Asset Management: Municipal Insights

December 2016 Municipal Insights

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November muni bond returns worst since 2008

Strong outflows from municipal bond funds led to the worst total returns in the municipal market since 2008. Negative returns, which began in September and worsened in October, drove investors out of municipal bond funds in November — outflows totaled $10.8 billion.


Municipal yields moved rapidly higher over the month with the 10-year AAA spot 0.75 percentage points higher (or 75 basis points) ending at 2.50%. That’s 115 basis points higher since the end of June. The Bloomberg Barclays Municipal Index returned a disheartening -3.73%. Year-to-date, the Index returned -0.92%.

Source: TM3, ICI
Source: TM3, ICI

Much of the municipal bond sell-off was in sympathy with the broader fixed income domestic market. With the Republican win, bond investors’ immediate reaction was negative due to President-elect Trump’s aggressive plan to increase fiscal policy (and perhaps fiscal deficits). Other concerns for bond investors include a more upbeat economic outlook and the potential for increased inflation and/or inflationary expectations from tariffs and other trade restrictions. Long Treasury yields rose about 40 basis points as a result. Long municipal yields rose by 70 basis points, underperforming other fixed income securities due to continuing heavy new issue supply as well as the tax-reform plans of the incoming administration; more on that below.

Market commentary

Sector performance

Lower-quality bonds significantly underperformed for the month as outflows from high-yield municipal funds and ETFs weighed on the low-quality sectors. As mentioned last month, high-yield funds’ most liquid holdings are BBB-rated bonds, and a much larger than normal amount of these were put out for the bid to fund billions in outflows from the sector. The Bloomberg Barclays BBB-rated Bond Index returned -4.32% versus -3.55% for the AAA-rated Index. The Bloomberg Barclays Muni High Yield Index returned -5.95%. The worst performing sub-sector was the HY Tobacco index which returned -9.19%. This is a more liquid sector in municipal high yield and typically experiences this type of volatility when high yield funds experience outflows. Credit spreads for BBB munis are at their widest levels over the past year.

Supply and demand

Municipal bond volume dropped 9% in November to $24 billion. Issuance year-to-date is $416 billion; just $18 billion shy of surpassing 2010’s record issuance of $433 billion. Refunding deals increased 60% from October 2015 as issuers rushed to market before the election and a likely Fed hike in December. As interest rates rose dramatically over the month, municipal bond deals were canceled or delayed. Prerefunding deals declined by 7% from last year and new money deals declined by 21%. Average weekly supply this year is running at $8.6 billion versus $7.6 billion last year.

As mentioned above, demand for municipal bonds weakened substantially. With November’s outflows, year-to-date inflows to
municipal bond funds and ETFs have dropped to $46 billion from $57 billion last month. The outflows are creating some challenges for the municipal market with dealer inventories growing as bid-wanted lists from the mutual fund managers soared over the month.

Yield curve

Source: Thomson Municipal Market Monitor
Source: Thomson Municipal Market Monitor

Over the month, municipal yields spiked 70 basis points higher from the 5-year spot on out. Yields for bonds maturing less than five years were 20 to 60 basis points higher. Total returns across the curve grew progressively worse the longer the maturity. The 1-Year Index returned -0.43%, 5 Year -2.68%, 10-Year -4.48% and the Long Bond Index returned -4.95%. Yield curve positioning and duration management were the primary drivers of municipal returns over the past month.

Trump impact on muni market

This past November, voters went looking for change, and beginning in January, change is what they will get. President-elect Trump will be the primary catalyst for change and uncertainty in 2017. It’s fair to say that potential changes by President-elect Trump will not benefit all states evenly. Regions reliant on energy production may profit while those reliant on international trade may suffer due to trade protectionism (import inflation?). Immigration policy could have wide-ranging effects across several states. Texas and California rely on immigrants for agriculture, construction and food service jobs that may not be easily filled after possible immigration policy changes. Additionally, a loosening of regulatory policy could ease financial burdens across various industries, particularly the financial industry. However, we think the most immediate and primary areas of concern for the municipal market are tax reform, repeal and replacement of The Affordable Care Act (ACA), and infrastructure spending. However, before we finalize our strategy, we need more clarity on policy, which should be forthcoming as the new administration prepares a federal budget. The President typically releases a federal budget proposal the first week of February. The President’s State of the Union address will be in mid to late February. President-elect Trump’s plans will be heavily scrutinized by more fiscally conservative Republicans looking for revenue-neutral policies.

Tax reform

Comprehensive tax reform now appears likely in 2017 as Republicans control the White House and both houses of Congress. President-elect Trump ran on a platform of lower taxes and House Speaker Paul Ryan also has a strong desire to change the tax code. However, the GOP does not have enough votes in the Senate to stop a Democratic filibuster. So, to some extent, tax policy is going to be subject to deal-making between the President-elect and Congress.

President-elect Trump’s tax plan will reduce income and corporate taxes. His latest version proposes to 1) reduce individual income tax rates and lower the number of brackets from seven to three — 12%, 25%, and 33%; 2) eliminate the Alternative Minimum Tax (AMT); 3) eliminate the 3.8% net investment tax (Medicare surcharge); 4) lower the corporate tax rate to 15% from 35%.

These policies are very close to those presented by House Republicans this past summer. Negotiations for a compromised plan could proceed relatively quickly. Some have suggested that the probability of enacting comprehensive tax reform by August is as high as 80%. We shall see.

Importantly for municipal market investors, this plan may have some negative impacts on municipal bond prices. The question of how much of an impact is difficult to answer. Lowering income tax rates may pressure municipal bond prices lower (yields higher) if the demand for tax-exempt bonds diminishes. Why? Because the attractiveness of the taxable equivalent yield is lower at the 33% tax bracket versus the current highest bracket of 39.6%.

We would counter that most municipal bond investors are not in the 39.6% tax bracket. Also, the taxable equivalent bond is still very attractive to investors in a 33% tax bracket. For example, 10-year, AAA municipal bonds were recently offered at a 2.53% yield. The taxable equivalent yield for an investor in the 33% tax bracket would be 3.78% — that is 1.30 percentage points over the 10-year Treasury bond (or 130 basis points)! Municipal bonds are viewed by many as the second
safest fixed income investment in the U.S., right behind Treasury bonds, and they can be had at taxable equivalent yields much higher than most other fixed income securities.

Additionally, lower tax rates have not always resulted in cheaper municipal bonds relative to other fixed income investments. For example, in 1987-92 the upper tax bracket was much lower than now at 28–31%. The 10-year muni/treasury yield ratio average 77%. Over the past year, the highest bracket has been 39.6% and the 10-year muni/treasury ratio has averaged 93% (higher ratio = cheaper muni) — munis are much cheaper now with a much higher tax bracket. There is no correlation between the level of tax brackets and the demand or relative value of munis.

One of the more concerning aspects of both plans, not mentioned above, is the possible restriction of deductions. It’s too early to tell if there are any plans to cap municipal tax deductions, but we do not think it is on the agenda at this time.

We believe bonds subject to the alternative minimum tax are attractive in light of the plan to eliminate the AMT. AMT bonds have recently offered an extra 0.30-0.40% more yield than non-AMT bonds. That difference would likely disappear if the alternative minimum tax is eliminated — AMT bonds would outperform.

On the corporate tax side, reducing the rate from 35% to 15% could reduce demand for munis from insurance companies and possibly banks. However, individual investors still own approximately 70% of municipal bonds either directly or through mutual funds and ETFs.

Repeal & Replace the Affordable Care Act (ACA)

President-elect Trump vowed to “repeal and replace” ACA during his campaign. This is the top healthcare priority for the new administration. The reduction or elimination of subsidies is slightly negative for hospitals as volumes will likely suffer and uncompensated care will likely increase. People who received insurance due to Medicaid expansion will likely continue to be insured. States could be facing some tough decision should the funding for Medicaid expansion be eliminated or reduced. States may have to decide whether to fund the additional cost or eliminate or reduce coverage. The move to value-based reimbursement from fee-for-service will continue, pre-existing conditions will continue to be covered, and offspring to age 26 will continue to be covered.

Some thoughts on this front for 2017. Work towards repeal and replace could move quickly as a reconciliation bill that repealed key aspects of Obamacare passed through Congress in late 2015 but was vetoed by President Obama. This could be the blueprint going forward. We do not believe a repeal will occur without some replacement. A large unknown is what it will mean for providers reimbursement rates and Medicaid expansion. While we do not expect near-term operating problems for most credits, the potential speed of change and the lack of clarity for reimbursements leads us to reduce our overweight to the hospital sector. We will continue to hold our stronger, well-diversified systems.

Infrastructure spending

We don’t think many would argue against the need to repair America’s infrastructure. Numerous studies have pointed out crumbling roads, faulty bridges, and lead in water pipes all costing trillions to repair. President-elect Trump’s infrastructure plan calls for $1 trillion worth of infrastructure investment over 10 years. However, instead of relying on
the typical financing through state and local governments (municipal bonds), Trump is proposing giving federal tax credits to private investors who back transportation projects. Trump believes that the private sector will be more efficient in construction than governmental entities. The plan also mentions public-private partnerships and Build America Bonds as other potential financing sources. It has also been suggested that President-elect Trump’s desire to repatriate dollars (the tax thereon) from U.S. corporations overseas could be a significant source of funding for infrastructure needs.

So, it is unclear if increased spending on infrastructure will increase municipal bond issuance. Private investment and public-private partnerships would only work on projects that have tolls or user fees. If taxable Build America Bonds were used, as they had been in 2009-10, we could see a reduction in the use of tax-exempt bonds, causing tax-exempt bonds to appreciate. It’s just too early to say at this point.

Credit

Election results

A record number of ballot initiatives, including higher minimum wages, dedicated taxes for mass transit, greater infrastructure spending, and increased funding for schools, are keeping analysts busy quantifying the potential impacts to local economies. Voters decided on 590 municipal bond measures totaling nearly $70 billion, the highest amount requested since 2006. California maintained their position as leader in ballot initiative activity accounting for about $42 billion of the $70 billion. Overall, the results of ballot initiatives in November were positive for municipal issuers.

States

There were five states that voted on raising taxes at the state level. North Dakota and Louisiana passed measures establishing reserves for future years. Hawaii established the use of excess cash to pay down liabilities improving overall credit position. California and Maine both increased the personal income taxes to help fund education and healthcare. California voters also approved a cigarette tax increase of $2.00 per pack. The state accounts for 10% of cigarettes sold in the U.S. and this tax could prove negative for non-investment grade tobacco bonds owned largely by municipal high yield funds.

Education

Education received strong support across the country with most states increasing funding for K-12 with the exception of those states dependent on the energy sector.

  • Voters in California supported Proposition 51, a $9 billion statewide school bond program providing capital financing for K-12 schools, community colleges, charter schools and career tech facilities.
  • Denver voters approved a record $628 million bond issue for Denver Public Schools, the second largest bonding program in the district’s history.
  • Additionally, voters across Texas supported 692 ballot measures earmarking funds towards schools.

Charter schools generally receive the bulk of their revenues from state funding, on a per pupil basis. Therefore, growth in enrollment is a critical factor for the financial health of charter schools and is frequently needed to support escalating debt service. Many charter schools, particularly in California, Arizona, and Texas, support large immigrant populations. Therefore, any policies that reduce positive trends in immigration would be a negative factor for charter schools.

Infrastructure & transportation

As discussed above, infrastructure spending is likely to rise due to President-elect Trump’s infrastructure plan, but will also be boosted by numerous voter-approved initiatives. Mass transit projects in California, Washington and Georgia were approved with solid majorities of 60% to 80% of the votes. In Seattle, the Central Puget Sound Regional Transit Authority won the approval of a sales tax across three counties to finance the construction of an additional 62 miles of light rail system throughout the region. In Austin, voters approved a $720 million mobility bond for highway and local road projects. Los Angeles County approved tax increases that could raise $120 billion for transportation infrastructure over the next 40 years. Illinois and New Jersey voters approved the restriction on the use of transportation-related revenues for transportation-only purposes. These projects are much welcomed as Americans drove nearly 145 billion more miles in 2015 than in 2014.

Public power

President-elect Trump’s pro-coal stance and willingness to repeal the Clean Power Plan would be positive for the municipal power sector. The possible elimination of renewable energy tax incentives would also place power generators on a more even playing field. However, many states have embraced renewable energy and the reduction in carbon footprint so President-elect Trump’s policies may not be a game changer.

Strategy overview

Duration: Favoring short duration and defensive positioning as fund flows turned strongly negative in November – almost $11 billion in outflows. A post-election bear bond market was a major factor for outflows. The resulting crash of returns in the municipal market spooked investors. Record high bond issuance is also dampening muni market performance. The Fed’s rate hike in mid-December was widely expected and moved the federal funds target to ½ to ¾ percent. However, the Fed was modestly hawkish in suggesting a potential for three hikes in 2017 versus the previous expectation for two hikes. Watch municipal flows closely for some stabilization before lengthening duration. We also recommend moving up in coupon being more defensive to rising interest rates.

Curve: Retaining barbell structure with floating rate notes on the short-end of the curve and fixed coupon bonds on the longer end of the fund’s investment horizon. Maturing bonds are being invested in tax-exempt floating rate notes as daily and weekly rates are still elevated at about 0.65%. The weekly municipal floating rate index (SIFMA rate) moved 6 basis points higher (from 0.57% to 0.66%) after the Fed’s December rate hike.

Credit: While our lower-quality overweight continues to provide above-average yields, the performance of lower quality bonds, particularly BBB-rated bonds, significantly lagged higher quality bonds over the past month. Quality spreads widened out in November due to the backup in interest rates as well as cheaper prices on lower quality, new-issue deals to enable them to clear the market. Municipal high-yield funds and ETFs also caused BBB-rated bonds to underperform by dumping many of these bonds in the market to pay for investor redemptions. We think BBBs are cheap at this time and are adding exposure.

Sector: We are reviewing our hospital holdings in light of President-elect Trump’s plan to repeal and replace the Affordable Care Act. We are likely to reduce our overweight to this sector with select sales. However, we will continue to hold our stronger, well-diversified systems. We need more clarity on policy before reacting too negatively. Adding to revenue overweight when attractive bonds are available. Continue to find value in smaller, local general obligation bonds.

 

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