Bonds

Gimme shelter: In wake of bank fail fallout, municipal bonds in demand

Municipals finished out a nerve-wracking week on a strong note, with yields falling by as much as nine basis points on the short end while U.S. Treasuries strengthened and equities came under pressure.

As holders of bank stocks headed for the exits and muni investors looked on nervously from the sidelines as the Federal Open Market Committee met this week, bonds have seen renewed interest as the idea of safety suddenly became uppermost in eyes of buyers one again.

The muni market started off the week on a quiet note, with action subdued in both the primary and secondary ahead of the Federal Reserve meeting on Tuesday and Wednesday. After the Fed raised rates once again, the market remained calm.

Muni yields remained at their lows for most of the week and then moved sharply lower on Friday as demand for bonds outstripped supply and as worries were revived over contagion as Deutsche Bank’s stock came under pressure.

Fears eased in late trading as stocks recovered most of their earlier losses after Federal Reserve Bank of St. Louis President James Bullard said he raised his forecast for peak interest rates this year amid ongoing economic strength, based on an assumption that banking-sector strains will prove temporary.

“I had previously been at 5 3/8, now I’m at 5 5/8, so a little bit higher — 25 basis points higher — in reaction to the stronger economic news,” Bloomberg News quoted him as saying after a speech. Bullard said the upgrade was “also under the assumption that the financial stress abates in the weeks and months ahead.”

On Friday, Refinitiv MMD’s triple-A GO 5% yield scale was bumped as much as nine basis points while benchmarks calculated by ICE and IHS also saw yields fall as much as nine basis points.

The two-year muni-UST ratio was at 63%, the three-year at 64%, the five-year at 66%, the 10-year at 68% and the 30-year at 92%, according to Refinitiv MMD’s 3 p.m. ET read. ICE Data Services had the two-year at 64%, three-year at 63%, the five-year at 64%, the 10-year at 68% and the 30-year at 93% at 3 p.m.

Since the start of the banking crisis on March 10, the 10-year muni yield has dropped 22 basis points, while the 30-year has fallen 13 basis points, according to MMD. At the start of the month, the 10-year muni stood at 2.59% while the 30-year was at 3.56% on March 1.

Near the close, the Down Jones Industrial Average was up 0.36% while the S&P 500 rose 0.48% and the Nasdaq was 0.20% higher.

The U.S. Treasury two-year note was down eight basis points to yield 3.77%, the 10-year Treasury was off four basis points to yield 3.38% and the 30-year Treasury dropped five basis points to yield 3.65%.

Meanwhile, the primary calendar for the upcoming week is on the rebound with volume estimated at $5.40 billion, up from $3.45 billion in the previous week. Issuance consists of $3.87 billion of negotiated deals and $1.53 billion of competitive sales.

AAA scales
Refinitiv MMD’s scale was bumped across the board Friday. The one-year was at 2.49% (-9) and 2.40% (-9) in two-years. The five-year was at 2.24% (-9), the 10-year at 2.29% (-7) and the 30-year at 3.35% (-7) at 3 p.m.

The ICE AAA yield curve was also bumped: 2.54% (-7) in 2024 and 2.45% (-7) in 2025. The five-year was at 2.22% (-9), the 10-year was at 2.30% (-6) and the 30-year was at 3.39% (-5) at 3 p.m.

The IHS Markit municipal curve also saw yields fall: 2.49% (-9) in 2024 and 2.40% (-9) in 2025. The five-year was at 2.23% (-9), the 10-year was at 2.29% (-7) and the 30-year yield was at 3.33% (-7) according to a 3 p.m. read.

Is the Fed done?
Market uncertainty apparently subsided enough to give policymakers at the Fed enough confidence to deliver the central bank’s ninth rate hike of the past year, Tom Garretson, senior portfolio strategist at RBC Wealth Management, said in a market note.

The rate hike brought the Fed’s target policy rate to a range of 4.75% to 5.00%; the highest level since 2007.

But what happens now? 

At the beginning of March when the Fed was looing at continued aggressive rate hikes, markets were looking for hikes to a level as high as 5.75% this year, he said. Following the banking stress of recent weeks, markets are now looking for rate cuts, he added.

“We think the market broadly has it right. We believe the Fed is indeed done raising rates and that it will need to pivot to two 25 basis point rate cuts later this year as U.S. recession risks materialize, with rates ending 2023 at 4.50%, well below the Fed’s current projection of 5.25%,” Garretson said.

Fed Chair Jerome Powell said at a press conference the knock-on effects of recent bank turmoil could come in the form of a reduced willingness on the part of banks to extend loans and credit — the impact of which would be slower economic growth and reduced inflationary pressures.

However, Garretson noted that lending standards in the Fed’s quarterly senior loan officer survey were already tightening by the fourth quarter of 2022.

“Recent stress is only likely to amplify the tightening of lending standards when the Q1 2023 report is made available sometime in April. This both adds to our conviction that the U.S. economy is at greater risk of a recession this year — though mild — and that the Fed will end its rate hike cycle as a result,” he said.

“In a sense, reduced lending and tighter financial conditions would be doing the Fed’s job, so layering in further rate hikes on top of that would only raise economic jeopardy,” he added.

He stressed, however, that while the risk of a pull-back is higher in the aftermath of the March banking turmoil, recessions are a normal part of economic cycles and that any recession is likely to be mild because of a strong U.S. labor market and resilient consumer spending.

“In fact, we think a mild recession could even speed up the Fed’s achievement of its inflation goals, bring demand and supply back into balance, and form the foundation of a longer, stronger and more sustainable economic expansion,” Garretson said.

Secondary trading
California 5s of 9/1/2024 traded in a block of $5 million+ at price of 103.533, a yield of 2.46%, according to ICE. California 5s of 9/1/2026 traded in a block of $2 million+ at price of 109.028, a yield of 2.248%.

Los Angeles Department of Water & Power 5s of 7/1/2043 traded in a block of $5 million+ at a price of 112.86, a yield of 3.37%. Los Angeles Department of Water & Power 5s of 7/1/2025 traded in a block of $3.5 million at a price of 116.82, a yield of 2.116%.

Electronic trading flat in 2022
Municipal bond trading in 2022 was a sight to behold, according to Kevin McPartland, head of market structure and technology research at Coalition Greenwich, a division of CRISIL.

The average daily trade count in 2022 jumped to over 50,000 — an amazing 51% increase from 2020, McPartland wrote in a blog post.

On a notional basis, trading volume was 18% higher in 2022 than in 2020, and a more impressive 60% higher year over year. This uneven growth in trade count and notional volume traded led to a decline in average trade size, down 22% from 2022, which equates to $279,000 per trade, he said.

“The activity in munis largely reflects a similar trend we observed in U.S. corporate bond, where the average daily trade count soared and average trade sizes declined,” McPartland said. “But unlike the corporate bond market that saw e-trading surge in 2022, muni bond electronic trading as a percentage of the total has changed little.”

Coalition Greenwich’s estimates show that 14% of muni bond volume traded electronically in the fourth quarter of 2022, up 3 percentage points from the second quarter.

On the positive side, he noted this shows e-trading kept up with, and in some cases surpassed, the market’s volume surge.

Tradeweb, which Coalition Greenwich said can be used as a proxy for the muni e-market, saw volumes jump 56% from 2020 to 2022, with a 93% year-over-year gain.

“Nevertheless, the market overall continues to buck the electronic trading trend that has for the last decade taken over government and corporate bond markets,” he said.

So what’s ahead for 2023?

“Despite the slow progress, we remain convinced that more of the municipal bond market will trade electronically in the years ahead. The most tech-forward asset managers have already moved toward a world in which the majority of their trading is done on the screen,” he said.

“Further, automated market-making has existed in munis for years, and still presents spread-capture opportunities that are already drawing in new entrants,” McPartland said. “More liquid muni ETFs will only help that trend, just as credit ETFs did for corporate bonds.”

He noted that electronification wasn’t just about traditional electronic trading, but also increased automation of the trading and investing life cycle.

Even if the final terms of a trade continue to be negotiated via chat or the phone, he said there was nothing keeping pre- and post-trade workflows away from automation.

“One million CUSIPs and very regional demand for municipal bonds certainly complicate the move to the screen,” he said. “But the last decade is littered with electronic trading growth and innovation that was once thought to be impossible. The next decade will be the same.”

CRISIL is an S&P Global company that provides strategic benchmarking, analytics and insights to the financial services industry.

What’s on tap in the primary
New York City is set to issue $1.19 billion of general obligation bonds during the upcoming week, the largest issue on the calendar.

The deals are comprised of $950 million of tax-exempt fixed-rates and $240 million of taxables.

Book-running lead manager RBC Capital Markets is set to price the tax-exempts on Wednesday after a one-day retail order period.

BofA Securities, Citigroup, J.P. Morgan Securities, Jefferies, Loop Capital Markets, Ramirez & Co., Siebert Williams Shank, and Wells Fargo Securities are the co-senior managers.

Also on Wednesday, the city will competitively sell $240 million of taxables. Proceeds of the bond sales will be used to fund capital projects.

CDO structure
Wisconsin-based Public Finance Authority could price during the week $371 million of Series 2023-1 tax-exempt pooled securities although the deal participants said negotiations are ongoing and the sale’s timing is dependent on market conditions.

Wells Fargo Securities and HilltopSecurities are lead managers the $237.472 million of Aa1 rated Class A and $133.578 million of unrated social impact certificates in the upcoming week. Dallas-based Preston Hollow Community Capital is the sponsor and administrator on the issue.

The Class A certificates will have an initial remarketing date of March 1, 2029; the Class B certificates will not be remarketed.

Proceeds will be used to purchase various municipal bonds from HilltopSecurities, which had purchased the bonds from the sponsor.

Preston Hollow is a direct lender and originated most of the bonds being packaged in the pool. The firm is taking bonds from 18 transactions, worth $371 million and selling them to PFA, which is then selling the new munis that maintain a tax-exemption, backed by the portfolio of debt. Preston Hollow will hold the $134 million of subordinated unrated certificates so it takes the first losses in the event losses occur.

The underlying collateral consists of 18 municipal tax-exempt bonds from 10 states and Washington D.C. The states include New York, Florida, New Jersey, California, Ohio, Georgia, North Dakota, Pennsylvania, Virginia and Texas.

Sectors include special assessment, student housing, public school K-12, private higher education, skilled nursing, not-for-profit hospitals, hotels, federal qualified health clinics and property tax increment.

They have a weighted average coupon of 6.249% and a weighted average life of 20.57 years, or 9.84 years to call. The weighted average life of the Class A certificates is shorter than that of the collateral.

A collateralized debt obligation is a structured finance product backed by a pool of loans.

“A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset, according to Investopedia. “These assets become the collateral if the loan defaults.”

While CDOs backed by subprime mortgages were one of the underpinnings of the 2008 financial crisis, Investopedia says CDOs are a viable tool for diversifying risk and creating more liquid capital for investment banks.

Moody’s Investors Service assigned an Aa1 provisional structured finance rating to the Class A certificates with a final maturity date of Aug. 1, 2059.

Moody’s said its rating was based on its methodology and the agency said it considered all relevant risks, particularly those associated with the transaction’s portfolio and structure.

“Public Finance Authority 2023-1 Transaction is a static cash flow municipal CDO,” Moody’s said. “The issuer of the Class A certificates is a governmental entity established under the Wisconsin state statutes.”

Moody’s said it analyzed the credit quality of the underlying bonds by developing credit estimates.

In addition to the credit quality of the underlying bonds, Moody’s noted that it also considered the structural and legal aspects of the transaction in arriving at its rating. The issuer uses the total proceeds from the underlying bonds to pay interest and principal on the Class A certificates.

Preston Hollow Community Capital directs the disposition of watchlist or defaulted bonds, on behalf of the trustee, calculates coverage tests and directs purchase of additional bonds, Moody’s said.

In addition to the Class A certificates, Class B certificates subordinate to the Class A certificates will be issued, and these will not be rated by Moody’s.

Other deals ahead
Negotiated deals above $100 million on the calendar include:

The Michigan State Housing Development Authority’s (Aa2/AA+/NR/) $398.41 million of single-family mortgage revenue bonds consisting of Series 2023A non-AMT and Series 2023B taxable social bonds. Barclays Capital. Retail Tuesday, institutional Wednesday.

The City of Los Angeles Department of Airports (Aa3/AA-/AA-/NR) Los Angeles International Airport’s $299.93 million of Series 2023A subordinate refunding revenue green private activity AMT bonds and Series 2023B subordinate refunding revenue governmental purpose non-AMT bonds. Ramirez & Co. Pricing on Tuesday.

The City of San Diego Public Facilities Financing Authority’s (Aa2/NR/AA/NR) $226.81 million of Series 2023A senior water revenue bonds. Morgan Stanley. Pricing on Thursday.

The San Mateo-Foster City School District, California’s (Aaa/AA+//) $150 million of Election of 2020 Series B GOs. Stifel Pricing on Tuesday.

The Greater Texoma Utility Authority, Texas’ (///) $138.455 million of Series 2023 contract revenue bonds. Baird. Pricing on Tuesday.

The Tennessee Housing Development Authority’s (Aa1/AA+//) $120 million of Issue 2023-1A residential finance program social bonds. Raymond James. Pricing on Tuesday.

The Republic Services Inc.  (NR/BBB+/NR/NR) $115 million of remarketing, refunding of Series CMFA and PEDFA. BofA Securities. Pricing on Thursday.

The City of San Diego Public Facilities Financing Authority’s (/AA-/AA-/) $114.24 million of Series 2023A lease revenue refunding bonds for capital improvement projects. RBC Capital Markets. Pricing on Wednesday.

The Columbia County School District, Georgia’s (Aa1/AA+//) $107.33 million of Series 2023 GOs insured by the Georgia State Aid Intercept Program. Raymond James. Pricing on Tuesday.

The City of Santa Rosa High School District, California’s (Aa2///) $104 million of Series 2023A GOs. Raymond James. Pricing on Wednesday.

The Trustees of Purdue University’s (Aaa/AAA//) $100.835 million of Series 2023A student facilities system revenue refunding bonds. Wells Fargo. Pricing on Tuesday.

Competitive sales on the calendar include several large issues:

The city and county of San Francisco (Aaa/AAA/AA+/) is hitting the market with $236.3232 million of GO bonds in two deals on Tuesday. The sales consist of $207.47 million of Series 2023C taxable affordable housing social bonds and Series 2023B Embarcadero Seawall earthquake safety taxables and $28.85 million of Series 2023A tax-exempt heath and recovery bonds.

Also on Tuesday, Wake County, North Carolina, (Aaa/AAA/AAA/) will sell $384.865 million of GOs in two deals consisting of $309.675 million of Series 2023A public improvement bonds and $75.19 million of Series 2023B refunding bonds.

Oklahoma City (Aaa/AAA//) is selling $117 million of Series 2023 GOs on Tuesday.

In the short-term sector Wednesday, Anchorage, Alaska, (/SP1+//) is selling $125 million of tax anticipation notes.

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