How do record inflows and low interest rates impact municipal investors? We recently interviewed Ben Barber and Scott Diamond, portfolio managers from the GSAM Municipal Fixed Income team, for their insights on the macro environment and opportunities in the municipal market.
Q: How has the municipal bond market performed in light of the broader fixed income rally this year?
There’s been a big shift in the bond market this year. One year ago, we were debating whether the Federal Reserve (Fed) would ultimately hike rates again before the end of 2018 and how many times they would hike rates in 2019. So far this year, the Fed has cut interest rates two times and now the market is currently pricing in a high likelihood of an additional rate cut this year. Additionally, 10-year yields have dropped approximately 100 basis points (bps) year-to-date (YTD).1
Against this backdrop, municipal bonds (munis) have followed directionally with Treasuries, but also benefited from some really positive market technicals. Muni yields are lower by about 94bps.2 Similar to the Treasury yield curve flattening throughout 2018, the muni yield curve has flattened throughout this year.
Q: Given the rally in municipals this year, what does relative value look like?
Municipal / Treasury ratios, a measure of relative value in the muni market, have been volatile. Ratios were reasonable at the start of the year and following a swift bond market rally, they became more expensive. During the summer, shorter-term munis became extraordinarily rich but are now back to more attractive levels. The intermediate and long-end of the municipal yield curve was attractive at the beginning of the year, became more expensive in the spring, and now has become more attractive again.
Q: What themes have you seen in the municipal market this year?
We’ve been hearing a lot from investors about the scarcity of munis, and agree that scarcity is one of the themes in the muni market this year. On the other hand, with roughly $3.8 trillion of overall market capitalization and 50,000 different issuers, the muni market is a vast and complex market.3
Supply has been constrained over the last 10 years. Over the last 10 to 12 years, the market has experienced net negative supply approximately half of the time with more bonds maturing and/or being called out of the market than are coming in the primary market. With $300-$400 billion of primary market supply per year, we’ve seen net negative supply over the last 10 years to the tune of $20-$50 billion of net negatives in some years.4 This amount is not huge when compared to the overall muni market cap of $3.8 trillion. However, it is statistically significant from the perspective of the last 30-40 years when the market has usually grown in size. Nonetheless, the muni market has actually been shrinking.
When evaluating the technicals, it’s important to also consider the demand side of the equation. The demand ebbs and flows depending mostly on the rates. One of the best proxies to evaluate overall muni demand is open-end municipal bond mutual funds, which are usually tracked on a daily and weekly basis.
When rates were spiking higher at the end of 2018, there were redemptions out of open-end municipal bond mutual funds. 2019 YTD has been very positive. On a base of about $700 billion, municipal bond mutual funds received $9.9 billion of inflows in August 2019, bringing YTD inflows to $60.5 billion, continuing the best start to a year since inflows started being tracked in 1992.5
As illustrated in Exhibit 1, the combination of tepid supply, where we expect 2019 to be another net negative year, and strong demand YTD, may create a very positive technical setup in the muni markets. While scarcity is a concern and primary market supply can be constrained from time to time, it is important to remember that there are a lot of opportunities in the secondary market, given this market is very broad and fragmented.
Source: Federal Reserve Board Flow of Funds, BofA Merrill Lynch Global Research, and GSAM. Holdings refer to total muni holdings across households and nonprofits, funds, US banks, insurers, brokers and dealers, and rest of the world. Issuance refers to total issuance across new money and refunding. Past performance does not guarantee future results, which may vary. As of 12/31/2018
Q: Where do you find opportunities in the municipal bond market today?
We believe individual security selection is a primary driver of opportunity in the muni market. As a team, we spend time scouring the market to evaluate each muni sector. We examine the traditional muni sectors such as general obligations, water and sewer, utilities, and school districts, as well as non-traditional muni sectors, such as non-profit healthcare, special assessment districts, and special tax credits.
In the market, many dynamic relationships exist, including the relationship between bonds from different states and bonds from different sectors in the muni market. There are also interesting relationships between the municipal, treasury and municipal London Interbank Offered Rate (LIBOR) markets. Since liquidity is generally very scarce in the muni market, we find this challenge to create opportunities for our clients.
We are always looking for opportunities and they will often come structurally. For example, we evaluate differences between coupon bonds, zero coupon bonds and/or floating rate note bonds. Another example is examining the differences between tax-exempt and taxable municipal bonds. There are many different angles that we can explore in the muni market to find opportunities.