Market Review as of 06/30/2015

The U.S. municipal bond market (as represented by the Barclays Municipal Bond Index1) posted negative returns in each of the three months of this year’s second quarter. While municipal bond supply remained ahead of the prior year’s pace, rising interest rates have reduced refunding activity and new-money issuance lagged that of last year.

Individual investor demand was volatile throughout the quarter, as investors were concerned about the impact that Federal Reserve monetary policy decisions might have with regard to the timing and magnitude of prospective interest-rate hikes. Shorter maturities outperformed their longer-dated counterparts, causing the yield curve to steepen, as longer interest rates rose more during the quarter, following the trend in the treasury market.

In the second quarter, bonds in the lower investment-grade and high-yield categories underperformed higher-rated bonds, which was a reversal from the first quarter. However, the high-yield municipal market was heavily impacted by the negative returns of Puerto Rico bonds, which suffered late in the quarter from uncertainty surrounding the commonwealth’s ability to continue servicing its debt. Otherwise, overall credit quality remained stable in an economic environment marked by steady growth and low inflation.

High-profile issuers, such as Illinois, Puerto Rico, and New Jersey, continued to remain in the spotlight during the past quarter, as unexpected downgrades, struggles over pension issues, and political constraints caused budget-balancing activities to remain challenged. Puerto Rico continued to receive outsized attention, as remarks made by Puerto Rico Governor Alejandro Garcia Padilla, on June 29, suggested that the Commonwealth’s $72 billion in debt was “unpayable.” Consequently, the municipal market experienced significant repercussions in the following day’s trading session. As of the end of the second quarter, the future direction of Puerto Rico’s financial situation remained uncertain. Despite these pockets of distress, overall creditworthiness continues to improve, as most states’ finances experienced rising revenues and maintained balanced budgets. 


During the second quarter, increased interest-rate volatility—caused by investors’ concerns regarding the timing and magnitude of future interest-rate hikes by the U.S. Federal Reserve—posed challenges to the municipal market. While demand remained relatively strong during the first quarter, the second quarter showed a reversal, with subdued investor demand for credit risk and a willingness to extend out in maturities. While it is possible that this trend will continue until investors become more comfortable with the interest-rate environment at hand, municipal yields continue to provide investors with compelling taxable-equivalent income in a low interest-rate environment, and historical default rates remain low. Although supply persisted at a relatively high level through the first quarter of 2015, the majority of issuance was for refunding purposes, as municipalities refrained from issuing debt for new projects in the second quarter, as longer interest rates rose. Going forward, the volume of supply likely will depend on the direction of future interest-rate moves.

Recently, Treasury bonds have outperformed municipal bonds, as Greeks rejected proposed austerity measures in their referendum vote, which triggered a flight to quality. However, if global macro events are contained, municipals could outperform Treasuries going forward, due to slowing new-issue supply and strong overall credit quality. While lower-rated bonds have posted strong returns in past years, credit-quality trends suggest that despite the reversal in the second quarter, lower-quality bonds could outperform in the quarters to come, as demand for incremental yield in a low interest-rate environment and steady economic growth have supported credit quality of municipal issuers. While the pace and the magnitude of interest-rate changes will determine which maturities could outperform in the upcoming quarters, it is likely that longer maturities will outperform, as longer bonds may provide a significant income advantage to investors, given the recent steepening of the yield curve.

With respect to the financial health at the state level, it is important to distinguish between the isolated fiscal challenges and the strong overall health of states. Many states with rising revenues and effective fiscal management have continued to balance their budgets. While a few high-profile issuers, such as New Jersey and Illinois, are hampered by challenges, such as pension reform and funding of pension liabilities, it is important to focus on overall creditworthiness, which is expected to remain strong. With respect to Puerto Rico, it appears that there are several different scenarios that might unfold, and potential outcomes may differ by issuer within the commonwealth. It is noteworthy that the situation in the commonwealth is very different from the rest of the market, which can be seen in the performance of the broader municipal market in spite of Puerto Rico woes. The market has differentiated between the two, and it is expected that such differentiation will continue. 

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