March bucks trends
Not a typical March for the municipal market. Historically, seasonal tax-exempt issuance increases in March and demand ebbs as retail investors sell municipal bonds/funds to pay their tax bills. While we saw this to some extent, it was much more subdued than in past years. The municipal market also benefited from a mid-month rally in the government bond market. Ultimately, the Barclays Municipal Bond Index eked out a positive 0.32% for the month. First-quarter performance came in at a strong 1.67%. At this time, we see no signs that would cause a strong reversal in year-to-date performance. We continue to take cues from domestic economic releases and, increasingly so, domestic and global financial markets. In a recent speech, Fed Chair Yellen dampened expectations for any imminent rate hikes with some very dovish comments. Fed moves now hinge on data flow and headlines, and you can’t forecast headlines.
Lower-quality bonds posted the best returns in the municipal market over the month. For example, Barclays’ BBB index retuned 0.60% for the month versus 0.21% for the AAA index. The lower-quality hospital index (0.81%) and the corporate-backed IDR/PCR index (0.76%) also outperformed higher-quality indexes. High-yield municipal bonds (1.05%) posted the best returns as prices rose and spreads tightened due to significant demand from tax-free high-yield funds, which witnessed sizable inflows over the month. Similar outperformance of lower-quality bonds held true for the quarter as BBB-rated bonds (2.03%) outperformed AAA-rated bonds (1.51%) by over 50 basis points.
Supply & demand
Municipal bond issuance totaled $43 billion for the month, bringing first-quarter total volume to about $100 billion. March issuance led to a solid quarter of new volume for the municipal market, but was down about 7% from the same period in 2015 in which we saw a record amount of refunding activity. As seasonal patterns predicted, net issuance jumped (to $16 billion) as fewer bonds matured or were called away, adding to the amount of municipal bonds outstanding. Net issuance is total monthly issuance less maturing bonds, redemptions and coupon payments. April issuance is expected to be in the $40 billion range with only $22 billion expected to mature or be called away, the lowest amount in over a year.
Despite improved equity markets, municipal bond funds reported their 26th consecutive week of inflows. Municipal funds had over $5 billion of inflows in March and approximately $14 billion year to date. We see no reason at this time for investors to reverse the trend of inflows into municipal bonds. If equity market volatility continues, we expect demand for tax-exempt bonds to remain healthy.
Yield curve positioning was a dominant determinant of performance for the month of March. The 10-year-and-longer portion posted positive returns while the shorter portion of the curve posted negative returns. The Barclays Municipal Long-Bond Index posted the highest total return at 0.88% while the Five-Year Index declined 0.38%.
Long-term care market aided by the strong housing market
The not-for-profit long-term care sector realized strong performance in 2015 after showing signs of recovery following the recession. This sector of the municipal market is composed of continuing-care retirement communities (CCRCs), assisted living facilities, and skilled nursing facilities. Continued strength in the housing sector combined with the aging population should continue to support the long-term care sector going forward. Wells Fargo reported recently that debt issuance in the long-term care sector was up 35% to $4.5 billion over the past year, the highest level of debt issuance in the sector since 2007. Bond deals in this riskier municipal sector typically offer more yield to investors as most of the obligors are in the A-rated category or lower.
The CCRC sector was hit hard following the real estate downturn of the last recession. Most CCRCs require an entrance fee from new residents. As the real estate market sank, many elderly people looking to relocate to a retirement community were unable to sell their homes to pay the entrance fee. The resulting drop in new residents led to lower occupancy and weaker financial results, which limited the ability of CCRCs to issue debt. Management teams worked to stabilize occupancy levels and put off any additional capital spending. According to S&P, 2014 occupancy levels reached prerecession levels, allowing management teams to review capital programs, including renovations and expansions. The expectations are that debt issuance will remain elevated as the population ages. The U.S. Census Bureau has projected the senior population to reach 84 million by 2050 from the current level of 46 million, suggesting current capacity will be insufficient.
Experienced credit analysts are needed to invest in this sector. S&P reports that 60% of the CCRC ratings are rated BBB or below investment grade. However, according to LeadingAge, the industry magazine, fewer than 20 CCRCs have filed bankruptcy since 2008. One reason for this relatively low level of failures is that the smaller size of many of these facilities allows management more flexibility when addressing occupancy levels and cost containment. Mergers have also helped facility operators gain cost efficiencies and maintain credit profiles. These factors combine to support the long-term care sector particularly CCRCs, as an investment opportunity going forward. We expect this sector to take a growing share of the municipal market over the next few decades, providing experienced investors with more opportunities to support the retirement community and receive an attractive return.
Pennsylvania governor finally gets it
After a nine-month delay, the Commonwealth of Pennsylvania’s 2016 fiscal year budget became law on March 28 after Democratic Governor Tom Wolf decided not to veto the budget the Republican-controlled legislature had passed. The budget delay was primarily caused by differences between the governor and the legislature regarding additional taxes, pension reforms and funding levels to schools. The governor pressed for tax increases in order to increase education funding and close the structural budget deficit. Republican house and senate leaders resisted tax increases and pushed to change the retirement system to a 401K plan for new government workers.
The delay demonstrated the commonwealth’s lack of political will to rectify fiscal issues. This factor, along with an estimated $2 billion deficit for the 2017 fiscal year budget due June 30, 2016, and an enormous $54 billion unfunded pension liability, sets the stage for the start of another budget delay this summer. The market would most likely continue to punish Pennsylvania with higher borrowing costs in the future without a long-term resolution to the commonwealth’s structural budget deficit. Pennsylvania, which has suffered rating downgrades over the past few years, is currently rated Aa3 (negative outlook) by Moody’s and AA- by both S&P (negative outlook) and Fitch (stable outlook). Investors can expect continued negative outlooks and possible downgrades should the commonwealth not address its structural imbalance and pension liabilities.
Illinois stands alone
Illinois Governor Bruce Rauner, unlike his Pennsylvania counterpart Governor Wolf, appears to be in no hurry to sign off on a budget he does not like. With Pennsylvania having signed a fiscal year 2016 budget, the state of Illinois is now the only state without a 2016 budget. Local schools have had a better time in Illinois as Governor Rauner and the legislature did provide for the payment of local school funding (Pennsylvania did not). While local school funding has been appropriated, the governor has not signed off on a recent spending bill that would provide funding for higher education students and institutions. The governor noted that the state does not have sufficient revenue to meet its level of higher education spending and that Illinois needs to address how it provides for higher education. The lack of funding has put many universities at the risk of not opening for the fall 2016 academic year and damaged many community colleges across the state financially. The backlog of bills the state owes its many vendors has reached $9 billion, with many social providers having to close their doors without the state reimbursements. Recent commentary around the state is that a signed budget is most likely not going to occur until after the November general election.
Despite Illinois’ deadlock, local schools remain on a positive path
The Illinois State Board of Education (ISBE) released its annual school district financial ratings. Districts are scored according to several credit metrics based on their fiscal year 2015 filings with ISBE. Overall, school districts across the state appear to have improved financially, despite the state’s delayed payments on state aid. The number of districts receiving the highest designation, Financial Recognition, rose to 568 from 553 in 2014, while the number of districts in the lowest category, Financial Watch, fell to 32 from 38. Additionally, several Illinois school districts will benefit from recent voter-approved tax levies.
Chicago pension reform denied
As expected, the Illinois Supreme Court agreed with the Circuit Court of Cook County and ruled that Chicago’s new pension reform law was unconstitutional. The Supreme Court provided a small piece of insight as the ruling indicated that an employee could knowingly agree to modifications in exchange for other considerations. This ruling was expected by most market participants and the value of Chicago-issued bonds was basically unchanged following the ruling. The city remains pressured to present a funding plan. Moody’s and S&P had both previously indicated that the lack of a solution to address the unfunded pension liabilities is a credit negative.
New York shrugs off weak market
Two municipal issuers, New York City (AA) and the state of New York (AA+), both heavily reliant on the financial industry, have been unfazed by weaker bonuses in the financial sector. Though accounting for only 4% of total employment in New York City and only 2% statewide, the securities industry in 2014 accounted for 20% and 12% of total wages in New York City and the state of New York, respectively. Bonuses alone accounted for about 8% of total wages in New York City and about 5% in the state of New York. From a budgetary perspective, the state budgeted for a 2.5% decline in bonuses while the city forecast flat bonuses. Anemic bonus growth is not likely to require budgetary cuts or result in rating downgrades.