In the current market landscape, one thing that is hard to argue is the very clear shift by global central banks toward a more hawkish sentiment. While there still could be an argument about the impacts of demographics and other structural forces on long-term rate expectations, the prospect remains for near-term volatility in fixed income markets.
The pivot by the Fed, beginning in December of last year, has been replicated by the BOE and, more recently, a surprise change of language by the ECB. Even the BOJ has allowed rates to get to the upper end of their target.
With the continued short-term inflationary pressures taking hold and central banks new willingness to fight them, we have seen the global basket of negative yielding debt fall significantly, now the lowest since 2015, to $4.7trln down from $14.1trl in late December.
Source: Bloomberg Global Agg Negative Yielding Debt Market Value, USD BNYDMVU Index.
During this low-rate regime, we have seen across the globe over the last few years, municipal issuers have smartly turned to lower coupon debt structures. With the insatiable demand for tax-free yield and the one-way street to tighter spreads, from 2nd qtr 2020 through 2021, investors snatched up these lower coupon bonds in record numbers without much concern for what happens when/if rates were to turn higher.
If you have had a conversation with our team, you know how important we believe it is to maintain the highest average coupon we can, targeting an average coupon rate across our intermediate strategies of at least a 4.75%. Higher coupon rates not only generate a greater level of re-investable income, but also provide greater defense against rising interest rates.
Lower coupons carry a higher level of market risk and can see large, quick adjustments to their duration characteristics. With the market having moved toward a lower coupon structure as a whole, we feel it is more important than ever to understand your downside risk in a volatile fixed income market.
Source: Bloomberg Municipal New Issue Pricing, Siebert Williams Shank.
“In an uncertain future, one thing we can continue to control is the level of defense we provide to our client portfolios.”
— KYLE GERBERDING
Using the ICE Muni Broad Index, we have seen the overall market-weighted average coupon drop from a 4.81% in February 2018 to a 4.71% in 2019, 4.64% in February 2020, 4.58% last year, and down to an average of 4.42% today.
Coming into this year, we felt stronger than we have in a long time about the firmness of municipal credit, and could agree with the market sentiment of tight credit spreads and the value of the additional carry that some lower-rated issuers provided. However, we could not find the value in reaching down in coupons, lowering our average premium, and taking on more market risk at record tight coupon spreads at record low ratios vs. taxable counterparts.
The volatility in January was a great reminder of how quickly retail fund flows can adjust our market, with the same large funds that were buying any and all the issuance they could get their hands on becoming the ones that had to sell into a down market.
This quick change in sentiment created a stated (MMD) spread widening of 15 bps on 3s vs. 5s with bid-side in secondary much weaker than that. We have seen deals priced last year as sub-3s quickly drop to discount dollar prices, which brings a slippery slope of dwindling bidders and the risk of de minimis taxation into the picture.
Source: ICE, TM3 pricing.
In an uncertain future, one thing we can continue to control is the level of defense we provide to our client portfolios.
Our focus remains on positions that we feel should perform well in all markets, provide a firm ballast in down periods, and most importantly, do so without forfeiting fair market liquidity.
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