January muni rebound after dismal fourth quarter
The fourth quarter of 2016 is one we muni investors would all like to forget. The broad Bloomberg Barclays Municipal Index was down 3.62%. Every part of the curve posted negative returns, however, the long end suffered the most with the Bloomberg Barclays Long Bond Index down almost 5.00% while the One-Year Index was down a relatively minor 0.17%.
While these are not extremely large numbers relative to historical equity returns, muni investors don’t expect large swings and were not happy with one of the worst quarterly returns since 4Q 2010.
Back then, a good portion of the muni sell-off was due to an analyst induced media scare. A banking analyst predicted hundreds of billions of dollars in municipal defaults. As we all know, that never materialized and it ended up being a great buying opportunity. Last quarter’s dismal returns were a combination of historically high issuance and tax loss selling. Municipal issuance in 2016 was the highest on record at $445 billion. On top of heavy year-end new issuance, retail investors flooded the secondary market with bond sales and pulled money from muni mutual funds to take losses, offsetting gains taken in the equity markets.
The good news, January muni returns rebounded as tax loss selling stopped cold with the New Year and issuance dried up over the holidays. Actually, munis started their recovery in mid-December when municipal yields across the curve rose above Treasury yields. This prompted non-traditional buyers to snap up cheap munis. The positive momentum continued through the first two weeks of January helped in part by the reinvestment of January 1st coupons and maturing bonds. The Bloomberg Barclays Municipal Bond Index ended the month with a positive 0.66% return — a 0.30% price return plus 0.36% coupon return.
Headwinds this year to the broad fixed income market are well-known by now: the potential for looser fiscal policy, higher inflation and tighter monetary policy. On the positive side, the economy should be experiencing a boost in those scenarios. The municipal market faces specific challenges as well: tax reform and the potential impact on muni bond value, repeal and replacement of the Affordable Care Act, and increased infrastructure spending impacting supply.
A number of potential hurdles this year, but, we believe investor concerns for the municipal market are overblown at this time. The municipal market will not likely see yields return to the historic lows we saw last summer, but munis will do what they do best: provide investors with tax-exempt income, which will continue to be attractive on a taxable equivalent yield basis.
Lower quality bonds stabilized over the month recovering slightly from fourth quarter underperformance. Much of the positive flow into municipal funds over the past month went into high yield muni funds. As such, lower quality bond spreads tightened, but remain at wide levels. The Bloomberg Barclays BBB rated Bond Index returned 0.74% versus 0.58% for the AAA rated Index. The Bloomberg Barclays Muni High Yield Index returned 1.40%. The best performing sub-sector was the HY Tobacco index which returned 3.85%.
Supply and demand
Despite many Wall Street firm predictions of 2017 municipal supply being down 10% to 15%, January supply, at $34 billion, was up 30% from January 2016. A decline in refunding deals of about 25% from last year was more than offset by an increase in new money issuance of 42%. We do expect new money issuance to outpace refunding deals this year. We wrote in our last Municipal Insights that new revenue and bond ballot issues were well received by voters last November.
For example, nationwide voters approved about 75% of transportation ballot initiatives, providing $200 billion for state and local transportation projects over the next few years.
Demand for municipal bonds turned on a dime at year-end. January saw about $1.9 billion in net inflows to municipal funds and ETFs. Not nearly enough to offset the $27 billion in outflows last quarter, but a solid start to the year and a good indicator of investor confidence in our market.
The municipal curve was largely unchanged over the past month, but remains 60 to 80 basis points higher than yield levels at the end of the third quarter in 2016 and about 100 basis points above the lows of last summer. Returns were mixed across the curve and were driven in part by demand from retail investors as they sought to reinvest January coupons and maturing bonds. The five-year portion of the curve, which retail prefers, posted the best returns. The Bloomberg Barclays Five-Year Index returned 1.05% versus 0.61% for the Long Bond Index.
Tax reform worries overblown
The potential for tax reform this year is high. The most common reaction we hear from our clients on reform headlines is that municipal bonds will lose value if income tax rates are reduced. The belief being reduced tax rates lowers the attractiveness and thus demand for tax-exempt munis. Also, many investors believe that the dramatic increase in municipal yields at the end of 2016 was due to this possible tax cut.
We disagree with both points and argue the following:
First, the jump higher in municipal yields over the past few months was due to a fixed-income-wide “reflation trade,” not from tax reform talk. Taxable and tax-exempt U.S. fixed income yields rose in the belief that President Trump’s looser fiscal policy agenda would usher in higher inflation.
- This is also sparking talk of a “great rotation” out of bonds and into stocks. We put little credence in this idea. In fact, investors have plowed about $33 billion into taxable bond funds and ETFs since last November.
- Municipal bonds did underperform at one point due to tax-loss selling. This underperformance corrected itself by mid-December.
Secondly, municipal bonds have no correlation with changes in income tax rates. If tax brackets for individuals drop by several percentage points as suggested, municipal bonds will not necessarily cheapen relative to corporate and treasury bonds.
Finally, many municipal investors are not in the highest marginal tax bracket. Estimates have shown that the average tax rate for holders of tax-exempt bonds is much lower than the top marginal rate; perhaps in the 25 to 28% range. This suggests a lower sensitivity of municipal bond prices to changes in tax rates than many believe.
We are not saying we are bullish on municipal bonds at this time. We are saying that it is too early to know what form policy will take and what the impact will be on municipal bonds. We are defensively positioned as we feel the potential volatility this year will give investors several opportunities to purchase munis at attractive levels. Also, current levels are not historically unattractive.
The municipal market is a $3.8 trillion market responsible for building much of the infrastructure in the U.S. including, roads, airports, schools, hospitals, clean water facilities, etc. State and local governments have and will be fighting to avoid losing this tool for building America.
Trump administration tells ACA, “You’re fired!”
Campaigning is dead and gone and the election a fading memory along with the inauguration and its trappings. Rhetoric has moved into a period of formulating action. Republicans, led by the Trump Administration, wasted no time in crafting a “repeal and replace” (R&R) option for the Affordable Care Act (ACA). However, there remains much uncertainty as to the timing of R&R. That is, will it occur simultaneously or will replace be much delayed after repeal? No one knows. But, with 32 states having adopted ACA expansion, changes will have nationwide implications. Many of these 32 states that accepted Medicaid expansion (largely federally funded) may see substantial fiscal challenges should ACA be repealed and not immediately replaced. How do they fund expanded Medicaid? Hopefully, the powers in Washington keep this in mind.
At the local hospital level, most of the negative impact will be related to changes in health insurance eligibility. This will cause a reversal in the gains made in reducing uncompensated care which improved the bottom line for hospitals. Approximately 20 million additional people have gained insurance through ACA, not including the current enrollment period. If ACA is repealed and not replaced, some estimates show increases in the number of uninsured individuals of roughly 80 to 90 percent within 10 years. More uninsured means higher uncompensated care costs for hospitals.
The hospitals most negatively impacted will be the ones that gained the most from increased coverage. These hospitals saw significant declines in uncompensated care costs. They are at risk of deteriorating margins and liquidity, which could lead to rating downgrades.
No matter what road the Trump Administration and Republicans take, “repeal and replace” will not change the philosophical direction that the healthcare industry has been moving towards — a philosophy based on a “value” proposition. That is, healthcare providers manage the overall health of their patient population and are reimbursed based on the quality and efficiency of care as opposed to being compensated based on the number of healthcare services provided.
The municipal healthcare sector provides investors with an appropriate risk-reward opportunity. BMO GAM continues to focus on larger hospital systems with strong market share, strong liquidity positions and favorable operating performance. We look for those institutions that have gained in same-store volume growth from expanded or improved services along with a manageable government payor mix.
- Favoring slightly shorter duration and defensive positioning primarily due to potential turmoil surrounding President Trump’s tax reform efforts. Also, fiscal policy stimulus and trade restrictions could increase inflation expectations. There may be better opportunities to buy munis over next several months than currently exists.
- Despite a more hawkish tone from Federal Open Market Committee (FOMC) members, we are largely discounting any tightening moves at
this time. At its February meeting, the FOMC left the federal funds target rate unchanged at 0.50% to 0.75%. The statement released after the two-day meeting was little changed from December and gave no indication of future moves.
- Municipal fund flows turned positive at the beginning of the New Year. We are attributing most of the large outflows at the end of 2016 to tax loss selling. We will continue to monitor closely, but we feel that flows should remain flat to slightly positive over the next quarter. We do not expect flows to change our duration positioning this quarter.
- Retaining barbell structure with municipal floating rate notes on the short-end of the curve and fixed coupon bonds on the longer end of the fund’s investment horizon. We earn more incremental credit spread on the longer end but remain duration neutral.
- Daily and weekly tax free floating rate notes remain at elevated yields, providing attractive yields to interest rate sensitive investors. The weekly municipal floating rate index (SIFMA rate) is at 0.65% versus 0.72% and 0.56% on December and November month-ends, respectively.
- The front end of the municipal curve (10 to 15 years) continues to exhibit steepness and good roll-down.
Credit and structure
- Lower-quality bonds have reversed the drastic underperformance in 4Q 2016. We continue to look for undervalued A and BBB rated bonds,
which could outperform this year if we see sustained positive flows into municipal high yield funds.
- The higher yield (wider spread) of the lower quality bonds also helps performance.
- We continue to focus on bonds with 4 and 5 percent coupons due to their defensiveness.
- We have reviewed our hospital holdings in light of efforts to repeal and replace the Affordable Care Act. We found no significant exposure to issuers at risk of undue credit deterioration. We may selectively reduce exposure to this sector over the quarter. However, if spreads widen across the hospital sector, we will look for solid credits at cheaper spreads.
- We are being more selective in the higher education sector. National demographic trends are working against this sector, with fewer
high school graduates, particularly in the Northeast and Midwest. Also, strained state budgets are squeezing the funding to public higher
education schools. Look for institutions with good demand due to name recognition or a niche, like a good engineering school.