October 9, 2017 | Fixed Income Strategy

Muni Fortnightly

Bottom Line:
Treasury yields moved slightly higher in mostly directionless week after a week of more conviction.
Important economic data were and will likely continue to be heavily caveated by hurricane-related
effects.
Hurricane Harveys impact on Texas credits is broadly manageable.
Virgin Islands credit rating withdrawn by S&P and Fitch on lack of on-going disclosure.
Moodys assessment of the as proposed tax reform to be net credit negative on state and local
governments.
The Bloomberg Barclays September Municipal Index total return was +0.76% (+5.2% YTD).
Moodys comments that the impact of deferred state and local infrastructure capital expenditure is
likely to be higher costs in the future.
Puerto Rico bond prices thrown for a loop on seemingly haphazard comments.
S&P Puerto Rico Total Return Index was -8.3% two weeks; -15.2% YTD.

What Happened in the Bond Markets Last Week?

Treasury yields bounced around all week before finishing slightly higher on Friday after the labor report. With a
week full of tragic headlines Treasuries reacted little. The eye of the market was fixed on the end-of-week labor
data with some intermittent important data thrown in. But like the labor report on Friday which put some levity
into yields, all of the economic data were caveated and heavily asterisked with hurricane-related uncertainty.
The biggest fixed income impacts came from hot winds from the White House aimed upon Puerto Ricos
bondholders. Markets are beginning to get focused on whom will be the big winner of the seat of the Fed Chair.
In the meantime, the market is pricing in a high probability (80%) for a December rate hike.
Municipal yields directionally followed Treasury yields. The AAA GO Ratio currently stands at 85.6.

Yields (Figure 1):

For the week ending 10/6/17 Treasury yields traded slightly higher; 2-year Treasury Note yields were +2.5 bps
to 1.51%, 5-year Notes yields were +3.1 bps to 1.96%, 10-year Notes yields were +3.6 bps to 2.37% and 30-
year bonds yields were +4.6 bps to 2.91%.

Bloomberg Municipal Index curve yields were higher; AAA-rated GO yields; 2-year bonds were +3 bps to
1.04%, 5-year bond yields were +3 bps to 1.40%, 10-year bond yields were +3 bps bps to 2.03% and 30-year
bonds were +1 bps to 2.90%.

The Ratio of 10-year AAA GO debt to 10-year Treasury yields rose slightly to 86.1 from 85.8 last week. The
year-to-date average is 89.9 and the 12-month average is 91.7.
.

David N. Violette, CFA

Sr. Fixed Income Analyst
Vice President
dviolette@rwbaird.com
414-298-7688
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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

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Supply (Figure 3) Bloomberg 30-Day Visible Supply currently stands at $11.2 billion down from $12.7 billion this time
last week. The YTD average visible supply is $10.8 billion and the 12-mo average is $11.4 billion.

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

Articles of Interest
Municipal Fund Flows: According to Lipper data muni funds had net outflows of $140.3 million after $378 million of net
inflows during the previous week. The four-week moving average was $263 million. High-yield funds had net outflows.
Hurricane Harvey Part II (Moodys): Moodys issued a Sector In-Depth report on the impact of hurricane Harvey with
the conclusion that impacts on credit will be broadly manageable. The highlights of the report include: 1) Most local
governments will be unaffected but some will face challenges with 37 municipal utility districts (MUDS) of over 450
credits placed on review for possible downgrade. 2) The State of Texas (rated Aaa Stable) will experience temporary
economic slowdown due primarily to industrial idling. 3) Most higher education will be largely unaffected. 4) Hospitals
will probably be the most negatively impacted as they face higher expenses and lower patient volume. 5) Infrastructure
credits are exposed to economic activity but have strong liquidity that limit the credit impact.
Virgin Islands Credit Rating Dropped Due to Non-Disclosures: S&P and Fitch both dropped its credit rating for the
Virgin Islands citing the governments decision to discontinue providing necessary information to make an informed
credit rating. Prior to dropping its rating S&P had rated senior and subordinate matching-fund loan notes at CCC+ and
gross tax receipt notes at CCC. Moodys currently rates the matching fund bonds at Caa1.
Tax Reform Credit Negative for Munis (Moodys): While very preliminary and subject to much negotiation and detail
disclosure, some available proposed elements of the tax reform point to be net negative credit according to Moodys. It
is generally viewed that it would place pressure on the federal budget deficit and federal debt. Lower corporate rates
and beneficial capital expenditures would benefit corporate credit quality. However, the proposed elimination of state
and local tax deduction is a credit negative for states and local credits as it would raise the effective cost of state and
local taxes for taxpayers by reducing disposable income, increase resistance to raising state and local taxes, suppress
home values thus property tax values in particular high-tax locations.

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Delay in Local Cap-Ex a Future Cost to Manage (Moodys): The Bureau of Economic Analysis released Q2 report
showing that state and local capital expenditures has declined to 1.7% of national GDP. Capital expenditures have
remained relatively constant since 2009, but as a proportion of the economy it has fallen significantly. Had a constant
proportion been spent since then there would have been approximately 27% than what has been spent. As state and
local governments have spent more on other necessary items (pensions, education etc.), infrastructure spending has
been deferred and in particular in water and sewer systems, which tend to be less visible politically. Moodys expects
even greater make-up spending to occur through time as assets deteriorate.
September Municipal Tax-Exempt Performance:
Bloomberg Barclays Municipal Bond Index had a -0.51% total return in September but outperformed the
Treasurys Index return. The negative municipal index return comprised of a price return of -0.85% and a
positive coupon return of +0.34%. Through September, the year-to-date total return is +4.66% and the last 12-
months total return is +0.87%.
o The ending Yield-to-Worst (YTW) for September was 2.23% (+15 bps) with a 5.1 modified duration-to-
worst.
The General Obligation Index had a -0.48% total return in September. Through September GOs had a +4.65%
total year-to-date and +0.77% during the last 12-months.
o The YTW at the end of September was 2.10% (+15 bps).
o The State General Obligation sub-index had a -0.45% total return in September, with a +4.34% total
return year-to-date and a 12-month total return of +0.78%.
Notable geographic indexes September returns include; Laggards SD (-1.04%), CO (-0.82%)
and SC (-0.75%); Leaders Puerto Rico (+0.71%), US Virgin islands (+0.37%), NJ (+0.34%).
Other notable jurisdictions; AZ (-0.61%) CA (-0.47%), CT (-0.53%) FL (-0.68%), IL (-0.05%), IA
(-0.54%), KS (-0.69%), MI (-0.56%), MN (-0.52%), NJ (-0.34%), NY (-0.57%), OH (-0.55%), OR
(-0.66%) PA (-0.66%), Puerto Rico (+0.71%), TX (-0.57%), WA (-0.55%), WI (-0.54%).
The ending YTW for the State G.O. sector was 1.98%.
o The Local General Obligation sub-index had a -0.51% total return in September, with a 5.01% total
return year-to-date and the 12-month total return of +0.75%.
The ending YTW for the Local G.O. sector was 2.23%.
The Revenue Bond Index had a -0.54% total return in September, with a year-to-date total return of +4.99%
and a 12-month total return of +0.89%.
o The best performing revenue sectors in September were leasing (-0.10%), industrial revenue (-0.28%)
and resource recovery (-0.41%).
o The laggard revenue sectors were water and sewer (-0.69%), special tax (-0.67%), and electric (-
0.60%).
o The ending YTW for the Revenue sector was 2.39%.
The returns across maturities for the Barclays Muni indexes were; 3-yr -0.33%, 5-yr -0.69%, 10-yr -0.58% and 20-yr -
0.45%
Puerto Rico:
o The Fallout from Hurricane Irma is Still Far from Being Understood: The obvious human and physical toll
on the island is far from being understood. The financial toll on both the populace of Puerto Rico and
bondholders is equally unknown. Recent, hazardous and seemingly uninformed off-the-cuff comments claiming
Puerto Rico debt will be wiped out are subject to much speculative interpretation. The definition of wiped out
is either obvious (legal restructuring does that). While the intentions of said comment, if not to just stir
sensational reaction, certainly are unknown, it is likely that even the most severe definition is not possible
legally (there is a federally appointed board called PROMESA already working through this already complex
problem), nor legislatively (would they really let that happen?) nor logically (how smart would it be to let bonds
got to zero for the future cost government debt?). Clearly the comments stirred another storm, this time in the
price of Puerto Rico bonds for example one benchmark 2035 GO bond fell 20-25%.
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o Moodys on Puerto Rico Default Status of Entities: Moodys notes that nearly all of the Puerto Ricos
approximately $74 billion of bonded debt outstanding is in default or is expected to default. The damage to
infrastructure and the direct and indirect (think potential population drain) economic impact supports the
argument for lower bondholder recoveries and extends the timeline for the process being led by PROMESA.

o The S&P Municipal Bond Puerto Rico Index finished at 149.9 on Thursday vs. 163.4 at the end of two weeks
ago, -8.3%%. Year-to-date the index is -15.2%.

S&P Municipal Bond Puerto Rico Index Level (1-year)

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Relative Value by Maturity

Table 1 - AAA Muni Ratios and Spreads by Maturity - Data Source: Bloomberg
10/6/2017 Yield-to-worst (%) 0% Tax Rate 35% Tax Equivalent
Maturity (yrs.) AAA Gen. Oblig. Treasury Spread (bps) Ratio (%) Spread (bps) Ratio (%)
1 0.95 1.34 -38.9 70.9 12.2 109.1
2 1.04 1.51 -47.6 68.5 8.2 105.4
3 1.17 1.65 -49.0 70.4 13.8 108.3
4 1.28 1.86 -57.5 69.1 11.7 106.3
5 1.39 1.98 -58.6 70.4 16.4 108.3
7 1.68 2.21 -53.7 75.7 36.4 116.5
10 2.02 2.38 -36.1 84.8 72.7 130.5
15 2.47 2.45 2.6 101.0 135.6 155.5
20 2.71 2.65 5.8 102.2 151.9 157.2
25 2.83 2.78 4.9 101.8 157.4 156.5
30 2.90 2.91 -1.1 99.6 155.2 153.2

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

AAA G.O. Muni Ratio and Spreads

(0% Tax Convention)
105.00 20.0
100.00
95.00 0.0

Spread (bps)
90.00
-20.0
Ratio %

85.00
80.00
-40.0
75.00
70.00 -60.0
65.00
60.00 -80.0
1 3 5 10 20 30
Maturity (yrs.)

Ratio (%) (Left) Spread (bps) Right

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Relative Value by Rating

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

4.00
Muni Yields by Rating
3.50

3.00

2.50
Yield (%)

2.00

1.50

1.00

0.50

0.00
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

Treasury AAA AA A

For more information please contact your Financial Advisor.

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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 bonds 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 (Moodys) and Standard & Poor's Corporation (S&P). Moodys lowest investment-grade rating for a bond is
Baa3 and S&Ps 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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