Three themes of Q1
With the first quarter of 2015 now in the books, it offers an opportunity to reflect on the macro-forces impacting municipal market returns year-to-date. Fortunately, returns across all the BMO tax-free strategies were positive for the quarter, albeit only modestly so among our shortest strategies. Like others, we anticipated heightened volatility this year, primarily in expectation of a final lift-off from the Fed’s zero interest rate policy and the potential missteps that might occur in the process. On cue, the market was volatile through much of the quarter, with yields moving sharply in both directions: lower in January and back up in February. But last month, volatility took a (spring) break despite some important changes in Fed views.
What we saw in March was modest curve flattening, which continues to be one of our macro-calls for the year. Short rates rose by as much as 5 basis points (bps) out through five years, while intermediate and longer term yields fell by a similar amount. However, the curve movements were not that straightforward for the full quarter. Instead, since year-end what we have seen from the curve is more “bending,” rather than flattening. For the visually inclined, picture someone pulling lower five-, ten- and 30-year yields, while simultaneously pushing up the 12- to 20-year maturity segment. This odd twisting of the curve only makes sense in light of the cause, which was an abundance of refunding activity.
Refundings occur when municipalities refinance outstanding debt to lower their interest costs, not unlike a homeowner refinancing their mortgage. Heavy issuance 10 years ago at higher interest rates allows municipal issuers to call bonds now and issue replacement debt (current refundings) at a significantly lower cost. In addition to the current refundings, a heavy slate of advance refundings is also occurring. In an advance refunding, the outstanding debt may still have a few years before they can be called, so new debt is issued and the proceeds are deposited into an escrow account, typically in U.S. Treasuries. The escrow funds are then used to call the debt on the first call date. It’s a means for issuers to lock in the cost savings “in advance” of the call date. The result of both current and advance refundings has been an abundant new supply in the 10- to 20-year segment of the curve, which placed upward yield pressure on yields in that maturity range. So the first big theme for the quarter was abundant municipal supply, 70% of which have been refundings.
Total municipal issuance in the quarter was just over $100B, which is 60% above last year’s pace and higher than the first quarter average of $83B over the past 10 years, according to J.P. Morgan Securities. While the higher supply has created excellent value in the municipal market (more on this below), as long as rates remain relatively low and refunding activity is high, yields on 10- to 20-year tax-free maturities are likely to remain higher than would otherwise be expected.
A second theme last quarter, which surprised both the market and the Fed, was relatively weak U.S. economic data. Away from the solid pace of new hiring, which produced over 860,000 new jobs in the last three months (ending February), much of the other data was softer than expected. This was most evident in the Bloomberg ECO Surprise Index (ESI), which, according to Bloomberg, monitors “the degree to which economic analysts under- or overestimate the trend in the business cycle.” The ESI ended March at its lowest level since the start of the economic recovery in March of 2009. For the second year in a row, weather had a dampening impact on economic activity, the full extent of which won’t be known for several weeks. Another cause for sluggish first quarter growth was the strength of the U.S. dollar relative to other global currencies, particularly the euro. While exports represent less than 15% of U.S. GDP, the dollar’s strength reduces the appeal of U.S. exports and lowers U.S. inflation pressures, both of which are working against the twin Fed goals of higher employment and moderately higher inflation.
The third quarterly theme relates to the second, in that the slower growth and tame inflation led to a modest revision in U.S. monetary policy. As widely expected, the Fed removed the word “patient” from their official statement, as far as the intent to hold off on the first rate increase, but they then softened market expectations in other ways, including a revision in the projected level and pace for the fed funds rate in the future. The Fed essentially capitulated to market views with the two now aligned around the view that the fed funds rate will end 2015 between 50 bps and 75 bps. This outlook provided a calming effect on market rates, leading to only modest yield changes in March.
The value in tax-free municipals
While investors are understandably frustrated with the persistently low absolute level of market rates, within the universe of fixed income options, municipals remain relatively attractive. To help illustrate this view we offer a few different perspectives: First, for the sake of discussion, let’s assume that the credit quality of a AAA rated municipal bond is equivalent to that of a AAA rated U.S. Treasury bond (S&P rates the U.S. government AA+, but all other major rating agencies rate it as AAA). If so, the yield difference between two equally rated bonds, one of which is taxable and the other tax-free, would be determined simply by the investor’s marginal tax rate. For example, with a taxable 10-year U.S. Treasury bond yielding 1.93%, the after-tax yield would be 1.09% for an investor in the highest marginal federal income tax rate of 43.4% ((1.09 *(1-0.434)). Therefore, if a AAA tax-free municipal bond were to yield more than the after-tax yield of the Treasury, 1.09%, the investor would be better off selecting the muni over the Treasury. In fact, the 10-year yield on a AAA tax-free municipal bond at month-end was 87 bps higher than this, at 1.96%, according to Municipal Market Data.
Another way to look at valuations across the municipal yield curve is what is known as the municipal/Treasury yield ratio. This ratio compares the tax-free municipal yield to the taxable Treasury yield. Sticking with the 10-year example above, the muni/Treasury yield ratio would be 102% (1.96/1.93%). Once again, in theory, the ratio of these two yields should be determined primarily by current effective tax rates. But with tax-free municipals yielding more than comparable maturity taxable Treasuries, the implied tax rate is zero! Theoretically then, any tax-paying investor would opt for the tax-free municipal bond, regardless of their tax bracket. And, the higher the tax bracket, the better the relative value. The investor in the highest tax bracket (43.4%), would, in theory, be indifferent with a muni/Treasury yield ratio of 56.6% (1 – 43.4%). So, at the current ratio of 102%, the tax-free yield is an easy decision for the higher bracket investors.
In reality, however, many factors can influence the muni/Treasury yield ratio at any point in time beyond just current tax rates. Among those are: cross-market liquidity differences, perceived credit variations, uncertainty over future tax rate changes, supply/demand imbalances and the nominal level of rates. Not surprisingly, the relative value between tax-free debt and taxable debt varies over time, sometimes dramatically. In 2006 and 2007, for example, before the financial crisis, the 10-year municipal/Treasury ratio traded in a range of 75% to 90%, slightly rich to the average yield ratio over the last 10 years of 93%.1 After Lehman Brothers filed bankruptcy in 2008, however, the yield ratio spiked higher, peaking at 186% when tax-free yields were double those in the Treasury market. To be clear, corporate and mortgage credit spreads also rose to record levels at that time, so it was a global phenomenon that impacted all non-Treasury yields, not just the municipal market. Post-crisis, municipal yields have never fully returned to the richer trading levels they experienced back in 2006/07. The more recent ranges for the 10-year municipal/Treasury yield ratio have generally been between 85% and 110%. At 102% currently, the municipal/Treasury yield ratio continues to represent an attractive relative value.
Finally, we’ll use a real-world example from a recent new issue to help illustrate the value in tax-free bonds. On March 25, the Dupage County, IL, Forest Preserve District issued more than $29 million of tax-free debt. This credit is backed by an unlimited tax general obligation of Dupage County, which is rated Aaa by Moody’s and AAA by S&P. The five-year Dupage bond, due 1/1/20, was issued with a tax-free yield of 1.50%. On the same day, the five-year U.S. Treasury yielded 1.35%. Once again, the nominal yield of the tax-free bond was higher than that of the taxable Treasury, making the marginal tax rate of the investor unimportant from a yield perspective. Yet, for an investor in the top tax bracket (43.4%), the pre-tax equivalent yield of the Dupage Co. bond was 2.65% ((1.50/(1-.434)), or 130 bps above the Treasury yield. Obviously, if an investor is willing to consider lower quality tax-free issues, perhaps in the AA or A rating category, while the risk profile diverges further from a U.S. Treasury issue, the excess pre-tax yield also increases at the same time.
In the October 2014 issue of Municipal Insights, we began a conversation about liquidity concerns across the fixed income markets. Concerns regarding sufficient market liquidity for bond investors have been raised by regulatory bodies, money managers and market pundits, all of whom are looking at the massive flows into fixed income markets over the last several years, thanks in large measure to the Fed’s own extraordinary monetary policy. At the same time that the assets have grown, there are fewer dealers involved in trading today than pre-financial crisis and among those dealers, less capital at risk to provide bid side support during periods of heightened volatility. Some have argued that the liquidity burden has at least partially shifted from dealers to investors. In fact, investors have always born the risk of market volatility, but have perhaps been lulled into a greater sense of comfort in recent years thanks to the stable monetary policy. How investors will react to a tighter monetary stance is uncertain, but that uncertainty contributes to expectations for heightened volatility.
As we stated last October, liquidity concerns are nothing new to the municipal market. Liquidity risk is inherent in a market as disparate as municipals, which includes thousands of issuers, traded through hundreds of dealers, with the majority ownership (60%) of the asset class being households and retail-oriented mutual funds. When sentiment shifts among individual investors, as it did in the summer of 2013 with concern over the taper of Fed asset purchases, outflows persist and market liquidity declines. However, since the outflows stopped in January 2014, the market has experienced the flip side of the illiquidity trade. Inflows have been the dominant theme ever since. According to Investment Company Institute (ICI), the municipal market has experienced 36 consecutive weeks of inflows. While this momentum won’t last forever, liquidity has been more than ample in recent months.
In the BMO tax-free mutual funds, we track the liquidity conditions of the market very closely. We monitor market flows over a rolling four- and 12-week period for the entire municipal market, as well as for each fund sub-category, including: short, intermediate, long and high yield municipal funds. Both the direction and magnitude of the fund flows serve as a starting point for the overall level of liquidity that is deemed appropriate for the funds. Beyond that, each security held in the funds is analyzed through a proprietary system that then assigns a liquidity score to each individual bond.
The liquidity of a security will vary based on seven different metrics, which include:
- the par value of the security
- the par value of the entire maturity of the security
- the size of the total issue
- the credit rating
- the state of issuance
- the effective maturity date
- the coupon/price of the security
Each security is then ranked from the most liquid to least liquid and assigned to one of four liquidity tiers: primary, secondary, tertiary and illiquid. On an ongoing basis across all the BMO tax-free funds, we manage the allocation to each of the four liquidity tiers depending on the predetermined liquidity expectation. For example, when inflows are consistently positive, the desired level of liquidity would tend to decline. Conversely, when market inflows slow or reverse, liquidity indicators will lead to higher levels of liquidity in the funds. The liquidity system is a guide, but the ultimate level of liquidity will also depend on other decisions, such as the relative duration posture and yield curve allocation. It’s flexible enough to not overly constrain the portfolio management process, yet useful in preparing the funds for anticipated liquidity needs.
Regulators and investors alike are appropriately raising liquidity questions across the fixed income spectrum. The extraordinary monetary policy over the last six years has very likely encouraged some investors to take on more risk than they truly desire. Unfortunately, this realization may not be evident until the Fed’s normalization process is further along. In the BMO tax-free funds, we will continue to actively monitor liquidity conditions in the market very closely. Our goal is to never be in a position where we are forced to liquidate holdings at disadvantaged prices to meet shareholder redemptions. Look for further updates on this topic in future Municipal Insights.
1 Source: Municipal Market Data.