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WEALTH SOLUTIONS GROUP

Muni Fortnightly

Treasury curve continues to flatten despite


supportive economic data. Municipal bonds David N Violette, CFA
Senior Fixed Income Analyst
underperformed.

November 20, 2017

Bottom Line:
Treasury yields fell and the curve is now at the flattest level (2s-10s spread) since the financial
crisis.
Muni yields rose. Some weight to the market as there is some expectation for a rush to issuance.
Moodys upgrades outnumber downgrades in Q3.
Some municipal market implications from tax legislation this is fluid.
S&P Puerto Rico Total Return Index was -0.1% two weeks; -16.8% YTD.

What Happened in the Bond Markets Last Week?


Treasury yields after rising a bit early in the week in anticipation of a cornucopia of economic data and the
vote on the House version of tax legislation. The economic data were broadly supportive of higher yields as
they broadly met expectations (inflation data) or exceeded expectations (industrial production and housing
starts) while some soft data (regional surveys) were softer than expectations. The tax bill, as passed by the
House, was self-touted to be growth promoting. The Treasury market found it all to be rather unconvincing as
the Treasury curve was decidedly flatter. The 2s-10s spread has now reached post-financial crisis lows
(currently at ~61 bps). The December Fed meeting currently has a Fed Rate hike market-implied probability
of almost certainty.
Municipal yields underperformed Treasuries. As was mentioned a few weeks ago, the municipal market is still
trying to digest the probability and magnitude of tax changes on the municipal market.

Yields (Figure 1):

For the week ending 11/17/17 Treasury yields traded notably flatter; 2-year Treasury Note yields were +6.3
bps to 1.72%, 5-year Notes yields were flat at 2.05%, 10-year Notes yields were -5.7 bps to 2.23% and 30-
year bonds yields were -10.5 bps to 2.78%.

Bloomberg Municipal Index curve yields were higher and the curve flatter, AAA-rated GO yields; 2-year bonds
were +6 bps to 1.22%, 5-year bond yields were +5 bps to 1.56%, 10-year bond yields were +4 bps bps to
2.03% and 30-year bonds were +1 bps to 2.77%.

The Ratio of 10-year AAA GO debt to 10-year Treasury yields rose off week-ago levels; 86.7 from 832 last
week. The year-to-date average is 89.2 and the 12-month average is 90.4.
.

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Figure 1 - Yield Curve and Muni Curve Changes Data Source: Bloomberg

One can observe these changes by looking at how rates have changed along the curve for both the Treasury curve
and for the AAA-rated G.O. Index since last week. The top panel shows four yield curves; two for the Treasury curve
(in red) - one for the most current date and one from last week and two for the AAA-rated G.O. (in blue) - current and
last week. The bottom panel of the graph shows changes in the rates along both curves for the week for both
Treasuries and the AAA G.O. Index.

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Figure 2 - Muni Ratio Data Source: Bloomberg

AAA 10-Year G.O. Muni Ratio to Treasury


110.0

105.0

100.0
Ratio (%)

95.0

90.0

85.0
86.7
80.0

Mid Price SMAVG (50)

Supply (Figure 3) Bloomberg 30-Day Visible Supply currently stands at $12.1 billion up from $10.6 billion this time
last week. The YTD average visible supply is $11.1 billion and the 12-mo average is $11.1 billion.

Figure 3- Bloomberg 30-Day Visible Supply - 1 Year; Data Source: Bloomberg


Bloomberg 30-Day Visible Supply
U.S. Total

25,000

20,000

15,000
$ Million

10,000

5,000

Articles of Interest
Municipal Fund Flows: According to Lipper data muni funds had net inflows of $418 million after $463 million of net
inflows during the previous week. The four-week moving average was $121.9 million of inflows. High-yield funds had
net inflows.

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Moodys Q3 Upgrades Outnumber Downgrades: Moodys issued its report on Q3 rating activity in which it made
122 upgrades and 104 downgrades but the principal amount of downgrades exceeded the amount upgraded. Texas
municipalities saw the most upgrades on tax base growth and Pennsylvania municipal credits had the most
downgrades on declining municipality reserves. In addition, Puerto Rico Electric Power Authority (PREPA) saw
another downgrade to Ca Negative. The State of Wisconsin (rated Aa1 Stable) accounted for the largest amount
upgraded driven by positive pension funding while the second largest downgrade amount (Kentucky) was for poor
pension funding.

Tax Legislation: Municipals, I the current tax legislation holds, will be affected. Broadly, participants are not looking
favorably upon the House bill and are hoping that that the Senate bill will prove more favorable. There will likely be
much written and digested in order to determine the ultimate impact on existing and new municipal bondholders and
issuers.
PABs: the House bill put an end to private activity bonds (PABs) issued by nonprofit hospitals, educational
facilities, airports, ports, solid waste facilities, sewage treatment facilities, low-income housing, stadiums etc..
The current Senate bill saves PABs. Eliminating PABs is envisioned by many to make infrastructure spending
more expensive and has the potential to slow/reduce such spending that is otherwise what most political-
beings are looking to speed/increase. The bond market implications are for a potential for a rush to issuance
and making outstanding PAB bonds (especially those subject to AMT) relatively more highly valued.
SALT: the House bill eliminates the deduction for state and local income and sales taxes and caps the
deduction for property taxes at $10,000. This has a negative impact, in particular, on residents in high-tax
states.
Repeal of ACA Mandate: This would be a credit negative for healthcare credits by reducing the pool of
insured patients and thus increasing the potential for uncompensated care requirements particularly for higher
expense emergency care.
Advance Refundings: Advance refundings, used to take advantage of lower borrowing costs if available
before the maturity of a bond, accounted for a large portion of municipal issuance. The elimination of the
exemption on advance refundings could eventually reduce municipal bond issuance and raise financing cost
for issuers and reduce financial flexibility.
BABs: could be at risk as potential eventual federal PAYGO budget cuts could trigger sequestering and thus
extraordinary call features.

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Puerto Rico:
o Misc.:
Puerto Rico, according to lawyer for the oversight board, may seek a debt-service moratorium for five
years. Puerto Ricos benchmark 8% GO bond due in 2035 traded at a new low 24.
Puerto Rico has asked for $94 billion of federal aid.
Controversy regarding PREPA rebuild continues. The head of PREPA has resigned amid questions
about handling of the rebuilding effort.
o The S&P Municipal Bond Puerto Rico Index finished at 147 on Friday vs. 147.2 at the end of two weeks
ago, -0.1%%. Year-to-date the index is -16.8%.

S&P Municipal Bond Puerto Rico Index Level (1-year)

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Relative Value by Maturity

Table 1 - AAA Muni Ratios and Spreads by Maturity - Data Source: Bloomberg
11/20/2017 Yield-to-worst (%) 0% Tax Rate 35% Tax Equivalent
Maturity (yrs.) AAA Gen. Oblig. Treasury Spread (bps) Ratio (%) Spread (bps) Ratio (%)
1 1.15 1.58 -42.4 73.1 19.7 112.5
2 1.23 1.72 -48.9 71.6 17.3 110.1
3 1.34 1.82 -48.3 73.5 23.7 113.0
4 1.45 1.96 -50.4 74.2 27.7 114.2
5 1.57 2.05 -48.0 76.6 36.4 117.8
7 1.77 2.22 -45.1 79.7 50.3 122.6
10 2.03 2.34 -30.6 86.9 78.8 133.7
15 2.41 2.39 1.9 100.8 131.4 155.1
20 2.61 2.55 5.7 102.2 146.0 157.3
25 2.71 2.66 4.7 101.8 150.6 156.6
30 2.77 2.78 -0.4 99.8 148.8 153.6

Figure 4 AAA General Obligation Ratios and Spreads Data Source: Bloomberg

AAA G.O. Muni Ratio and Spreads


(0% Tax Convention)
105.00 10.0
100.00 0.0
95.00
-10.0

Spread (bps)
90.00
Ratio %

85.00 -20.0
80.00 -30.0
75.00
-40.0
70.00
65.00 -50.0
60.00 -60.0
1 3 5 10 20 30
Maturity (yrs.)

Ratio (%) (Left) Spread (bps) Right

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Relative Value by Rating

Figure 5 Muni Index Yield Curve by Credit Rating Data Source: Bloomberg

4.00
Muni Yields by Rating
3.50

3.00

2.50
Yield (%)

2.00

1.50

1.00

0.50

0.00
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

Treasury AAA AA A

For more information please contact your Financial Advisor.

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Appendix Important Disclosures

Some of the potential risks associated with fixed income investments include call risk, reinvestment risk, default risk and
inflation risk. Additionally, it is important that an investor is familiar with the inverse relationship between a bonds price
and its yield. Bond prices will fall as interest rates rise and vice versa.
When considering a potential investment, investors should compare the credit qualities of available bond issues before
they invest. The two most recognized rating agencies that assign credit ratings to bond issuers are Moody's Investors
Service (Moodys) and Standard & Poor's Corporation (S&P). Moodys lowest investment-grade rating for a bond is
Baa3 and S&Ps lowest investment-grade rating for a bond is BBB-. Ratings are measured on a scale that ranges from
AAA or Aaa (highest) to D or C (lowest).
The Bond Buyer 20-Bond Index consists of 20 general obligation bonds that mature in 20 years. The average rating of
the 20 bonds is roughly equivalent to Moody's Investors Service's Aa2 rating and Standard & Poor's Corp.'s AA. The
Bond Buyer 11-Bond Index uses a select group of 11 bonds in the 20-Bond Index. The average rating of the 11 bonds is
roughly equivalent to Moody's Aa1 and S&P's AA-plus. The Bond Buyer Revenue Bond Index consists of 25 various
revenue bonds that mature in 30 years. The average rating is roughly equivalent to Moody's A1 and S&P's A-plus. The
indexes represent theoretical yields rather than actual price or yield quotations. Municipal bond traders are asked to
estimate what a current-coupon bond for each issuer in the indexes would yield if the bond was sold at par value. The
indexes are simple averages of the average estimated yields of the bonds, are unmanaged and a direct investment
cannot be made in them.
This is not a complete analysis of every material fact regarding any sector, municipality or security. The opinions
expressed here reflect our judgment at this date and are subject to change. The information has been obtained from
sources we consider to be reliable, but we cannot guarantee the accuracy. Municipal securities investments are not
appropriate for all investors, especially those taxed at lower rates. The alternative minimum tax (AMT) may be
applicable, even for securities identified as tax-exempt. It is strongly recommended that an investor discuss with their
financial professional all materially important information such as risks, ratings and tax implications prior to making an
investment. Past performance is not a guarantee of future results.
This report does not provide recipients with information or advice that is sufficient on which to base an investment
decision. This report does not take into account the specific investment objectives, financial situation, or need of any
particular client and may not be suitable for all types of investors. Recipients should consider the contents of this report
as a single factor in making an investment decision. Additional fundamental and other analyses would be required to
make an investment decision about any individual security identified in this report.
ADDITIONAL INFORMATION ON SECURITIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST BY
CONTACTING YOUR BAIRD INVESTMENT PROFESSIONAL.
Copyright 2017 Robert W. Baird & Co. Incorporated.

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