Brexit leads municipal yields to ‘record’ lows

24 June 2016

by Maria Amante, Maryellen Tighe, and Andrew Scurria

 

Following “Brexit,” the UK’s vote Thursday to leave the European Union, yields on municipal bonds showed significant drops during trading Friday, said Triet M. Nguyen, managing director at NewOak Capital. Yields across the municipal bond curve tightened about 20bps in early trading on Friday, said Howard Cure, director of municipal bond credit research at Evercore Wealth Management.

 

By the end of the day, though, yields had fallen a total of 12bps on 10-year maturities to 1.77% and 18bps to 3.83% on 30-year maturities of municipal bonds, Cure said. This mirrored a 17bps drop in 10-year Treasuries to 1.5667% and a 14bps fall in 30-year Treasuries to 2.4159%.

 

“It’s as big of a move in a single day as I’ve ever seen,” Nguyen said. “There are record lows across the board.”

 

The decreased rates come after a week of a small 10bps rally on 30-year bonds to 4.01% on Thursday from 3.91% on 16 June, Cure said.

 

“People didn’t think this would occur, and now the market’s going in the opposite direction,” Cure said. “There’s a weakening in the market—rates were going up while prices were going down over the last few days as people had no expectation of Brexit. But now, yields have gone down.”

 

This could prompt a continuation of foreign investors purchasing municipal debt, said Alan Schankel, analyst at Janney Capital Markets.

 

“Even though municipal demand comes, in theory, from US taxpayers, the yields are high enough that in a bunch of places… where they have negative interest rates or zero interest rates municipals have some sort of attraction,” Schankel said.

 

Investors will flock to municipals given the quality nature of the investments and more comfort in the domestic economy, Nguyen said. But it will also lead to additional scrutiny for high-yield or lower-quality issuers, he said.

 

“It’s a flight-to-quality phenomenon,” Nguyen said. “When you have a shocking event like Brexit, it’s not surprising. You’ll see … a flight to quality on the best credits but widening spreads or more suspicion of lower-rated credits because of the perception or concerns of a slowing economy.”

 

Despite declining yields, demand for US Treasuries and the municipal market will remain strong given the negative yields in European countries, Cure said.

 

But some say an alternative is also possible: If interest rates remain low as a result of Brexit, retail investors could determine they are better off with liquid assets – like cash – than investing in munis, said Craig Brothers, senior portfolio manager at Bel Air Investment Advisors.

 

“The municipal market will benefit from the strength of Treasuries, but is set to underperform Treasuries,” Brothers said, “Because of the retail nature of the municipal market, holders are individuals who require certain levels for a five or 10-year bond. It won’t keep pace 1:1 with the Treasury market.”

 

One issue for state and local governments to monitor, especially as they repair their reserve accounts, is the impact on the equity markets, Cure said. A decline in the equity market has a big impact on pensions, which are already a burden for many municipalities.

 

Brexit could create an influx of new supply as low rates provide incentive for refinancing, said Mary Talbutt, fixed income portfolio manager at Stanley-Laman Group.

 

The impact of flow to stable assets will likely be limited to through the weekend and into next week, said Bill Northey, a chief investment officer at US Bank Private Client Group.

 

“You’re seeing the effect of global capital flows moving to risk free assets,” said Northey. “As we round the weekend and there’s a great deal written… you will likely continue to see some higher degree of volatility.”

 

Though additional supply is likely, the factors creating the current low levels of municipal supply will still be in play, Cure said. Municipal issuance is low as issuers repair their reserves and experience burdens from legacy costs, Cure said. Issuers don’t want to add projects that may increase operating expenses, he said.

 

Longer term, the Brexit has decreased the chances for a rate increase from the Federal Reserve, said Northey. He had anticipated one to two rate increases this year prior to Brexit, and now anticipates zero to one. “I think at this point July is clearly off the table,” said Northey. “There has been a shift in our expectations at the margin.”

 

The vote continues to support a continued bid for safe havens, said Karissa McDonough, chief fixed income strategist at People’s United Wealth Management. Investors infer a lower chance of a Fed rate hike by year end while a rate cut becomes possible, she said.

 

There is also the risk of further exogenous shocks, such as similar exit campaigns in peripheral EU states. The success of the Brexit vote could shave off some degree of growth from Britain and, by extension, the US, McDonough said.

 

“It’s very good if you’re in safe havens, but if you think that rates are going to rise, and you were short duration, it’s a very difficult time to normalize duration,” McDonough said. There will be “fat” trading ranges, she said, as investors weigh the relative risk of holding cash versus and not having yield in their portfolios.