The January effect
Despite the Fed hike last December, the municipal bond market continued its climb higher through January for several reasons. First, the supply and demand imbalance we saw in the fourth quarter of 2015 continued. Secondly, the rapid decline in global equity markets resulted in a flight into the relatively safe municipal bond market. And lastly, at the beginning of each year, the municipal market benefits from seasonality in January — a month of heightened coupon payments and bond maturities, the cash from which is typically reinvested back into the tax-exempt market. And with investors already chasing positive returns seen at the end of 2015, the past month provided exceptional municipal performance. The Barclays Municipal Bond Index returned 1.19% in January and 2.31% over the past three months, which looked exceptionally strong relative to other asset classes.
Unlike 2015, where lower quality significantly outperformed high quality, investment-grade bonds performed similarly over the month. The difference in total return between AAA-rated bonds (1.17%) and BBB-rated (1.20%) was only three basis points. Likewise, general obligation bonds performed in line with revenue bonds. There were some differences within the revenue bond sectors. Hospital bonds underperformed due to heavier issuance in that sector and housing bonds underperformed — as they typically do in a bond rally — due to their below-average interest rate sensitivity.
Energy-dependent states (namely Alaska, Louisiana and North Dakota) also lagged in performance due to the continuation of low oil prices. The Commonwealth of Puerto Rico also underperformed, as it continues to struggle to meet debt payments. Most of the Commonwealth’s debt falls into the high-yield sector. Its underperformance was the main reason the Barclays Municipal High Yield Index lagged investment-grade bonds by about 80 basis points in total return over the month.
Supply & demand
Recent gains in munis were largely attributable to another month of demand outstripping supply. Municipal bond issuance totaled $24 billion for the month, which was flat month over month but down 16% from last January. Most of this decline is attributable to a drop in refunding deals, where issuers refund older, more costly debt. New-money deals increased 25% from last year, a hopeful sign that issuers are taking advantage of low interest rates to fund infrastructure projects.
We ended the month with 17 consecutive weeks of inflows into tax-exempt funds, benefiting from weak flows into equity and taxable bond funds. Equity funds have seen $65 billion in outflows over the past three months and taxable bond funds lost about $50 billion. Tax-exempt bond funds have been one of the few sectors to see inflows, with over $12 billion of net inflows over the past three months — over $5 billion in January alone.
While tax-exempt bonds cheapened a bit relative to Treasurys over the past month, they continue to look rich versus other fixed income sectors. For example, a 5-year AA municipal bond yield is about 1.15%. A 5-year AA corporate bond yield is 2.55% — 140 basis points higher yielding than the muni bond. Last year, the spread was about 110 basis points. We expect this spread to tighten (i.e., municipal bonds should underperform) as the outlook for equities and corporate bonds improves.
The driving factor for performance over the quarter was positioning on the yield curve. Typically in a strong rally like January’s, the longest portion of the curve would post the best returns. However, strong retail demand in the intermediate portion of the curve helped it outperform the long end by over 30 basis points (1.16% for Barclays Muni Long Bond versus 1.52% for Intermediate). You can see this in fund peer group performance as well. For example, the average year-to-date performance for funds in Lipper’s Long Municipal peer group is 1.10% versus 1.22% for funds in Lipper’s Intermediate Municipal peer group.
Credit outlook 2016
As we start 2016, the overall credit quality in the municipal market remains strong with all sectors maintaining stable outlooks from the major rating agencies. However, there are headwinds that may weigh on certain areas of the tax-exempt market: low energy prices, weak global markets, and greater fixed costs such as pension expenses. For example, the State of Alaska recently lost its AAA rating status due to low oil prices and their negative impact on state revenues. The higher education sector continues to struggle as many smaller four-year colleges face weak or declining revenue growth, limited pricing flexibility and challenged student demand. On the other hand, the transportation sector has a positive outlook supported by the economic recovery, improved consumer confidence, and low gasoline prices with the resultant increase in driving on toll roads. Ultimately, strong fiscal management, including a focus on cost containment, will be a major driver of municipal credit going forward. The following are our highlights for municipal market sectors over the coming year.
Our outlook on the state sector remains stable, although there are signs of strain in certain states, particularly energy-dependent states. States with significant exposure to the energy sector are currently revising budgets and bringing expenditures in line with lower tax receipts. Also, some pockets of the country have not realized the strong economic gains other areas have. The Northeast and certain Midwest states remain burdened by older manufacturing and infrastructure, as well as legacy union costs.
Across the country, governors are presenting their State of the State addresses and sharpening their pencils for upcoming budget sessions. State budgets are indicating flat revenue growth is to be expected in the upcoming fiscal year. Fixed costs such as pensions and debt service are projected to consume a larger percentage of revenues. We expect to see some marginal uptick in downgrades and negative outlooks for this sector as we progress through the year.
The rebound of the real estate market has been the backbone of the recovery for local governments. Property taxes have provided local governments with a stable revenue base and the ability to manage through the recession. As the economy maintains its modest growth, home values continue to rebound, enabling local governments to restore many of the services lost during the recession. Moody’s has projected property tax receipts to increase 2%–3% over the next year.
Water and sewer
This sector has benefited from management’s willingness to raise rates to maintain credit metrics. The Moody’s median debt service coverage for this sector is approximately two times — meaning water and sewer operational revenues can cover two times the amount of debt service payments. Rate increases have been more acceptable to users in this relatively stronger economic environment. Environmental Protection Agency restrictions on drinking water and treatment regulations may cause some headwinds in the future. Despite the severe drought in California, the willingness to raise rates, and conservation efforts, prevented a large number of downgrades among the state’s water districts.
Local school districts
The sector remains stable as many states continue to improve funding. In several states, including Texas and Washington, courts have ruled in favor of schools requiring improved local funding from state coffers. Most school district debt across the country is largely supported by property taxes, with several states (e.g., Michigan and Indiana) providing enhancement programs for local school district debt. The rebound of the real estate market has been a boon for the local school district sector.
A sector we are watching closely as it has been experiencing a challenging environment over the past several years. While most states are well into their recovery from the big recession, some are pulling back on funding higher education by attaching performance measures and tuition affordability to funding levels. The private higher education sector is the most challenged sector, due to more limited resources. Management continues to develop a diverse list of revenues, including student charges, miscellaneous fees and tuition adjustments. While we have seen few closures at this point, Moody’s estimates the pace of small college closures will triple to 15 per year by 2017. The ability to provide the programs and updated facilities is costly, particularly with the weak demographic trends. Expense management will be key to maintaining credit metrics.
This sector includes airports, toll roads and ports and has realized strong growth and credit improvement during the recovery. Increased air travel, wage growth and miles driven, and strong export activity have all benefited the various facilities in this sector. Airports will continue to improve with air traffic volume remaining on a positive trend. Stronger profits have allowed the airlines to finance capital improvements at major airports. Toll roads have benefited from increased car ownership and miles driven reached a new high in 2015. The lack of infrastructure funding remains a threat to toll roads, however, as several states in the past have transferred funds from toll roads to local road projects. While global economic weakness could spark a turning point for ports that have enjoyed strong cargo volumes in the recovery, low shipping costs due to excess container capacity and low oil prices should maintain container volume in the near term. Moody’s estimates cargo units to increase 3%–4% in 2016.
We expect the sector to remain stable over the year, though it should face some challenges from coal-dependent power producers. Both the decline in manufacturing jobs and technological advancements have been main drivers in the continued deleveraging of the public power sector and the improvement of operating margins. Energy usage in the U.S. has remained fairly flat over the recovery, limiting the need to build new large-scale generating assets and holding down debt issuance. The minimal growth in energy usage, despite the economic recovery, is due to technological advancements in energy efficiency.
The limited number of generation projects has allowed many utilities to retire non-efficient generating units, thus improving their overall cost structure. Challenges for this sector will come from the transition to a greater mix of generation from renewable sources. These generating sources are often more costly and less reliable. We could see debt issuance and leverage begin to trend upward while growth in usage remains flat.
Having benefited from solid gains in patient volume, revenue growth from insurance coverage and federal Medicaid reimbursement should continue through 2016. In addition, bad debt has been falling with the improved employment picture. Longer-term challenges remain, including the consolidation within the insurance industry and growing exposure to government insurance programs. Large health-care systems will continue to benefit from size. Mergers and partnerships will continue as health-care providers look to gain from economies of scale.
- The Chicago Public Schools (CPS) had to delay a planned $875 million deal last month due partly to a lack of investor interest despite yields significantly higher than prevailing rates. Additionally, S&P’s recent rating action on the CPS’ general obligation debt puts the issuer firmly in the below investment grade camp. In mid-January, S&P lowered its rating to B+ from BB and maintained its outlook at negative. Around the same time, Fitch also lowered its rating on the general obligation debt to B+ from BB+ with a negative outlook. Moody’s had lowered the rating to B1 back in December, but took CPS down another notch in late January, to B2. CPS continues to struggle with a structurally imbalanced budget, escalating pension contributions, and poor liquidity position.
- The Commonwealth of Pennsylvania (Aa3/AA-) remains without a FY2016 budget at the end of January. Governor Wolf signed a partial budget appropriating $23 billion in state spending. To the relief of educators across the state, this partial budget included $5.3 billion for education, providing local school districts with some financial relief. Interestingly enough, Governor Wolf is expected to present his FY2017 budget on February 9.
- The recent stock market volatility has the State of California reviewing its budget estimates. In 2014, state revenues increased 63% to $130 billion and again to $135 billion in 2015 due to strong capital markets. S&P reports that capital gains now account for an estimated 6% of total personal income for California residents. However, Governor Brown’s recent 2017 spending plan maintains his conservative fiscal stance with additional transfers to the budget stabilization fund and maintains a more conservative spending profile.
- Texas and West Virginia, leading a 27-state coalition, lost in the U.S. Court of Appeals (District of Columbia Circuit) when the court denied their request for a stay from the Clean Power Plan. The coalition has filed a stay with the U.S. Supreme Court. The Clean Power Plan, issued in August 2015, established carbon dioxide emissions standards by state with the intent that emissions would be reduced 32% by 2030 when compared against 2005. As an aside, West Virginia’s credit outlook was changed by Moody’s to negative (rating affirmed at Aa1). The outlook change reflects recent declines in coal and natural gas prices as well as continued layoffs across the state for key energy sector employers. The state’s unemployment rate has rapidly increased, reaching 6.3% in December 2015 compared to 5.9% a year ago.
- After 21 years in St. Louis, the NFL approved the relocation of the Rams to Inglewood, California. The Los Angeles area has been without a team since 1995 when the Rams moved to St. Louis. St. Louis will lose about $4 million annually from tax revenues. While this is less than 1% of revenues, the city is left with no NFL team and one older stadium. Inglewood is estimating a gain of $19 million to $28 million a year in revenues with the completion of the City of Champions Revitalization Project. The project, near the LA airport, includes a new 80,000-seat stadium for the Rams, an indoor entertainment venue with seating for 6,000 as well as 1,670,000 square feet of retail space and office space, a hotel and 25 acres of parks.