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By: Brandon Lippold
The objective of this update is to provide insight into key municipal market developments that have occurred since the start of 2019. Most of these occurrences revolve around yield curves; whether it’s their flattening, inversion, shift, changing expectations, or impending replacement. Overall, the municipal market has had a strong start to the year seeing increased demand for tax-exempt products, while muni issuers have been able to capitalize on a lower rate environment.
Changing Expectations for the Fed Funds Target Rate
Until recently, the Fed’s monetary policy has involved the use of interest rate hikes to temper a potentially overheating economy, with consistent increases to the Fed’s target rate beginning in late 2015. In 2019 this approach has flipped in light of current economic risks such as trade tensions (most significantly the trade fight between the United States and China), rising geopolitical tensions, a weakening global economic outlook, and stagnant domestic inflation. Expectations now are for a minimal rate cut to curb near term economic risks, as opposed to an overall change in stance corresponding with the beginning of a rate-cutting cycle as has typically taken place in the past. Rate cuts are projected to move the Fed target down by no more than 0.5% by the end of 2019, from a target of 2.25% to 2.5%.
Current Projections:
Past Projections (December 2018):
Flattening/Inversion of Benchmark Yield Curves
Most market benchmark curves have seen some form of flattening and/or inversion over the last year and a half, with this process accelerating significantly since the start of 2019. Some potential factors contributing to this movement include a weakened long-term economic outlook, shrinking term premiums, and a potential change in our understanding of the slope of the yield curve & business cycle[1]. No matter the cause, the most significant result for municipal issuers has been long term borrowing rates below historic averages and reduced forward premiums (particularly in the swap market ).
Another result has been a growing debate on the recession-predicting ability of an inverted curve. Historically, recessions have often followed inversions in the yield curve; however, while some economic concerns remain, the general consensus of Federal Reserve policy makers and the market seems to be that a recession is not looming at present as the business cycle has shifted.
Long-Term Rate Decreases
Long-term rates have seen a steady decline since the start of 2019, with 20-year MMD and LIBOR swap rates falling by approximately 35 basis points. This has left issuers in an advantageous position to borrow to longer points in the curve at a lower than anticipated cost.
LIBOR Transition
The global LIBOR transition continues, though since our last LIBOR transition update (LIBOR Transition Update) not much has changed. Pressure from different policy making institutions to transition debt and derivative instruments from LIBOR has increased; however, the official guidance/timing for this transition is still not finalized. Futures/swap markets continue to evolve and see improvements in liquidity. The market is still waiting on the development of a term structure for SOFR, as well as ISDA guidance on the transition.
SIFMA Volatility
The SIFMA rate has seen significant week-to-week volatility since the Tax Cuts and Jobs Act took effect at the beginning of 2018. The relationship between LIBOR and SIFMA has yet to fully normalize following the change in the corporate tax rate, with tax-exempt LIBOR based direct purchase bonds seeing tax factors hovering around 80% of 1M LIBOR while SIFMA-based tax-exempt VRDBs remain closer to 70% of 1M LIBOR. This mismatch in tax factor has resulted in a relative advantage for many issuers with borrowings utilizing an instrument that proxies SIFMA. Additionally, SIFMA’s typical April (tax season) volatility remains common.
Inflows/Outflows to Muni Funds
Muni fund inflows have been positive since the beginning of the year, following a consistent period of outflows at the end of 2018. This increased demand for municipals along with the previously discussed declines in long-term interest rates have combined to create a very strong borrowing environment for issuers in 2019. Although it’s difficult to conclusively predict how long this positive market climate will last, borrowers with potential capital plans on the horizon should carefully consider how current market trends may impact their financing strategies.
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About the author:
Brandon Lippold – Associate.
Brandon provides financial modeling, analytics, market data and research in support of the delivery of capital planning, debt and derivatives advisory and reinvestment services to Blue Rose clients. He holds a bachelor’s degree in financial management from the University of St. Thomas and is a Series 50 licensed municipal advisor representative.
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Comparable Issues Commentary
Shown below are the results of two negotiated, tax-exempt private higher education issues from the State of Indiana that sold in the month of June. Butler University and DePauw University priced their bond issues on June 18th and 19th, respectively. Both issues carried a single rating at the A3/A- level: Butler with a A-/stable outlook from S&P and DePauw with a A3/negative outlook from Moody’s. DePauw issued its Series 2019 bonds as a pure refunding issue, with the bonds serving to current refund the University’s outstanding Series 2009A and 2009B bonds. Butler’s issue also carried a refunding component, refinancing the note that funded the renovation of Hinkle Fieldhouse as well as an outstanding line of credit – however, unlike DePauw, Butler also incorporated new money projects in its 2019 borrowing. These include construction of a new academic building for the School of Business and a new atrium that will house science departments and the science library, along with renovation of existing halls and other miscellaneous capital improvement projects.
Both deals priced into a market that has remained strong for municipal borrowers. On Butler’s pricing date of June 18th, while MMD was relatively stable (unchanged from 2020-2030 and reduced by just 1 bp from 2030-2049), a rally in Treasuries provided strong momentum for the marketing of the bonds. DePauw, pricing a day later on the 19th, also entered the market at a stable time, with MMD completely unchanged that day from prior levels.
Butler’s issue was structured with a 25-year final maturity (2044), with DePauw’s set at a slightly shorter 20 years in 2039. The debt service structures of the two deals differed as well, with Butler using a level debt service structure from 2021-2039 before a step-down for the final 5 years of maturities resulting from the shorter duration of the refunding components of the deal. DePauw, meanwhile, had a fully serialized structure with two relatively level debt service terms from 2020-2022 and 2033-2039 (although debt service steps up by approximately $1.25M/year in the latter range) and an interest-only block in the middle of the curve from 2023-2032.
Each university structured its bonds with a standard 10-year par call option, and both opted for similar couponing choices as well, with a significant percentage of callable maturities for both deals sold with 4% coupons. DePauw used just one callable 5% maturity, which priced at a spread to MMD of 70 bps – in comparison, its callable 4% maturities priced at spreads of 98-100 bps, roughly 28-30 bps above the 5% maturity. Butler elected to concentrate its 4% maturities later on the curve, with 5% maturities used on the shorter callable maturities. The University’s 5% callable maturities priced at spreads ranging from 45 bps in 2029 up to 56 bps in 2035 – in comparison, spreads on its 4% maturities ranged from 79 bps up to 83 bps on the 2044 term maturity, a gap of 23-27 bps from the last 5% coupon maturity in 2035.
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Interest Rate Charts
