Bonds

New-issue supply scarcity amid large summer reinvestment a boon for munis

Reinvestment needs will top new-issue supply by about $30 billion from June to August, which should boost the asset class after May’s atypical losses.

Reinvestments, which includes maturities, called bonds and coupons, total over $114 billion over the next four months, according to ICE Data.

While June often begins softer as investors assess how new-issue demand progresses, late-June through August has historically been strong for municipals, said Anthony Valeri, director of investment management at Zions Wealth Management.

“Reinvestment needs look to be bigger than new issuance by about $20 billion to $30 billion” over the summer months, he said Thursday.

Valeri said the magnitude of gains might be limited given lingering uncertainty over Federal Reserve rate hikes and the pace of inflation.

“Still, even a coupon-clipping environment at the now-higher yields is a good thing for investors,” he said.

That, coupled with the other market technicals in the summer months, should boost municipals, especially following a challenging May, putting investors on better footing, Valeri said.

“May 2023 witnessed its worst monthly performance of the past 20 years, down 0.9%,” he said, adding that after a strong start to 2023, municipals were due for some giveback. 

“Municipals also lagged their Treasury counterparts during the month leading to more attractive relative valuations,” which can help going forward, he said.

The average municipal-to-Treasury yield ratio finished May near the highest levels of 2023, roughly 72% to 78%, depending on which metric is used, according to Valeri.

“This isn’t overly cheap on a long-term basis, but after spending February and April in expensive territory this is a positive development going forward,” Valeri said.

In addition, Fed officials at the end of May suggested rate hikes may pause at the upcoming June meeting, he noted.

“This provides a modest relief since a July rate hike is still a possibility,” he said. “However, the weakness during May correctly reflected that rate cuts are not necessarily going to happen in 2023, and that repricing puts bonds in a better place.”

While June’s performance is often mixed, Barclays PLC strategists are “still relatively optimistic in the near term.”

“With the debt ceiling standoff behind us, we might see some rate volatility, but it should not be overwhelming, in our view, as U.S. Treasuries seem to be stuck in the middle of the 50bp range where they have spent most of their time since last fall,” said Barclays strategists Mikhail Foux, Clare Pickering and Mayur Patel. “There is little doubt that investors will be extremely sensitive to economic releases, but at least for now they seem to be taking the glass-half-full approach.”

On a longer-term basis, Valeri said issuance has been trending lower in 2023 and will likely continue to do so over the remainder of the year, providing ongoing support, he added.

Tom Kozlik, managing director and head of public policy and municipal strategy at Hilltop Securities Inc., agreed.

“There should be a moderate to solid level of reinvestment dollars available to flow back into municipals,” he said on May 25.

“For the most part we expect investors to continue to remain devoted to the municipal — and especially municipal tax-exempt — asset class,” Kozlik said.

Demand during the spring and summer reinvestment season typically increases by over 50% from May’s levels and should last through August, according to Nisha Patel, managing director of SMA portfolio management at Parametric Portfolio Associates.

Patel said she is optimistic about the asset class heading into summer.

“Given the market environment in the summer months where the municipal market sees high reinvestment flows … relative to supply, we are bullish on muni bonds and the prospective performance,” Patel said in a May 24 report.

Primary market new issuance typically dwindles during the summer months and does not pick up until mid-September, she noted.

“This supply-demand imbalance will likely drive municipal-to-U.S. Treasury relative value materially lower, potentially into the mid-to-low 50% range, making munis expensive on a relative value basis,” Patel said.

New-issue supply has been in the $6 billion to $8 billion range, which Patel said “is good considering that supply is down over 25% year to date.”

If the weekly supply stays at the current $6 billion average, then net supply growth over the next four months will be negative $124 billion, according to Patel.

“Even if weekly supply doubles to $12 billion a week, then net supply growth over this time period will still be negative by $16 billion,” she said.

“Bottom line is that due to the lack of supply, and large redemptions, munis should continue to find supportive levels,” she wrote. 

Others, like Michael Pietronico, chief executive officer at Miller Tabak Asset Management, said reinvestment season should keep municipals well bid in this lower supply period. 

“Anecdotally, it seems that participants are expecting new-issue supply to remain lower than last year due to the surge in rates over the past few months,” he said. “The climate seems more positive than last year as our [separately managed account] business has picked up due to the higher absolute rates,” Pietronico continued. He added that cash coming out of mutual funds is flowing back into managers of SMAs, like Miller Tabak.

The coming months could also present market changes that trigger firms to alter their objectives accordingly.

“We expect the June/July reinvestment period to bolster the market, though we continue to monitor market weakness and volatility closely as it may influence allocations along the curve,” Shaun Burgess, portfolio manager and analyst at Cumberland Advisors said.

Patel said the firm expects to tweak its investment strategy in the municipal market to take advantage of value given the expected Federal Reserve actions.

“With the Fed likely being at the end or close to the end of the tightening cycle, we are in favor of selectively adding duration in clients’ portfolio,” she said.

“We favor a 10- to 20-year ladder over the five- to 15-year, given the roll return potential, or the steepness of the curve in the 10- to 20-year range,” she said.

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