Top of the Morning: Muni Market Guide - Leading the pack

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will focus back in on the municipal bond market as we will spend some time highlighting the June edition of the monthly Municipal Market Guide publication from the UBS Chief Investments Office, the title for the month of June, Leading the Pack, which covers a muni market update, positioning, as well as a spotlight on prepaid gas bonds.

Joining us for the episode today, glad to welcome back from the UBS Chief Investments Office, Senior Fixed Income Strategists, Sadiq Murkherjee, as well as Barry McElindan. With that, Sadiq, Barry, thank you both for dropping by, spending some time today with our listeners and our clients. Sadiq, let me now turn it over to you.

Thank you, Dan, and happy to talk about the muni market. So firstly, the story here is despite the trifecta of continued geopolitical uncertainties regarding Iran conflict, treasury rate volatility and elevated supply within munis, munis still managed to outperform other U.S. fixed income assets. So they're leading the pack, the total return is moderate, but still on a relative basis, they are leading the pack within U.S. fixed income year-to-date.

And the key driver of outperformance has been demand. We've seen record inflows, second highest in a decade on a year-to-date basis. And more recently, rising demand from redemptions and coupon payments, those two have, in conjunction, have more than offset supply pressures.

It's notable to say that supply is not just elevated, it's running 11 percent higher than last year, which was a record supply year. The macro environment continues to be challenging. The 10-year treasury yield moved higher decisively, and inflation concerns are front and center.

However, we believe inflation will ease by year-end, and we also expect the 10-year to be lower at around 4.25 percent by year-end. The Fed, we believe, will likely scale back its easing bias in its next meeting. We still currently expect one rate cut in late 2026, but that could easily be pushed out for next year after the upcoming Fed meeting.

Let's talk about positioning. The treasury curve is distinctly bear-flattened year-to-date, while the muni curve, interestingly, in terms of the two-year, 30-year slope, is modestly at least steepened from already steep levels. Investors are being compensated for duration risks.

However, given the rate volatility concerns that I just mentioned, we still recommend investors opt for a barbell in the two- and 20-year area of the curve. And also, interestingly, given the recent rise in two-year treasury yields, actually investors can use two-year treasuries instead of munis at that front end. With regards to credit, muni credit quality continues to be stable.

The good news is that we expect economic growth to be actually a trend line this year. On a three-month trailing basis at the muni index level, the amount of power upgraded is currently matching the power downgraded. That ratio has been moderating since the post-pandemic high, and it continues to moderate.

However, despite that moderation, index quality is near a record high, with 70% of the bonds in the double-A category are better. So in terms of preference, we are overweight single-A revenue bonds. So the outlook from here till year-end is constructive.

We are maintaining a muni that is in our attractive list. Munis relative to corporates and treasuries have a richer year-to-date, given the outperformance, and the June supply calendar is heavy. Nevertheless, some of the technicals in July-August should remain supportive.

The most important thing here for investors to note is that tax-equivalent yields continue to provide attractive carry and pick-up over treasuries and investment-grade corporates, and that should drive total return performance till year-end. Let's now pivot to talk about a sector that has witnessed sharp growth in issuance, and Dan mentioned this in his opening comments, and that is prepaid energy bonds, mostly prepaid gas, but now we are also seeing electricity in the mix. Prepaid energy bonds now actually comprise roughly 5.6% of the Bloomberg Muni Index.

They've seen a sharp growth in issuance in the last three or four years. These bonds basically enable municipal utilities to purchase long-term natural gas or electricity supply at discounted prices, that discount being a function of the difference of tax-exempt and taxable rates. As I said, issuance has grown significantly in recent years.

The thing to note about this sector is that these transactions are unlike municipal revenue bonds. They are backed typically by large financial institutions, so investors are looking to the supporting institution and not the municipal utilities for payment. Investing in these bonds are exposed, therefore, to the credit quality of the supporting financial institution.

They don't exactly guarantee debt service payments, but they guarantee obligations of the gas and energy supplier, which are pinhole risks in these transactions. The reason why this is of interest to investors is that they offer significant yield pickup over municipal revenue bonds and on a tax-equivalent basis over the senior unsecured bonds of the supporting institutions. Now, there are large U.S. banks, insurance companies, and more recently, hyperscalers are participants in this deal.

We have seen recently a large deal involving a hyperscaler. So, while this is not a core holding in many portfolios, we believe that investors with moderate and higher risk tolerance may consider adding them for an incremental portfolio yield, and especially those who are comfortable with structural complexity and relative liquidity and greater spread widening risk. As I mentioned, typically the supporting institutions in these energy pre-paid deals are these large banks and insurance companies, and with the recent entry of hyperscalers.

So, given that investors are really relying on the supporting institutions in terms of credit risk and the recent concerns around AI disruption, private credit, let me get my colleague, Barry McElindan, into the conversation to talk about our credit outlook of banks, insurance companies, and hyperscalers. So, Barry, how do we see these two segments of the market in terms of their fundamentals and their spreads from here on? Yeah, thanks, Sudeep.

We are seeing some differentiation between the segments that you mentioned. Let me start with banks. Banks are coming off of a very strong earnings season, really record revenues from both loan and deposit growth, as well as capital markets, fee-based advisory and M&A.

Their capital levels on the aggregate Tier 1 equity capital declined a bit, but that was really due from more clarity in banking regulation called Basel III endgame that gave them the clarity to deploy the capital. So, they've been growing businesses, particularly in trading and these capital markets areas. So, the fact that we saw their common equity Tier 1 capital ratios decline didn't lead us to believe that's a negative conclusion because they're still well above regulatory minimums and still much more robust than they have been during the pre-global financial crisis era.

I think banks in general are trading about in line with IG taxable corporates. We view that positively because banks go through phases where they trade tighter, sometimes wider. Probably the phase that we're coming off of when interest rate risk was a problem, you know, stemming from 2023, they traded wider than the IG corporate index.

Since then, there was a period late last year they traded tighter and now about in line. We actually view that as favorably given that, you know, the fundamental profile of the banks being as strong as it is. I think the fact that they're not trading tighter than the index stems from the supply, the amount of debt issuance that the large U.S. big six banks have come to the market with this year.

It's totaled $119 billion year-to-date for the big six U.S. banks, but that's actually more U.S. dollar supply than the tech big four hyperscalers. The hyperscalers issued $107. So just to kind of put it into perspective, it's a large issuance, even greater than I think the marketplace was expecting.

And part of that is just natural refunding, but part of that is growth in certain business lines, as I mentioned. And, you know, in terms of the Vista banks, really the focus over the last few quarters is really in the lending and to the private credit side. And banks have disclosed more granularity about this risk.

And when it comes to the big six U.S. banks, they've disclosed that their exposure is about low single digit of their total loan book. And, you know, according to the banks, they're seeing relatively stable credit performance in that portion of the loan book. They note that the exposures are mainly indirect exposures, not direct lending to a middle market counterparty, but indirect, like lending to funds or business development companies.

And they note that it's often senior secured status with investment grade credit risk. So the specific information the banks provide to the marketplace is always useful to gain a greater perspective. Obviously, it's still a risk that I think the market is going to be quite in tune to.

But nonetheless, we think even below a percentage of raw exposure, a risk that we're comfortable with. Now, it's also been a factor that's impacted insurance spreads. Insurance spreads are trading actually wider than the IG Corporate Index.

And I think this has to do with the fact that, you know, they do have a large part of their portfolios with private credit exposure, roughly one third on average of like North American insurance companies. But again, you really have to look more closely about the credit quality of the portfolios where you do have a large chunk that's investment grade rated. So again, nothing that's really ringing loud alarm bells at the moment, but it's something that the marketplace is going to be attuned to.

And I think for this reason, you know, that's why you see that most, I guess, prepaid bonds that are backed by certain insurers are actually trading wider than the ones issued by the U.S. banks. So that relationship is similar to what we're seeing in their taxable securities. And I think that's a relationship, again, that's likely to persist as, you know, the issues of private credit we think are going to be more of a gradual deterioration stemming from certain vintages that were underwritten in the early 2020s.

So nothing that's likely to occur rapidly in terms of credit losses, but a gradual, you know, in terms of non-performers. So we think it's something that the marketplace should be able to digest, you know, going forward. But again, something that I think is going to be reflective in how these categories of financials, how their spreads trade.

And then just to comment on hyperscalers, Sadiq mentioned we did see a large hyperscaler as the backer of a gas prepay recent bond issue. And here we look at hyperscalers in terms of the big five. Sometimes it's the big four, if you exclude Microsoft.

But in terms of the big four hyperscalers, you know, those are the ones that have really issued various fixed income instruments into the marketplace this year. They've been issuing a large volume of regular debt issues into the market. Again, it tallies $107 billion in U.S. dollar terms, but another about $52 billion have been issued outside the U.S.

So they're really utilizing various funding channels. But overall, their credit quality, if you're looking at the AA rated issued hyperscalers, is still exceptionally strong. You know, despite the massive capex that's expected, roughly about $685 billion this year, north of $100 billion next year.

You know, they're utilizing various sources to fund that. In addition to the debt, you know, a large part of it is their immense cash flow from operations for, you know, for many of them. So credit profiles, you know, we think should stay intact.

We haven't seen any changes on the negative trajectory from by the rating agency. They still have the credit outlook as stable for the hyperscalers that are rated AA or higher. So, yeah, overall, you know, I think that's something that the hyperscalers will look to obviously fund this massive investment, but do so in a way that even in the trajectories for higher leverage, I think it could still have like, you know, a strong balance sheet and credit profile, you know, intact is what we're seeing so far.

So those are kind of the comments from my taxable lens related to these segments. But as Sudeep mentioned, they are backers in that gas prepay market as well. So with that, I can turn it back to you, Sudeep.

Thanks, Barry, those are really excellent, comprehensive comments, rather fast-growing segment of the mini market, gas prepay and energy prepay deals will continue to be in the headlines. We expect more issuance and investor interest in this unique segment of the market. So overall, to finish up, our outlook on munis remains constructive, tax equivalent yields of around 6.2% for investors in the highest tax bracket, those are very attractive, credit is stable, even as macro uncertainties and credit rate volatility risks do remain elevated.

So I hope you found our thoughts on the market useful. And with that, I can turn it back to you, Dan. Well, Sudeep, Barry, thank you again for spending some time with our listeners and our clients here on top of the morning for an update on the municipal bond market.

Again, for you, our listeners, we have been highlighting the June edition of the monthly Municipal Market Guide publication series from the UBS Chief Investment Office. Again, the title for the month of June, Leading the Pack. This publication is now available up on UBS.com slash CIO, though for clients of UBS, please reach out to your UBS financial advisor if you would like to receive a copy of the latest Municipal Market Guide directly.

From UBS Studios, I'm Dan Cassidy. Thank you for joining us. Thank you for tuning in.

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