Muni Fortnightly - Robert W. Baird

September 25, 2017

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Fixed Income Strategy

Muni Fortnightly Bottom Line: •

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Treasury yields rose in bear-flattening fashion. The FOMC outlined QE-tightening commencing in October and the market priced in a higher probability for a December rate hike. Municipal yields moved higher; the GO Ratio remained steady. Moody’s comments on Texas municipalities’ abilities to broadly withstand Hurricane Harvey’s impact on credits. Pennsylvania Commonwealth credit downgraded by S&P to A+. Moody’s report highlights the largest 20 U.S. city reliance on federal funding. S&P downgrades Virgin Island Water and Power credit to CCC+/CCC and Port Authority to B+ citing hurricane impacts on already weak financial conditions. S&P Puerto Rico Total Return Index was -4.1% two weeks; -7.5% YTD.

What Happened in the Bond Markets Last Week? • Treasury yields bear-flattened over the course of the past week – notably some parts of the curve hit flattest level since 2007. The move was steady throughout the week with an additional thrust higher in yields on Wednesday after the FOMC meeting conclusion and somewhat lower yields on Friday as mutual geopolitical mudslinging raised military escalation fears. Risky assets markets mostly shrugged off nature’s wrath and destruction with a trifecta of equity index records midweek. On Wednesday, the FOMC spelled out the beginning of QE tapering, SLOW as it may be, was accompanied with indications that an incremental Fed Rate hike may be in the offing at the end of the year. Yields moved sharply higher, gold got smoked and equities were impacted only slightly. The market implied probability of a Fed Fund rate hike by the end of the year is 61% up from just 23% at the beginning of the month. • Municipal yields directionally followed Treasury yields. The AAA GO Ratio currently stands at 85.6. Yields (Figure 1): •

For the week ending 9/22/17 Treasury yields traded higher; 2-year Treasury Note yields were +5.5 bps to 1.43%, 5-year Notes yields were +6.2 bps to 1.87%, 10-year Notes yields were +5.8 bps to 2.26% and 30-year bonds yields were +2.5 bps to 2.79%.

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Bloomberg Municipal Index curve yields were higher; AAA-rated GO yields; 2-year bonds were +4 bps to 0.90%, 5-year bond yields were +9 bps to 1.28%, 10-year bond yields were +5 bps bps to 1.93% and 30-year bonds were +3 bps to 2.82%.

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The Ratio of 10-year AAA GO debt to 10-year Treasury yields rose to 85.6 from 85.5 last week. The year-todate average is 90.1 and the 12-month average is 92.0.

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David N. Violette, CFA Sr. Fixed Income Analyst Vice President [email protected] 414-298-7688 1o

September 25, 2017

Figure 1 - Yield Curve and Muni Curve Changes – Data Source: Bloomberg

One can observe these changes by looking at how rates have changed along the curve for both the Treasury curve and for the AAA-rated G.O. Index since last week. The top panel shows four yield curves; two for the Treasury curve (in red) - one for the most current date and one from last week and two for the AAA-rated G.O. (in blue) - current and last week. The bottom panel of the graph shows changes in the rates along both curves for the week for both Treasuries and the AAA G.O. Index.

Figure 2 - Muni Ratio – Data Source: Bloomberg

AAA 10-Year G.O. Muni Ratio to Treasury 110.0

Ratio (%)

105.0 100.0 95.0 90.0 85.0

85.6

80.0

Mid Price

SMAVG (50)

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September 25, 2017

Supply (Figure 3) – Bloomberg 30-Day Visible Supply currently stands at $11.7 billion up from $9.6 billion this time last week. The YTD average visible supply is $10.7 billion and the 12-mo average is $11.5 billion.

Figure 3- Bloomberg 30-Day Visible Supply - 1 Year; Data Source: Bloomberg

Bloomberg 30-Day Visible Supply U.S. Total

30,000

$ Million

25,000 20,000 15,000 10,000 5,000 0

Articles of Interest Municipal Fund Flows: According to Lipper data muni funds had net inflows of $250.4 million after $344.5 million during the previous week. The four-week moving average was $483 million. High-yield funds had net inflows. Hurricane Harvey Implications for Local Credits: 

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Moody’s issued a report on the impact of Hurricane Harvey on Harris County’s credit. Moody’s cites “ample” FEMA reimbursement, insurance payments and a strong liquidity position will help with any financial strain. Moody’s notes the possibility of declining property tax values but the significant tax rate flexibility to combat tax revenue losses. Moody’s issued a report on Houston Independent School District saying that the district will be “largely unaffected by hurricane damage. State and federal aid, insurance proceeds and sound liquidity are strong enough elements to maintain the district’s financial strength. 39 counties have been declared federal disaster areas. Moody’s believes that after some temporary liquidity stress that local governments will broadly emerge with limited-to-no credit impact. They note smaller issuers without diversification and weaker reserves will be more exposed to credit stress. However, revenue-raising flexibility, liquidity, debt service reserve balances, state and federal aid and insurance will be allowing local governments to manage the challenges. Moody’s says that Municipal Utility Districts (MUDS) which are not actively managed with limited budgets, less flexibility and less diversification are more susceptible than larger municipalities.

Pennsylvania Downgraded by S&P: S&P downgraded Pennsylvania Commonwealth credit rating to ‘A+’ from ‘AA-‘, state appropriation debt to ‘A’ from ‘A+’ all with a ‘Stable’ outlook after putting the state on negative watch in July. S&P says the downgrade reflects the state’s “chronic structural imbalance”, weakening liquidity and delayed expense payments. Moody’s rates the Commonwealth at Aa3.

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September 25, 2017

Largest 20 Cities leveraged to Federal Funding: Moody’s issued an in-depth report on large cities stating that federal funding is growing in importance to the cities’ credit profiles. Proposed federal assistance cuts and funding formulas would cause local tax rate hikes, reduce services and/or cut programs. The highlights of the report include: 1) Federal funding assistance account for 10% on average of the largest 20 cities with Washington D.C. (39%), Charlotte, NC (16%) and San Francisco (12%). Other federal funding exposures include Medicaid, and hospital, airport funding. 2) The largest cities spend the greatest proportion of their funding on health and social services (22%), housing and community development (21%) and infrastructure (15%). 3) Trump administration proposed cuts are critical funding streams. Toll Road Sector: Moody’s issued an in-depth sector report on government-owned toll roads calling the sector stable. The highlights of the report include: 1) the strength of the economy has driven (no pun intended) annual transaction growth of 4.6%. 2) Revenue growth has exceeded expense growth allowing for improved day’s cash on hand i.e. liquidity. 3) Between 2012 and 2016, debt per roadway mile has declined by 38% for small toll roads but rose by 53% for large tool roads reflecting the rising capital needs for larger/older toll roads. S&P Downgrades Virgin Islands Port Authority to B+: The cruise ship revenue dependent ports are vulnerable to tourist industry revenues. With the spate of hurricanes, revenue declines are expected but with the severity and duration in question, so are the port’s financial conditions. S&P Downgrades Virgin Islands Water and Power and Electric Authority Credit: Virgin Islands Water and Power Authority credit rating was cut to ‘CCC+’ by S&P. (from ‘BB+’) on the senior-lien debt and ‘CCC’ from ‘BB-‘ on subordinate-lien debt and all are on negative Credit Watch. The rating downgrades reflect the system’s weakened prospects after the hurricanes; tourist revenues, already weak financial position and weak liquidity. Puerto Rico: o

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The fallout from Hurricane Irma is far from being understood: The human toll is excruciating. The prospect of widespread (complete) loss of power for perhaps up to a month is partially a manifestation of the islands inability to maintain/improve its electrical system. This can only delay the bond recovery process. The impact on recovery is ever more indeterminable. The S&P Municipal Bond Puerto Rico Index finished at 163.4 on Friday vs. 170.3 at the end of two weeks ago, -4.1%%. Year-to-date the index is -7.5%. S&P Municipal Bond Puerto Rico Index Level (1-year)

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September 25, 2017

Relative Value by Maturity

Table 1 - AAA Muni Ratios and Spreads by Maturity - Data Source: Bloomberg Yield-to-worst (%)

9/25/2017

0% Tax Rate

35% Tax Equivalent

Maturity (yrs.)

AAA Gen. Oblig.

Treasury

Spread (bps)

Ratio (%)

Spread (bps)

Ratio (%)

1 2 3 4 5 7 10 15 20 25 30

0.79 0.90 1.02 1.15 1.28 1.56 1.93 2.39 2.63 2.75 2.83

1.29 1.43 1.56 1.74 1.85 2.08 2.24 2.31 2.51 2.64 2.77

-49.7 -52.6 -54.3 -58.5 -56.8 -52.0 -30.5 7.9 11.9 11.4 5.9

61.4 63.1 65.3 66.3 69.3 75.0 86.3 103.4 104.7 104.3 102.1

-7.1 -4.1 0.7 3.4 12.3 31.9 73.5 136.3 153.4 159.6 158.1

94.5 97.1 100.4 102.0 106.6 115.3 132.8 159.1 161.1 160.5 157.1

Figure 4 – AAA General Obligation Ratios and Spreads – Data Source: Bloomberg

AAA G.O. Muni Ratio and Spreads 20.0

110.00 105.00 100.00 95.00 90.00 85.00 80.00 75.00 70.00 65.00 60.00

0.0 -20.0 -40.0 -60.0 1

3

5

10

20

30

Spread (bps)

Ratio %

(0% Tax Convention)

-80.0

Maturity (yrs.) Ratio (%) (Left)

Spread (bps) Right

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September 25, 2017

Relative Value by Rating

Figure 5 – Muni Index Yield Curve by Credit Rating – Data Source: Bloomberg 4.00

Muni Yields by Rating

3.50

Yield (%)

3.00 2.50 2.00 1.50 1.00 0.50 0.00 0

2

4

6

8

10

Treasury

12

14

AAA

16

18

AA

20

22

24

26

28

30

A

For more information please contact your Financial Advisor.

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September 25, 2017

Appendix – Important Disclosures Some of the potential risks associated with fixed income investments include call risk, reinvestment risk, default risk and inflation risk. Additionally, it is important that an investor is familiar with the inverse relationship between a bond’s price and its yield. Bond prices will fall as interest rates rise and vice versa. When considering a potential investment, investors should compare the credit qualities of available bond issues before they invest. The two most recognized rating agencies that assign credit ratings to bond issuers are Moody's Investors Service (“Moody’s”) and Standard & Poor's Corporation (“S&P”). Moody’s lowest investment-grade rating for a bond is Baa3 and S&P’s lowest investment-grade rating for a bond is BBB-. Ratings are measured on a scale that ranges from AAA or Aaa (highest) to D or C (lowest). The Bond Buyer 20-Bond Index consists of 20 general obligation bonds that mature in 20 years. The average rating of the 20 bonds is roughly equivalent to Moody's Investors Service's Aa2 rating and Standard & Poor's Corp.'s AA. The Bond Buyer 11-Bond Index uses a select group of 11 bonds in the 20-Bond Index. The average rating of the 11 bonds is roughly equivalent to Moody's Aa1 and S&P's AA-plus. The Bond Buyer Revenue Bond Index consists of 25 various revenue bonds that mature in 30 years. The average rating is roughly equivalent to Moody's A1 and S&P's A-plus. The indexes represent theoretical yields rather than actual price or yield quotations. Municipal bond traders are asked to estimate what a current-coupon bond for each issuer in the indexes would yield if the bond was sold at par value. The indexes are simple averages of the average estimated yields of the bonds, are unmanaged and a direct investment cannot be made in them. This is not a complete analysis of every material fact regarding any sector, municipality or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates. The alternative minimum tax (AMT) may be applicable, even for securities identified as tax-exempt. It is strongly recommended that an investor discuss with their financial professional all materially important information such as risks, ratings and tax implications prior to making an investment. Past performance is not a guarantee of future results. This report does not provide recipients with information or advice that is sufficient on which to base an investment decision. This report does not take into account the specific investment objectives, financial situation, or need of any particular client and may not be suitable for all types of investors. Recipients should consider the contents of this report as a single factor in making an investment decision. Additional fundamental and other analyses would be required to make an investment decision about any individual security identified in this report. ADDITIONAL INFORMATION ON SECURITIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST BY CONTACTING YOUR BAIRD INVESTMENT PROFESSIONAL. Copyright 2017 Robert W. Baird & Co. Incorporated.

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