prior week’s US$1.1bn and exceeding their weekly average of US$1.15bn since August 7, 2019.

Prices of certain exchange-traded funds (ETFs), such as the iShares National Muni Bond fund (NYSEARCA: MUB) and the Vanguard Tax-Exempt Bond fund (NYSEARCA: VTEB), have been on the rise recently. The funds have been climbing back towards their 52-week, mid-August highs and have gained roughly 8.61% and 6.27%, respectively, since late November 2018.

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Demand for recent individual offerings has also been decent, with the Port Authority of New York and New Jersey having priced US$1.1bn worth of bonds at yields of between 1.7% to 3.5%; while the Dormitory Authority of the State of New York SUNY sold US$650m of facility-related revenue bonds at yields of around 1% to 3%.

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Buckle-up for the Week Ahead: MWAA Bonds in Focus

Although new issuance has slowed significantly in this shortened holiday week, supply is poised to ramp up again in the week ahead, with some market participants eyeing a swelling wave worth around US$20bn of deals.

Among the transactions on the near-term radar, the Metropolitan Washington Airports Authority (MWAA) is set to sell more than US$1.3bn of Dulles Toll Road (DTR) subordinate lien revenue and refunding bonds, Series 2019B, for Dulles Metrorail and capital improvement projects.

The Authority intends to use proceeds from the issuance to repay its Transportation Infrastructure Finance and Innovation Act (TIFIA) loan; pay principal and interest on maturing commercial paper; as well as a portion of the costs associated with its close to US$3bn Dulles Metrorail Project (Silver Line). The MWAA also expects to peg proceeds towards funding the Series 2019B debt service requirement and issuance costs.

The issuer’s repayment of the TIFIA loan appears to spur several benefits, in part as it will no longer be subject to certain of its requirements, including using part of its reserves to prepay principal on TIFIA bonds on a semiannual basis.

Paying down the TIFIA loan also means the elimination of a springing lien provision, which requires TIFIA payments to become payable on a parity basis with first senior lien bonds, under certain circumstances.   

In effect, the TIFIA loan agreement will be terminated, with the junior lien being rendered inactive, slashing the Authority’s outstanding liens from four to three.

Moody’s Investors Service, which has assigned a low-tier investment-grade ‘Baa2’ rating on the deal, noted that the payback of the TIFIA loan also reduces the Authority’s maximum annual debt service to around US$291m in fiscal year 2041 from US$340m in FY 2043.

Moody’s analyst Myra Shankin said that debt service is leveled after 2033, “allowing for greater flexibility around necessary toll rate increases after that point,” further contributing to support for the MWAA’s credit in the long-term.

The ratings agency also attributed its stable outlook to an assumption that the Authority would continue to raise rates, as needed, to support its rising debt service requirements and achieve its coverage level targets.

Shankin added that following the repayment of the TIFIA loan, and the shift of that debt to the subordinate lien, DTR will maintain coverage above 2.0x for first senior; 1.60x for second senior and 1.10x all in. The stable outlook also reflects MWAA’s and DTR’s ability to make reserve fund deposits; meet future DTR and Metrorail capital needs; maintain liquidity levels and deliver its Phase 2 Metrorail construction project on schedule and within the current overall budget.

The transaction is being co-lead managed by BofA Securities and Goldman Sachs and is slated to price as early as Thursday, December 5.

Another offering on the week ahead calendar, which analysts at Janney Montgomery think could be the “year’s busiest,” include New Jersey Transportation Trust Fund’s US$1.7bn sale – potentially the largest taxable bond issuance in over six years – with a separate issuance of US$650m of tax-free securities.

To date, the still ultra-low U.S. interest rate environment, coupled with diverging views on the trajectory of domestic economic growth in the year ahead, will likely continue to prompt further taxable muni bond deals. In the meantime, investors will generally be watching incoming data closely, alongside the FOMC, as it considers future rate decisions and overall monetary policy.

Disclosure: Interactive Brokers

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