CSG: Demand Note: Signs of Weakened Bank Demand are Showing Up
As CSG has discussed it's it weekly Perspective over the past year, there are several factors that are likely to sap aggregate net demand for munis by commercial banks.
The first, of course is the 40% cut in corporate tax rates, which made it more difficult for munis to compete with both Treasuries and corporates for the attention of bank portfolio managers.
The second factor is the flattening of the consumer yield curve as a higher Fed Funds rate has begun to push up yields on CDs and other consumer instruments. This bounce eats into banks’ benefit from “yield curve arbitrage.”
Signs of this weakened net bank demand for tax-exempts are already showing up in several ways. First of all, as the graph below shows, the yield advantage for bank-qualified bonds has already dropped sharply, from roughly 25 basis points to about 9 basis points.
Second, issuance of bank-qualified paper was down considerably more than the drop in aggregate issuance in April, off 34% from last year. Year-to-date, BQ paper issuance is off 36%. This pattern suggests that the medium-sized regional banks that tend to absorb BQ paper are less interested, post-Tax Cuts, and issuers are responding by selling less of it. Perhaps more strikingly, private placement issuance has fallen off a cliff, down from $2.01 billion last April to $288 million this year, a drop of 86%, and totals are off 55.6% year-to-date.
While not all bank direct purchases show up in this data, the drop is substantially greater than the decline in total issuance of 22.3% YTD, and is clearly indicative of a drop in institutional demand generally and bank demand specifically.
In any event, the muni market has held in pretty well despite stronger year-over-year issuance of late, the increased volatility in the taxable market, and clear signs that banks are providing less overall support. We still suspect that munis could underperform a bit if rates continue to move higher, but our concern remains limited.
A key factor for now will be the impending June/July spike in bond calls and maturities —with some continuation in early August. Although not all call/maturity money is being reinvested back into munis, it seems likely that this pattern will offset lower bank demand, at least to a degree. The increased relative strength of specialty states, such as New York and California, in the aftermath of the cut in SALT deductions, is a pretty clear sign that there is retail cash around.
We remain skeptical as to how strong that demand from retail cash will be going forward in longer intermediate maturities in particular, but it certainly can’t hurt. Meanwhile, however, the ongoing weak and erratic flows in muni bond funds as reported by both Lipper and ICI remain a worry.
On the other hand, there has been strong foreign demand, stemming from two factors: low yields in nearly all first world countries, with 10 year double-A muni yields somewhat higher than those, and the ongoing tendency toward a focus on “impact” investing. One can make a pretty good case, we think, that as global investors continue to increase their focus on impact, a broad swath of U.S. munis will become an increasing target for those activities.