For the first time in months, the main story in U.S. markets centered on the bond market rather than the stock market. A wave of U.S. government bond selling in February drove yields to their highest levels since before the pandemic and cast doubt on investor expectations of long-term bond yields staying “lower for longer.”1 Federal Reserve (Fed) officials noted the sell-off was likely prompted by heightened expectations for economic recovery in the coming year, as coronavirus vaccine distribution continues and economic stimulus appears likely within the coming weeks.2
The fixed income sell-off was not limited to government bonds; U.S. municipal bonds also saw yields rise dramatically. While AAA Municipal Market Data (MMD) yields inside of the 2-year tenor experienced single-digit increases, yields from the 3- to 7-year tenors advanced by 19 to 39 basis points (bps). Beyond the 7-year tenor, yields increased by 40 to 42 bps, with the 10-year tenor closing the month at 1.14%, its highest level since May 2020.3 Although weekly municipal fund flows remained positive through February, there were hints of a potential end to the nearly year-long inflow cycle in the month’s final weeks, as municipal ETFs and tax-exempt money market funds each reported outflows.4 $31.5 billion of total municipal debt came to market in February, just a 9% increase over January’s $29.0 billion. However, $11.8 billion of February’s total issuance figure was taxable, representing a 21% month-over-month increase.5 *
- While no Federal Open Market Committee (FOMC) meeting was held in February, some Federal Reserve officials commented on the month’s flurry of activity. Fed Bank of Atlanta president Raphael Bostic had this to say on the bond market selloff: “[Long-term bond yields] have definitely moved at the … longer end, but right now I’m not worried about that … I’m not expecting that we’ll need to respond in terms of our policy.” On the overall state of the U.S. economic recovery, New York Fed leader John Williams noted: “Despite the near-term challenges, the longer-term outlook for the economy has improved … [The Fed is] fully committed to supporting the economy through this period.” Mr. Williams also remarked that economic growth in 2021 has the potential to be the “strongest we’ve seen in decades.”6
- As municipal bond yields rose, prices fell and left munis in the red for the month of February. The Bloomberg Barclays Municipal Bond Index returned -1.59% in February, while the Bloomberg Barclays High Yield Municipal Bond Index was down 1.05%. The Bloomberg Barclays Taxable Municipal Index posted a 1.94% loss.7
- Despite falling to historic lows midway through February – the 10-year ratio dipped as low as 54.6% – municipal/Treasury ratios closed the month at higher levels than January. At February month-end, ratios equated to 150% at the one-year tenor (up from 113%), 74% at the five-year tenor (up from 50%), 79% at the 10-year tenor (up from 67%), and 82% at the 30-year tenor (up from 75%).8
- Secondary market trade volume increased by 4.5% in February after a relatively quiet January. February trades totaled nearly 649,000 (up from ~621,000 in January) while par traded amounted to $192 billion (up from $173 billion).9
Muni technicals in focus: Fixed income market jitters impact municipals
Rising rate and inflation expectations rattled fixed income markets in February, as the continued vaccine rollout, pent-up consumer demand, and the growing prospect of additional federal stimulus spurred fears of an overheating economy. At its February peak, the 10-year breakeven rate climbed to 2.24%, its highest point since August 2014.10 Real bond yields surged, as the 30-year TIPS yield climbed into positive territory by mid-month and reached a high of 0.22% – the highest real yield since March 2020.11 Driven in part by an under-bid 7-year note auction, the 10-year Treasury yield ascended ~40 bps over the month, breaching 1.5% for the first time since last February.12 13 With investors scrutinizing inflated valuations – particularly in growth names – equities dipped in tandem with fixed income during the latter half of the month, while commodities rallied on their inflation-hedging properties.14 Although the Fed attempted to quell concerns, signaling no short-term plans for tapering or monetary tightening, Fed funds futures priced in a January 2023 rate hike by month-end.15 16
For municipals, the first half of the month was largely a continuation of January. Strong demand, coupled with relatively low issuance, continued to push municipal yields downward while municipal credit spreads continued to tighten. By mid-month, the 10-year municipal/Treasury ratio had sunk to a record low of ~54.75%.17 However, on February 16, municipal yields sharply reversed course and began tracking Treasury yields upward. Municipal yields rose 36-46 bps across the curve, and the 10-year AAA municipal yield closed the month at 1.14%, its highest level since May.18 Following January’s positive return, the Bloomberg Barclays Municipal Bond Index returned -1.59% in February, the lowest return since March 2020. As municipal credit spreads were stagnant over the latter half of the month, the Bloomberg Barclays Municipal High Yield Index posted a slightly more favorable -1.05% return, its lowest since April.19
Despite negative performance, strong municipal market technicals generally persisted over the month. While new issuance of $30.61 billion surpassed last month’s $24.02 billion, supply fell more than $11.5 billion short of last February.20 Demand remained robust, as retail investors contributed ~$6.22 billion to municipal funds in February, although the final week of the month saw only a $38 million inflow after nine consecutive weeks of $1+ billion inflows.21 Citigroup projects that municipal reinvestment capital will outweigh new sales by $4.9 billion in March, a noteworthy decline from Citi’s $13.4 billion estimate for February.22Although the 10-year municipal/Treasury ratio has risen from its mid-month nadir to ~78.75% at month-end, this figure is reminiscent of levels at the start of the year, and municipal valuations remain elevated relative to Treasuries.23
February’s most notable credit event was the severe weather event that hit much of the South and caused widespread damage in Texas. The winter storm appears likely to be the costliest natural disaster in Texas’ history given that all 254 counties in the state were affected, unlike most natural disasters where damage tends to be more localized.24 We expect the event to have minimal impact on credit quality for Texas municipal issuers given both expected FEMA reimbursement for storm-related expenses and the fact that most high quality local governments in Texas benefit from strong cash reserves and ample margin underneath state-imposed property tax limitations, providing the flexibility to respond to unexpected costs. Additionally, we would expect Texas, with its ample rainy-day fund, to be well-positioned to not only cover its own costs, but to potentially assist other municipal issuers affected by the storms.
The portion of the municipal market that has attracted the most attention following the storm is public power utilities. Texas’ grid operator, the Electric Reliability Council of Texas (ERCOT), was forced to shut down wide swaths of the state’s power grid to protect the system from collapsing, ultimately leaving millions of customers without power for days during frigid conditions. Given the massive imbalance between power supply and demand caused by outages at generators throughout the state, coupled with the storm’s impact on natural gas deliveries, prices on the ERCOT market spiked to $9,000 per megawatt hour from just $30 prior to the event, leaving many utilities with massive bills for purchased power.25 Notably, these price hikes affected power customers in states beyond Texas. We anticipate high quality utilities will manage through this stress through combinations of utilizing available liquidity, seeking short-term external liquidity such as lines of credit, or even issuing long-term debt to amortize the costs over longer periods. Nonetheless, we continue to closely monitor the sector for potential signs of distress. In the final week of February, we witnessed ratings agencies S&P and Fitch move all Texas utilities that are ERCOT members to Negative Watch, under the expectation that their financial profiles may weaken as they take on additional leverage or spend down available cash. This move increases the probability of downgrades in the near- to medium-term future.26
In February, the U.S. House also passed the Biden administration’s $1.9 trillion COVID relief bill, which was signed into law in March. The relief package includes $350 billion of aid to state and local governments, which provides much-needed needed stimulus to issuers throughout public finance and could help stave off a wide array of state and local spending cuts.
To learn more about investing in municipals at PIMCO, please visit pimco.com/munis