Supply Shocks Not as Dramatic for Munis as Expected

- Bloomberg – Historic Week of Sales Faces Municipal Bond Buyers, Sellers
  Issuers crowd in as House, Senate GOP resolve tax bills
  Welcome to the biggest week of the year, perhaps to the biggest week of any year for some time to come. Estimates for the amount of municipal bonds to be sold this week range from $19 billion to $21 billion, or almost triple the average for a week so far this year. The figure could go higher. The Senate this weekend passed its version of tax reform, which includes prohibiting tax-exempt advance refunding. The next step is for the House and Senate to resolve differences between the two versions.

Summary

Municipal bonds have not always been significantly impaired by supply shocks. Significant drawdowns are not likely given markets already pricing in a December rate hike. We continue to lean on alternative data (Google search trends) to assess value and credit ratings across each state’s municipal bonds.

Comment

Investors have not shunned municipal bonds in the face of the Republican-led tax plan. The chart below shows 5-day rolling flows into municipal bond ETFs remain quite strong.

The newswire burst with stories about the rush of supply by issuers to front-run the tax plan. The chart below shows the 5-day average of the 30-day visible supply as determined by Bloomberg and Bond Buyer. Visible supply has surged to the highest since 2000.

However, municipal bonds have not always incurred drawdowns in response to these so-called supply shocks. The next chart offers the cumulative returns for each instance when 30-day visible supply exceeded 3 standard deviations from the 1-year average. The most significant losses occurred in November 2016 after the election and the Federal Reserve built the case for another hike.

For December 2017, markets have already priced in hawkish rhetoric by Yellen et al calling for the 5th hike in this tightening cycle. We showed last week extreme underperformance by municipal bonds relative to the S&P 500, like the current situation, are followed by sizable rebounds.

We continue to lean on Google search trend data within each state’s boundaries to assess excess yields to the S&P Municipal Bond Index.

For example, we measure the frequency of searches by individuals within each state for ‘unemployed,’ ‘foreclosure,’ ‘bankruptcy,’ and ‘payday loans.’ Higher frequencies of these particular searches likely indicate greater economic distress. We can assess the quality of government with words like ‘bipartisan agreements,’ ‘balanced budget,’ and more. We also include trends for the new economy including ‘artificial intelligence,’ ‘renewable energy,’ and ‘solar power.’

The chart below shows each state’s excess yield (orange), fair value estimate (blue), and past six-month trading range. Residuals offer the degree to which each state is deviating from fair value estimates (green = cheap and red = rich).

Additionally, we classify each state’s credit rates as determined by S&P using excess yields and the same Google search trends. The chart below shows the probabilities of each state falling within each credit rating from BBB- to AAA. Higher probabilities at lower credit ratings than current would raise flags.