Municipal Market Insight - RBC Wealth Management

Municipal Market Insight

January 2023

Portfolio Advisory Group ? U.S. Fixed Income Strategies

What's inside:

2 Market investment strategy & market commentary

3 This month's focus Two important updates

5 Municipal news

4 Ratings corner Notable state and local issuer rating updates

5 Territorial updates

Fixed income markets' challenging year ends

December was a difficult end to a difficult year for fixed income. Bond yields-- which move in the opposite direction of prices--were higher across the Treasury curve in December, with the 10-year yield increasing by 0.26% and the 2-year yield higher by 0.13%. Corporate bonds in general underperformed their U.S. government counterparts, with yields rising at a faster clip among lowerrated corporate issuers. We believe the selling pressure was driven primarily by flows from short-term traders and year-end positioning shifts, with the price moves exacerbated by a holiday-driven drop in liquidity.

Looking at 2023, we believe conditions are, in general, positive for fixed income, as we expect slowing economic activity to help rein in inflation, allowing the Federal Reserve to move away from restrictive policy. Interest rate futures indicate a shift to rate cuts is likely by mid-2023 and, if that materializes, we believe it would be a positive for bond prices. Key to this view is demonstrated progress on inflation, and we believe Treasury bonds will continue to be very sensitive to inflation and employment data in the near term.

U.S. Treasury rate forecasts (%), December 2022

FF 2-yr 5-yr 10-yr 30-yr

Q1 0.38 2.28 2.42 2.32 2.44

2022

Q2

Q3

1.63

3.13

2.92

4.22

3.01

4.06

2.98

3.83

3.14

3.79

Q4E 4.38 4.15 3.90 3.60 3.60

Q1E 4.63 3.95 3.65 3.35 3.40

Source - RBC Economics

2023

Q2E

Q3E

4.63

4.38

3.55

3.05

3.30

2.95

3.15

2.95

3.25

3.10

Q4E 4.13 4.00 2.60 2.75 2.90

Treasuries vs. municipals (%)

For important disclosures and authors' contact information, see page 9.

Beginning of month (12/1/22) Mid-month (12/15/22) End of month (12/31/22)

5-yr TSY 3.67% 3.62% 4.01%

5-yr Muni 2.53% 2.43% 2.52%

10-yr 10-yr 30-yr 30-yr TSY AAA Muni TSY AAA Muni 3.61% 2.61% 3.60% 3.48% 3.45% 2.47% 3.50% 3.42% 3.88% 2.63% 3.97% 3.58%

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

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.

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Municipal Market Insight, continued

Despite the rise in Treasury yields during December, the dollar index declined by 2.3% during the month, as yields rose even more quickly on bonds issued by major U.S. trading partners. The potential for an earlier shift to rate cuts in the U.S. acts as a headwind to currency appreciation, as overseas investors may look to repatriate funds into their own domestic currency bonds.

Market investment strategy & market commentary

Municipals eke out a narrow gain to end the year

Overall, 2022 proved to be a very challenging year for fixed income markets as economic concerns, inflation, and aggressive rate tightening action by the Fed left many investors on the sidelines. After getting off to a strong start in December, investor concerns over the Fed's next rate hike helped erase gains earlier in the month. After peaking at 1.09% on Dec. 16, municipals ended the month giving back 0.80%. The news was not all bad, municipals returned 0.29% in December, their second consecutive month of positive returns and only the fourth time they posted positive returns in 2022. Municipals ended the year returning -8.53%, outperforming both their Treasury and corporate bond counterparts, which returned -12.46% and -15.76%, respectively.

Taxable municipals underperform alongside taxexempts Taxable municipals finished December down about 2.4% after Fed Chair Jerome Powell's comments during his December press conference were more hawkish than expected as policymakers believe the battle against inflation is far from over, driving the terminal rate north of 5%, also referred to as the peak fed funds rate. According to the Bloomberg Taxable Municipal Bond Index, taxable muni yields rose about 30 basis points in December to 5.29%, the largest monthly advance since October 2022,

Bloomberg index returns

Jan-22 Feb-22 Mar-22 Apr-22 May-22 Jun-22 Jul-22 Aug-22 Sep-22 Oct-22 Nov-22 Dec-22

0%

-5% -10% -15% -20%

-8.53 -12.46 -15.76

-25%

Municipals

Corporates

Treasuries

Source - RBC Wealth Management, Bloomberg; data through 12/31/22

while yield spreads over Treasuries narrowed by about 10 basis points for the month.

While taxable municipals were one of hardest hit sectors in 2022, we expect relatively attractive performance potential this year given our view that rates are on the path lower throughout the remainder of this Fed cycle.

What led to 2022's weak performance?

The fixed income markets experienced a challenging year, one driven by multiple factors that contributed to weak performance. Investors either remained on the sidelines or in many cases chose to exit their fixed income holdings on inflation fears, the Fed's aggressive interest rate policy, and geo-political uncertainty. These factors drove investors to withdraw in excess of $81 billion from municipal bond funds, according to Refinitiv data. A 16.5%

Recent municipal fund flows

$2,000M

Ultra-short Intermediate

$1,000M

$0M

-$1,000M

-$2,000M

-$3,000M

-$4,000M

-$5,000M

-$6,000M

High-yield

Long-term

Jan-05 Jan-19 Feb-02 Feb-16 Mar-02 Mar-16 Mar-30 Apr-13 Apr-27 May-11 May-25 Jun-08 Jun-22 Jul-06 Jul-20 Aug-03 Aug-17 Aug-31 Sep-14 Sep-28 Oct-12 Oct-26 Nov-09 Nov-23 Dec-07 Dec-21

Source - Refinitiv Lipper U.S. Fund Flows, RBC Wealth Management; weekly data range: 1/5/22?12/28/22 January 2023 | RBC Wealth Management

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Municipal Market Insight, continued

or $76 billion drop in issuance did not provide enough demand to offset the $81 billion of cash that exited municipal bond funds, which drove yields higher and bond prices significantly lower. The tide began to change near the end of the year amid attractive yields and prices, which drove improved demand, in turn causing municipals to end November and December with positive returns, helping to offset the year's significant losses.

Tax-exempts off to a solid start in January Municipal bonds are off to a good start in 2023, and we expect the market to post gains this month on the back of light new issue supply and historically strong demand during January as investors typically have fresh coupon and principal payments to reinvest. State and local governments are projected to return $20 billion of principal and pay $13 billion in interest payments to investors this month, while new issue supply volume over the next 30 days stands at about $3.6 billion after averaging around $9.8 billion during 2022.

As illustrated by the chart below, the municipal market in January has posted positive returns 75% of the time over the last 20 years driven by typically light supply and elevated demand.

Issuance to remain in line with 2022 figures An attractive yield environment combined with RBC Capital Markets' issuance projections of $385 billion ($313 billion new money; $40 billion refunding activity; and $32 billion of combined refunding and new money) this year should provide support for improved investor demand, which we expect will drive yields lower and municipal bond valuations higher amid tighter supply metrics, leaving cash-rich investors with reduced alternatives in the municipal market. We believe the municipal market is poised to post solid gains this year, following last year's dismal performance.

This month's focus: Two important updates

Focus 1: Puerto Rico Electric Power Authority ? Formal debt restructuring released

The Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) Oversight Board-- as representative for the Puerto Rico Electric Power Authority (PREPA)--submitted its formal restructuring plan with the bankruptcy court on Dec. 16, 2022, after years of tentative agreements and court-ordered mediation proved fruitless. This latest restructuring plan is less generous than previous proposals, which we believe could lead to further infighting and confirmation delays.

The restructuring plan offers uninsured bondholders the option to consensually accept the debt restructuring proposal or opt to continue litigating bondholders' security lien and recourse rights.

Bondholders are arguing that they have a continuing lien on the utility's future net revenues, whereas the Oversight Board disputes this lien claim. The Oversight Board contends that even if bondholders have a valid lien, it is only on amounts on deposit at the commencement of the bankruptcy proceedings and not on future revenues. Since there is only about $16 million available on deposit, the outcome of this litigation will have a material influence on recovery values.

Plan coaxes settlement The restructuring plan is structured to incentivize bondholders to accept the debt restructuring proposal. Uninsured bondholders that accept the proposal would receive at least 50% principal recovery in the form of new PREPA bonds and a small cash payment plus up to an additional 50% principal recovery depending on the number of bondholders that settle--if the pending

Historical municipal performance in January over 20 year timeframe

3.66%

1.73%

0.94%

0.57%

0.27%

1.26%

0.52%

2.31% 1.95%

1.77%

1.19%

0.42%

0.66%

1.80%

0.76%

0.64%

-0.25%

-0.26%

-0.74%

-1.18%

-2.74%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Source - Bloomberg, RBC Wealth Management January 2023 | RBC Wealth Management

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Municipal Market Insight, continued

litigation is ruled in the utility's favor and if future electricity usage exceeds projections. The additional recovery would be in the form of new PREPA bonds and a Contingent Value Instrument (CVI).

Conversely, uninsured bondholders that do not settle will be exposed to a wider range of potential recovery values based on the outcome of the litigation. If uninsured bondholders prevail on both their lien and recourse challenges, principal recovery could be 100%--although highly improbable--but could be less than 1% if the Oversight Board prevails on both legal challenges.

Insured bondholders likely not to take a loss Insured bondholders should be held harmless assuming the bond insurers guaranteeing the debt remain financially viable over the long run. The bond insurers will assume any debt haircuts and are legally obligated to make insured bondholders whole to the terms of the original debt obligation.

PREPA bondholders believe restructuring plan is flawed The negotiating PREPA bondholder group, which includes some of the bond insurers, believes the debt restructuring plan is "deeply flawed" and "absurdly complex", and unlawfully solicits creditors prematurely. Furthermore, the group argues the plan relies on "a highly coercive, opaque structure designed to force individual bondholders" to make uninformed choices between different recoveries prior to a court-approved solicitation process.

The creditors also allege the Oversight Board wants bondholders to make a financial decision before the bankruptcy court approves the summary disclosure statement, before any plan-related discovery, and likely before the bankruptcy court rules on the security lien and recourse rights litigation, which are all necessary to make an informed decision.

The bondholder group also highlights the formal debt restructuring plan offers a much lower recovery compared to the Oversight Board's prior restructuring proposal that was offered only a few weeks prior. It also argues that the Oversight Board seems to believe that it can arbitrarily decide how much is an appropriate recovery without disclosing how much net revenue PREPA can fairly and equitably generate.

Not all Oversight Board members were onboard One Oversight Board member voted against the restructuring because he felt the plan treats bondholders unfairly and is based on flawed financial analysis that solves for a desired outcome to repay as little debt as possible.

New PREPA bonds and CVI The new utility bonds would be secured by PREPA's net revenues up to an amount equal to a flat monthly connection charge and an electric usage charge that would be added to PREPA's current electrical bills. The bonds would be structured with a 50-year final maturity although full repayment is projected to be 35 years. The new bonds could consists of one or a combination of current interest, capital appreciation, and/or convertible bonds with between 5.625% and 6.5% interest rates.

The Contingent Value Instrument would mature in 35 years and would pay only if the new PREPA bonds are fully repaid prior to the CVI's maturity date. Therefore, the CVI is truly contingent on the utility generating greater revenues than currently projected because the new PREPA bonds are estimated to be repaid in 35 years, which is the CVI maturity date.

Confirmation process The presiding federal bankruptcy judge may confirm the restructuring plan--formally known as the Plan of Adjustment (PoA)--if it complies with various requirements, including consistency with the certified fiscal plan, and it's feasible and in the best interest of creditors. Although bondholders will still be asked to vote, it is important to note that the plan can be crammed down on all creditors if the federal judge determines the plan meets the prerequisite criteria since at least one creditor group has already agreed to the restructuring plan.

A longer road ahead Bankruptcy and litigation are typically messy businesses, which is proving especially true for PREPA's debt restructuring. PREPA first defaulted on its debt obligation in July 2017 and bondholders have endured numerous fruitless debt restructuring proposals over the years.

We think the Oversight Board's formal debt restructuring plan is disappointing because it ostensibly offers significantly less recovery than one presented a few weeks prior, attempts to force bondholders to make uninformed choices, and pits bondholders against each other. We are hopeful that the negotiating bondholder group can persuade the bankruptcy judge to reject the formal restructuring plan, but acknowledge that bankruptcy proceedings are inherently unpredictable.

Focus 2: Texas Permanent School Fund (PSF) nears cap

The Texas Permanent School Fund (PSF) guarantees repayment of bonds issued by participating state school districts and charter schools. In the event of a default, which has never happened in the history of the program, bondholders are paid by PSF's financial assets totaling $56 billion as of August 2021.

January 2023 | RBC Wealth Management

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Municipal Market Insight, continued

PSF guaranteed bonds are rated Aaa/AAA/AAA based on strong management, a diverse creditworthy borrower pool, ample liquidity, and an excellent loan-to-asset ratio.

Guarantee capacity The PSF program's capacity to guarantee bonds is capped by state law at $135 billion and by the Internal Revenue Service (IRS) at $117 billion. Because total guaranteed debt under the program is within a hair's breadth of the cap, when it is breached, the program will be barred from guaranteeing new debt until either the cap is increased or more capacity becomes available as outstanding debt matures. The PSF last hit the IRS cap in late 2009 but was lifted in early 2010 after the IRS increased the limit in December 2009.

Positively, Texas officials are pursuing regulatory and statutory solutions to raise the IRS capacity limit, and two U.S. Congress members introduced legislation in September 2022 to permanently remove the IRS cap.

Our thoughts When the IRS cap is reached, Texas school districts will need to issue debt based on their underlying credit fundamentals, which in most cases will be weaker than if issued with the PSF guarantee.

The result is higher yields for investors willing to purchase Texas school district debt without the PSF guarantee. Additionally, outstanding PSF-guaranteed debt may bid up if enough investors desire the AAA ratings, enhanced security protections and liquidity obtained by the PSF guarantee.

Furthermore, if the cap is increased, we believe the PSF would still have sufficient latitude to support increases in the size of the guarantee program without threatening the AAA ratings.

Municipal news

Airport Sector ? Shifting to stable The airport sector has changed to stable from positive, according to a Dec. 8 Standard & Poor's report. The revision highlights the substantial recovery of travel demand to pre-pandemic levels. Many airport ratings are where they were, or in some cases higher than they were, prior to the pandemic as demand is near full recovery, according to the report.

Hospital Sector ? Challenges to persist in 2023 Following a bruising 2022, the not-for-profit hospital sector is set to face continued operating pressure in 2023. Kaufman Hall, a sector follower that tracks hospital margins said October's weaker results means the sector is likely to end 2022 in negative territory. Staffing challenges and higher operating expenses have been the main

catalysts for 2022's potentially negative performance, a trend that Kaufman expects to continue in 2023.

Illinois update

Stock market rout increases pension liabilities After posting strong equity gains in 2021, which allowed the state to cut its pension liabilities, the equity market's 2022 poor performance reversed 2021's positive trend. The state's pension liability across its five retirement systems increased to $139.7 billion, a 7.5% y/y increase. The $139.7 billion liability balance remains below FY2020's peak $144.2 billion balance.

Revenue forecast boost Illinois' Commission on Government Forecasting and Accountability revised the state's revenue projections by 11% to $51.3 billion, or $4.9 billion higher than originally forecast. The upward revenue revision was driven in large part by higher-than-forecast personal income tax collections, increased revenue from an Income Tax Refund Fund transfer, and federal aid, all of which contributed to the boost in forecast revenue. The Commission said, it is possible, if not likely, there could be further upward revenue revisions.

Sales tax receipts ? Remain strong The U.S. Census Bureau reported October sales tax receipts increased 5.9% y/y to $27 billion in October, according to data provided by 29 states compiled by Bloomberg. All major taxes collections rose with the exception of the tobacco tax, which decreased 6.6% to $900 million.

State finances ? Still strong, but challenges surface National Conference of State Legislatures CEO Tim Storey said the health of state budgets is the best in decades. In addition to healthy budget conditions, rainy day funds in many cases are at historic levels as tax collections outpace forecasts. While state budgets remain healthy and reserve funds are flush with cash, Storey said labor shortages and unforeseen threats could negatively impact states if they are not prepared. Natural disasters for one, caused over $300 billion in damage last year alone. While the rate of new debt issuance remains uncertain, states need to be prepared to handle unforeseen challenges.

Texas ? Projecting record surplus Strong sales tax collections have propelled the state to a projected record $32.7 billion budget surplus, which is 21% more than the $27 billion originally forecast, according to State Comptroller Glenn Hegar. The surplus, combined with cash transferred to reserve funds leaves the state with $188.2 billion of revenue available for general spending for the fiscal 2023?2024 biennium.

January 2023 | RBC Wealth Management

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