Municipal Market Insight

Municipal Market Insight

November 2019

What's inside

2 Market investment strategy & market commentary

4 This month's focus: Municipal default risk ? The sky is not falling

5 Territorial update 6 State news 7 Regional updates and other

market news

Click here for authors' contact information.

Investment and insurance products offered through RBC Wealth Management are not insured by the FDIC or any other federal government agency, are not deposits or other obligations of, or guaranteed by, a bank or any bank affiliate, and are subject to investment risks, including possible loss of the principal amount invested.

Disseminated: Nov 7, 2019 9:00ET Produced: Nov 6, 2019 15:21ET

Portfolio Advisory Group ? U.S. Fixed Income Strategies

Got losses?

If so, with just about every asset class posting gains for the year, your portfolio would be the exception. Year-to-date through October, the S&P 500 is +23.16%, U.S. Treasuries are +7.78%, investment-grade corporates are +13.89%, and municipals are +6.94%. With so few, if any, portfolio losses in 2019, this creates a conundrum for investors as this is typically the time of the year when we recommend scouring portfolios with an eye toward harvesting losses to offset portfolio gains.

This year, for a change of pace, we think muni investors should consider a year-end portfolio "tune-up." Strategies we recommend include:

? Cross-asset class swaps: As muni yields remain near all-time lows, consider taking advantage of higher yields in taxable fixed-to-floating rate preferred securities.

? Cash flow extension swaps: In a low rate environment, call risk increases with issuers more likely to exercise call features. Selling these issues and buying bonds with longer call protection offers protection against reinvestment risk.

U.S. Treasury rate forecasts (% as of October 31, 2019)

2019

2020

31-Oct

Q4E

Q1E

Q2E

Q3E

FF

1.625

1.625

1.625

1.625

1.625

2-yr

1.52

1.50

1.60

1.65

1.70

5-yr

1.52

1.50

1.60

1.65

1.85

10-yr 1.69

1.50

1.70

1.85

2.00

30-yr 2.18

1.95

2.10

2.25

2.40

Source - RBC Economics

Q4E 1.625 1.70 1.95 2.10 2.45

Treasuries vs. municipals

Beginning of month (10/1/19) Mid-month (10/15/19) End of month (10/31/19)

5-yr TSY 1.49% 1.60% 1.52%

5-yr Muni 1.22% 1.13% 1.15%

10-yr TSY 1.64% 1.77% 1.69%

10-yr AAA Muni

1.41%

1.41%

1.49%

30-yr TSY 2.09% 2.24% 2.18%

30-yr AAA Muni

2.00%

2.01%

2.06%

Source - Bloomberg (Treasury), Thomson Reuters TM3 (Municipals)

2 | Municipal Market Insight

? Upgrade portfolio quality: Sell lower-quality issues and buy higher-quality bonds. Many investors have reached for yield recently, but we think now is the time to play defense by focusing on quality.

The Federal Reserve cut rates by 0.25% in October, the third reduction in as many meetings. We think the long-awaited pause in rate cuts may be in place, but it could be a short-lived stint on the sidelines because even if there is a surprise trade resolution, that may not be enough to reverse the slowing economy in the short term. As a result, investors should expect the "lower-for-longer" interest rate environment to continue for the foreseeable future.

The muni market experienced wild swings in October as issuance surged over $52 billion ...

Market investment strategy & market commentary Market performance ? A blitz in issuance erases early October gains

The muni market experienced wild swings in October as issuance surged over $52 billion, which will likely be revised up when month-end final deals are tabulated. Driving issuance the past few months has been an increase in taxable bonds, which began in August when low taxable yields presented an issuers with an opportunity to "advance refund" tax-exempt debt. A majority of this year's taxable $46.2 billion issuance was sold in the period August through October and is almost double the $24.4 billion issued during the same period last year. With two months remaining in 2019, issuance will top RBC Capital Markets' full-year projection of $341 billion during the first week of November, based on the approximately $14 billion scheduled for the week.

2019 Projected supply vs. redemptions ($ billions)

$60B $50B

2019 Projection 2019 Actual 2018 Actual

$40B

$30B

$20B

$10B

$0B JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC

Source - RBC Capital Markets

After the muni market rallied in the first week of October following September's negative returns, October trended negative for most of the month before eking out a slight positive return to end the month. The surge in October issuance drove muni yields upward as investors demanded higher returns amid the robust inventory, causing issuers to adjust yields to primary market offerings. Throughout the recent surge in issuance, demand has continued to support the muni market, providing a barrier to runaway higher yields, especially with the year-end rapidly approaching.

Over the last 43 consecutive weeks, investors have added $52.4 billion to muni funds that report weekly; when including inflows to muni funds that report monthly, investors have poured more than $74 billion into muni funds in that period. With two months to go in the year and average weekly inflows of around $1.2 billion, muni funds appear to be on track to break 2012's record of $80 billion of total inflows to these funds.

November 2019 | RBC Wealth Management

3 | Municipal Market Insight

2019 muni fund flows

$3,000M

Ultra-short

$2,000M

$1,000M

$0M

-$1,000M

-$2,000M

Intermediate

High-yield

Long-term

Jan 02 Jan 16 Jan 30 Feb 13 Feb 27 Mar 13 Mar 27 Apr 10 Apr 24 May 08 May 22 Jun 05 Jun 19 Jul 03 Jul 17 Jul 31 Aug 14 Aug 28 Sep 11 Sep 25 Oct 09 Oct 23

Munis erased a -0.10% monthly return by gaining 0.28% on the last trading day to end October with a +0.18% return.

Source - Lipper U.S. Fund Flows, Refinitiv, RBC Wealth Management; weekly data through 10/30/19

This month's unexpected performance After getting off to a strong start in October following September's poor performance, munis sold off throughout the month before rallying on the final trading day of the month. Munis erased a -0.10% monthly return by gaining 0.28% on the last trading day to end October with a +0.18% return.

Bloomberg Barclays indexes

1.50% 1.00%

Municipal

0.50%

0.00%

Corporate

Treasury

0.61%

0.18% 0.07%

-0.50%

-1.00%

-1.50% 10/01/19

10/08/19

10/15/19

10/22/19

10/29/19

Source - Bloomberg Barclays; data through 10/31/19

Through October 31, the Bloomberg Barclays Municipal Bond Index has returned +6.94% year-to-date, trailing the performance of both the Bloomberg Barclays Treasury Index (+7.74%) and the Bloomberg Barclays Corporate Bond Index (+13.89%), with two months of performance remaining this year.

Muni market may weaken under weight of surging issuance calendar Looking ahead, we expect a continuation of the trend of issuing taxable bonds to "advance refund" tax-exempt debt, at least through the remainder of the year and possibly extending into Q1 2020. Investors with "dry powder" should focus their attention on high-grade municipal bonds with higher coupons and, more importantly, extended call protection in light of recent refunding trends.

November 2019 | RBC Wealth Management

4 | Municipal Market Insight

Despite the longest economic expansion in modern history, many municipalities are facing fiscal pressures caused by constrained revenue growth and swelling costs ...

November 2019 | RBC Wealth Management

This month's focus ? Municipal default risk: The sky is not falling The municipal market was jostled by Detroit's bankruptcy in 2013 and then shaken to its core when Puerto Rico stopped paying its debts beginning in 2015. The magnitude of Puerto Rico's bankruptcy coupled with the breadth of impact on investors forced the muni market to re-evaluate the sector's risk profile. No longer could municipal debt be universally considered virtually riskless, or that fallen angels automatically signaled screaming buys.

Despite the longest economic expansion in modern history, many municipalities are facing fiscal pressures caused by constrained revenue growth and swelling costs--most notably pension obligations, and unfavorable demographic trends. More troubling, the stigma of municipal bankruptcy appears to have weakened, and there are hordes of professionals eager to advise municipal officials about the political expediency of attempting to foist losses on bondholders--security protections notwithstanding.

As a result of these circumstances, the frequency of municipal defaults has increased since the beginning of the Great Recession. According to Moody's Investor Services, in its rated universe, 48% of the 113 municipal defaults that occurred over the past 48 years (1970?2018) happened in the past 11 years, including 83% of the 29 general government defaults.

But the sky is not falling, in our opinion. Municipal defaults make for good news fodder because they are such infrequent events. Every day tens of thousands of municipalities fulfill their duties, including unquestioningly honoring their debt obligations. Unfortunately, the modest number of municipal defaulters has recently swung the perceived risk pendulum too far in comparison to the roughly 30,000 municipal debt issuers in the $3.8 trillion muni market that faithfully honor their obligations.

Relative risk The simple fact is municipal defaults historically have been extremely rare, and general government defaults have been even more so. To hammer home this point, over rolling 10-year periods between 1970 and 2018, the default rate of municipal issuers that were rated investment grade by Moody's at the start of the 10-year period was only 0.10% during the 10 years, while the default rate of general government issuers was a paltry 0.05%! For a relative comparison, the default rate of investment-grade corporate bonds was 2.3% over the same rolling 10-year time periods.

Municipal vs. corporates: average cumulative default rates, 1970-2018

5-year history

10-year history

Rating

Municipal Corporate Difference Municipal Corporate

Aaa Aa A Baa Ba B Caa Investment-grade Speculative-grade

0.00% 0.01% 0.03% 0.48% 2.03% 12.50% 20.90% 0.04% 5.05%

0.08% 0.29% 7.20% 1.52% 7.91% 20.66% 34.02% 0.89% 18.43%

0.08% 0.28% 7.17% 1.04% 5.88% 8.16% 13.12% 0.85% 13.38%

0.00% 0.02% 0.11% 1.13% 3.65% 17.91% 25.75% 0.10% 7.47%

0.37% 0.78% 2.10% 3.70% 15.48% 34.30% 48.20% 2.28% 28.79%

Source - Moody's Investors Service

5 | Municipal Market Insight

Another way to think about the relative risk is A-rated muni bonds defaulted exponentially less than AAA-rated global corporate bonds over the rolling 10-year periods between 1970 and 2018! Admittedly, the small AAA-rated sample size may skew the data, but this is still a thought-provoking statistic nonetheless.

But as mentioned earlier, the recent circumstances faced by municipalities have led to an uptick in defaults. Regardless, the incidence of default is still nominal even considering a time period when both Detroit and Puerto Rico defaulted.

Building off last year's momentum, the commonwealth reported it collected $2.8 billion of revenue for Q1 FY2020.

Territorial update Puerto Rico updates

PREPA ? Floats $20 billion plan Puerto Rico Electric Power Authority (PREPA) Executive Director Jose Ortiz, along with Puerto Rico Governor Wanda V?zquez, announced a $20 billion plan to overhaul the island's electric grid system. The plan is projected to take 10 years to implement and is expected to be funded with federal and private funds. PREPA came under fire recently when it announced a rate increase of between $0.64 and $1.79 per month, beginning November of this year. The governor announced her opposition to the rate hikes.

PROMESA board ? Challenge rejected The U.S. Supreme Court left intact a lower court ruling that said holders of the commonwealth's $2.9 billion of pension obligation bonds have collateral in the bonds. The PROMESA fiscal oversight board argued that bondholders had used an improper legal name in court filings and therefore the lien held by bondholders was not immune from being contested. The Supreme Court disagreed with the PROMESA board's decision.

Replacement hospital still awaiting FEMA funds More than two years after Hurricane Maria decimated a remote island hospital, FEMA has not approved replacement funds for the hospital. Approximately 9,000 residents depend on the hospital for treatments that include dialysis, dentistry, and basic care. FEMA and Puerto Rico officials have said they remain in talks to secure the funding.

Revenue ahead of projections Building off last year's momentum, the commonwealth reported it collected $2.8 billion of revenue for Q1 FY2020 (July through September), beating government projections by $485 million. This trend could lead to a similar outcome as last year when the commonwealth collected $1.1 billion more than expected. The revenue surge in FY2019 was driven by the island's economy, which grew 4%, according to the PROMESA oversight board.

U.S. officials urged to reject PROMESA proposal Ra?l Grijalva (D), who chairs the U.S. House of Representatives Natural Resources Committee, is proposing changing the PROMESA law to allow the commonwealth to "discharge" its unsecured debt once every seven years. The executive director of the PROMESA board and the head of the Puerto Rico Fiscal Agency and Financial Advisory Authority urged congressional representatives to not support the proposal. They argue it would cause lenders to likely demand more security from the commonwealth in order to lend money.

U.S. Virgin Islands ? Junk rating withdrawn On October 24, S&P withdrew its junk rating on the Virgin Islands Port Authority revenue bonds. The rating was pulled because the authority failed to provide S&P with timely information to maintain the rating.

November 2019 | RBC Wealth Management

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