October 9, 2017

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Fixed Income Strategy

Muni Fortnightly Bottom Line: •

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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 Harvey’s impact on Texas credits is broadly manageable. Virgin Island’s credit rating withdrawn by S&P and Fitch on lack of on-going disclosure. Moody’s assessment of the as proposed tax reform to be net credit negative on state and local governments. The Bloomberg Barclay’s September Municipal Index total return was +0.76% (+5.2% YTD). Moody’s 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 Rico’s 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 30year bonds yields were +4.6 bps to 2.91%.

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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%.

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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.

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

October 9, 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

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October 9, 2017

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 (Moody’s): Moody’s 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 government’s 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’. Moody’s currently rates the matching fund bonds at Caa1. Tax Reform Credit Negative for Munis (Moody’s): 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 Moody’s. 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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October 9, 2017

Delay in Local Cap-Ex a Future Cost to Manage (Moody’s): 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. Moody’s expects even greater make-up spending to occur through time as assets deteriorate. September Municipal Tax-Exempt Performance: • Bloomberg Barclay’s 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 12months’ 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-toworst. • 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 Barclay’s 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%. 4o

October 9, 2017

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Moody’s on Puerto Rico Default Status of Entities: Moody’s notes that nearly all of the Puerto Rico’s 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.

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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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October 9, 2017

Relative Value by Maturity

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

10/6/2017

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

0.95 1.04 1.17 1.28 1.39 1.68 2.02 2.47 2.71 2.83 2.90

1.34 1.51 1.65 1.86 1.98 2.21 2.38 2.45 2.65 2.78 2.91

-38.9 -47.6 -49.0 -57.5 -58.6 -53.7 -36.1 2.6 5.8 4.9 -1.1

70.9 68.5 70.4 69.1 70.4 75.7 84.8 101.0 102.2 101.8 99.6

12.2 8.2 13.8 11.7 16.4 36.4 72.7 135.6 151.9 157.4 155.2

109.1 105.4 108.3 106.3 108.3 116.5 130.5 155.5 157.2 156.5 153.2

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

AAA G.O. Muni Ratio and Spreads 20.0

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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October 9, 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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October 9, 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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