It seems as though the summer slowdown hit the municipal market early this year. July is typically one of the best performing months in the municipal market. Not so this year with the Barclays Municipal Bond Index barely able to eke out a 0.06% return over the past month.
Early in the month, the municipal market was firmly in negative territory. However, an end-of-month rally in the fixed income markets helped munis recover. There was some recovery in U.S. and global economic confidence over the month. Enough for market pundits to raise the possibility for a September or December Fed hike. In fact, the Federal Reserve’s (Fed’s) most recent comments stated “Near-term risks to the economic outlook have diminished.” But, we still believe Fed tightenings for 2016 are off the table. Combine that with a continuation of negative interest rates in Europe and Japan and we have little reason to believe that domestic interest rates will rise significantly through year-end. It seems like a good month to focus on some credit thoughts below.
With relatively flat returns over the month, there was little noticeable difference in sector returns. For example, the Barclays General Obligation bond index returned 0.07% while the Revenue bond index returned 0.04% — rather forgettable returns in what has been a stellar year-to-date performance. One notable bright spot in the municipal market for July was the high yield sector. The sector returned 0.65% for the month, which was largely the result of a 1.10% increase in high yield Puerto Rican bonds.
Supply and demand
We saw about $28 billion in supply over the past month, down about 40% from a strong monthly issuance in June. Year-to-date new issue total supply is $242 billion, down 2% from this time last year. Net fund flows for July totaled $6.7 billion. Year-to-date, $44 billion has piled into tax-exempt bond funds.
Municipal yields were virtually unchanged over the month of July but remain significantly lower year-to-date. For example, the 10-year spot fell from 2.00% at the end of 2015 to 1.45% at the end of July — a decline of 0.55 of a percentage point (or 55 basis points). However, for the month of July, the best returns were on the very short end of the curve where yields were flat or slightly lower over the month. The 5-year spot had the best monthly total return at 0.38% according to Barclays Municipal Bond Index.
And the survey says…
A survey of 146 municipal analysts revealed what keeps them awake at night. A recent survey conducted by PNC Capital Markets asked municipal analysts from investment firms, sell-side Wall Street firms and bond insurance companies what the top five most important issues in municipal credit are today. A whopping 93% of the analysts identified public pension funding as the leading concern followed somewhat distantly by issuer willingness to pay, increasing use of Chapter 9 bankruptcy, lack of infrastructure investment and Puerto Rico.
Analyst’s top concern, pension funding, is a widely recognized problem across the nation. Pension funding needs continue to grow, squeezing out spending for basic government services. Pension plans are funded from three revenue sources: employee contributions, government contributions and investment earnings. The National Association of State Retirement Administrators (NASRA) reported that state and local pension fund asset values declined from $3.2 trillion at the end of 2007 to $2.1 trillion in March 2009 following the market crash. Prior to the ensuing recession, very few states required employee contributions. However, after the recession, all but a dozen states increased employee contribution rates. Forty states reduced pension benefits between 2009 and 2014 according to NASRA. Despite these efforts, the low interest rate environment will continue to hinder the funding of pensions. Loop Capital Markets recently reported that the 15-year annual growth rate of the 25 largest state pension funds fell to 5.9%, short of the targeted 7.5%-8.0% investment returns included in pension funding estimates. This does not bode well for future funding levels.
The second most prevalent concern for muni analysts is issuer willingness to pay. As a result of the city of Detroit default, municipal market participants are becoming less enchanted with the typical government general obligation pledge. The City’s full faith and credit tax pledge did not guarantee full recovery for bondholders as general obligation bondholders recovered 74 cents on the dollar. Analysts also noted the increasing number of discussions around the use of Chapter 9 as an option to restructure municipal debt. Analysts admitted that while they continue to have a moderate to high level of trust in state and local officials with respect to honoring their financial obligations, approximately 80% acknowledged the level of trust has diminished.
The National Federation of Municipal Analysts recently released a white paper identifying the need for full disclosure in bond offering documents with respect to legal provisions of a state’s general obligation so that investors are fully aware of their legal rights.
Despite the diminishing trust and growing concerns, the municipal market appears to quickly forgive. The survey reported that over 70% of municipal analysts felt the Detroit Chapter 9 decision was unfair to bondholders. However, just two years after defaulting on billions of debt, the city sold $224 million of municipal bonds, albeit at cheaper levels than comparable rated municipal deals. So far, the impact on the general obligation bond sector appears to be limited, however, future hits to general obligation bond holders could diminish the appeal of this sector and cheapen it relative to the rest of the market.
Schools benefit from open borders
The steadily growing economy, high cost of higher education and fewer graduating high school students in the United States have led to declines in total enrollment at American universities. A recent report stated that overall post-secondary enrollment has decreased 1.3% from 2015 to 18.0 million students in 2016. The decrease was most dramatic for four-year for-profit institutions where enrollment declined 9.3% to 1.1 million. Enrollment at two-year public colleges declined 2.8% to 5.6 million. These institutions cater to adult students, and enrollment levels at these are especially susceptible to employment trends, decreasing when unemployment declines as adult learners enter the work force instead of enroll in post-secondary institutions. Bucking the overall national trend in enrollment are four-year public universities and four-year not-for-profit private universities, whose debt is included in the municipal higher education bond market. From 2015 to 2016, enrollment at four-year public universities rose 0.6% to 7.6 million and increased 0.7% to 3.7 million at four-year private universities. From 2011 to 2016 the increases were 3% and 7%, respectively. The overall enrollment trends would have been worse if not for an increase in international students.
The influx of international students accounted for more than half of the growth of students over the past five years and represents an increasing share of U.S. higher education. Some of this increase has been due to U.S. universities increasing international recruitment efforts in order to offset declines in domestic demand and to maintain fiscal stability. The International Educational Exchange (IEE) reported that the number of international students at U.S. colleges and universities rose 10% to 975,000 in spring 2015. China is the top country of origin for international students, increasing 11% to 304,000 in 2015, while India is the fastest growing, rising 29% to 133,000. The IEE also has reported that in 2013 there were over 70,000 international students enrolled in American high schools, many with the hope of raising chances of being accepted to high-ranking American universities.
Enrollment trends are a critical factor in the evaluation of bonds issued by four-year public and private universities. S&P cited this as a major reason for downgrades outpacing upgrades for the past six years. Four-year universities rely heavily on tuition and student fees for revenues. According to Moody’s Investor Services, tuition and auxiliary revenues (housing, dining and bookstore sales) on average account for 75% of private not-for-profit university operating revenues, and 50% at four-year public universities. Declines in enrollment, and financial aid used to entice students to enroll, have a negative impact on revenues. Also, on average, public four-year universities receive about 30% of their revenues from their respective states. As states deal with other budgetary issues such as slow economic growth, crumbling infrastructure and rising pension obligations, this funding source has come under pressure.
Rising enrollment levels allow universities to be more selective in their admission process, which increases the prestige of institutions and could allow for more pricing power. Further, international students usually receive little financial aid. Therefore, a university’s admission of international students generally has a positive impact on revenues. The downside is that slots for U.S. students can be more difficult to obtain.
Future international student demand, as well as the revenue potential of American public universities, will be driven by the growth in the college-age population, income growth, labor market demand, the supply and quality of higher education in foreign locales, as well as policy changes
by foreign governments.
Happy 60th birthday to…the Interstate Highway System
This year marks the 60th year since funding for the interstate highway system (IHS) was approved by Congress in 1956. The IHS is the most critical transportation link in the nation’s economy and provides high levels of mobility to its citizens and visitors.
While 1956 was the start date of constructing the highway system, it took 30 years to complete the original scope of the project. Currently, the interstate system consists of 47,662 miles. Over the past 60 years, annual vehicle miles traveled in the U.S. have increased from 630 billion miles to approximately 3 trillion miles. The number of vehicles has increased from 65 million to 260 million and the nation’s population has increased from 168 million to 321 million.
The importance of the IHS as the key transportation link in the nation’s economy can be demonstrated by a couple of key statistics:
• The interstate highway system comprises only 2.5% of all roadway miles but accounts for 25% of all vehicle travel in the nation.
• Over 50% of all large commercial truck travel was on the interstate system in 2014.
Over the past 60 years, we have seen large increases in the U.S. population, number of cars, miles traveled, and the size and volume of trucks that use the interstate system. The increase in use combined with roadway maintenance underfunding have led to increasing congestion and roadway deterioration. Over 40% of the interstate system in urban areas is congested, 12% of the system is rated to be in poor or mediocre condition and 18% of bridges are rated as functionally obsolete. The Department of Transportation estimates that the current backlog of improvements totals $190 billion and that the federal government is only spending 60% of what is needed to keep the system in good repair.
A well-functioning, well-maintained interstate highway system is critical to the transportation needs of the U.S. for economic and mobility purposes as well as for global economic competitiveness. The current level of funding is inadequate to address the increasing need for congestion relief and pavement and bridge improvements. An increased level of investment will pay for itself by saving time and the reducing the costs of vehicle repairs. This message has been repeated numerous times in media reports; let’s hope our politicians find a way to make it happen.
From rigs to riches and back
As oil prices reached all-time highs a few years ago, Alaskan officials prudently built up budgetary reserves. State cash reserves, or rainy day funds, socked away over this time reached a record $22 billion. The state’s reliance on petroleum related revenues peaked during this time making up nearly 90% of state revenues. At the same time, officials increased the growth rate of governmental spending.
However, the rainy days have arrived as oil prices plummeted and active rig counts declined by over two-thirds, forcing state officials to dip into cash reserves. At year-end 2015, budget reserves totaled $18 billion or about 280% of expenditures, a very conservative level. However, current expectations are that 2016 and 2017 will end with deficits of about $3.5 billion each and may draw reserves down to about $5 billion. Rating agencies have noted these changes. Moody’s downgraded the state in a two-step move from Aaa to Aa2 and currently maintains a Negative Watch. The state is attempting to improve projected deficits; while not solving all the state’s problems, the governor recently used line item veto power to cut $1.3 billion from the proposed 2017 budget. State officials will likely continue to make the necessary cuts while drawing down reserves.
The state recognizes making budgetary cuts is not a long-term solution. Ultimately, some diversification away from the energy sector is needed. As the state works through this difficult period, local government credits will be pressured, particularly K-12 school districts that will need to find funding to compensate for cuts in state aid. We will continue to monitor the state’s economic growth as well as local government financial positions.
Duration: Maintaining neutral duration as investor inflows continue. We are a bit more cautious as the seasonally strong months for municipal bonds are behind us and as municipal yields remain close to all-time lows. We expect investor interest in municipal bonds to remain healthy over the next several months of global uncertainty.
Curve: Retaining general barbell structure but continuing to reduce floating-rate note position (particularly in the intermediate products) as the probability of near-term Fed hikes declined. We have been buying longer bonds in each fund’s respective investment horizon.
Credit: Lower-quality overweight continues to provide above-average yields and is additive to performance. Quality spreads remain relatively tight and we expect spreads to remain tight over the next few quarters. We are finding value in lower quality continuing care retirement communities.
Sector: Adding to revenue overweight when attractive bonds are available. Continue to find value in smaller, local general obligation bonds. Cheaper bonds can be found from select issuers in Illinois with required input from research staff.