A dovish hike?
After a year of guesswork by market prognosticators, the Fed finally delivered what they had been anticipating — the first increase in the target range for the federal funds rate after nearly a decade. In a unanimous vote at its mid-December meeting, the Fed increased its target rate by 25 basis points to 0.25%–0.50%. The reaction in the bond markets was relatively muted as the tightening had largely been priced into prevailing levels. The tax-exempt market actually rallied into year-end despite the Fed hike due in large part to strong demand, as noted below.
The next challenge for investors is determining the pace of policy normalization. In its press release, the Fed stated its intent to use “gradual adjustments” to achieve its target of maximum employment with 2% inflation. As it states, the actual path will be highly dependent on incoming economic data. The market is currently pricing in a 0% chance of a Fed rate hike at its next meeting in January and a 40% chance in March. So, prepare yourself for another year of Fed punditry!
The end of 2015 was kind to muni investors with December marking six consecutive months of positive returns. The Barclays Municipal Bond Index (the broad municipal index) returned 1.50% in the fourth quarter and 3.30% for the year, which looked especially strong relative to other asset classes.
A-rated bonds outperformed over the month of December as investors continued their search for additional yield in a low supply environment. A-rated bonds outperformed AAA bonds by 37 basis points (0.89% total return versus 0.52%). Likewise, sectors with an overweight of A-rated bonds outperformed higher-quality sectors. For example, the Barclays Hospital index (average rating of A) returned 0.85% for the month versus the main Municipal Bond Index’s return of 0.70%. Year to date, the Hospital index has returned 4.09% versus 3.30% for the broad index. Revenue bonds, in which we have a substantial overweight, boosted fund performance, returning 0.79% for the month versus 0.67% for general obligation bonds. We continue to favor this overweight.
Supply & demand
Long-term municipal bond issuance fell for a fourth straight month, falling 43% from the same period last year and ending December at $22 billion. As in the prior two months, a large portion of the decline was attributable to a drop in refunding deals. In December, refunding deals — where issuers refund older, more costly deals — were less than half the amount issued a year earlier. An increase in direct lending by banks to municipal issuers was also cited as a reason for the decline. As a result, for the last three months of the year, quarter-over-quarter volume fell by 24%, leaving tax-exempt investors with fewer options. Despite this decline in new bond deals, total volume for 2015 came in at $398 billion, significantly higher than the past two years and the highest since 2010. Early 2015 expectations for higher interest rates with Fed tightening pushed much of the new issue volume into the first half of the year.
Demand for tax-exempt bonds continued to be strong with over $4 billion in net flows into municipal funds over the month. Net inflows were strong for the last quarter of the year, totaling over $9 billion and bringing year-to-date inflows to over $13 billion. This surprisingly strong demand, combined with weak supply, drove municipal bond outperformance versus Treasurys. For example, the 10-year AAA municipal yield went from 92% of the 10-year Treasury yield to 85% by month-end as the Treasury yield rose by 6 basis points, while the AAA municipal yield fell 10 basis points.
With the beginning of Fed tightening finally underway, Treasury yields ended the month of December higher across the curve. The two-year Treasury yield increased 12 basis points, ending at 1.05%, approximately 40 basis points higher than at the beginning of the year, while the 10-year rose by 5 basis points, only 10 basis points higher than at the start of the year. With the strong demand and weak supply noted above, the municipal curve reacted differently, with two-year yields rising 5 basis points to 0.77%, while the 10-year muni yield fell by 10 basis points. As a result, we saw slightly negative returns on the short end of the municipal curve and positive returns out on the longer end.
- Municipal market news over the month centered on Puerto Rico, which has been struggling with over $70 billion in debt. After many warnings from Puerto Rico’s governor, the Commonwealth defaulted on approximately $37 million of nearly $1 billion in debt payments due January 1. There was little discernible broad market reaction to the news, likely due to the overabundance of media coverage the Commonwealth has received over the year and particularly over the fourth quarter. This is likely the beginning of a long process of negotiations between the Commonwealth and bondholders as well as an assortment of legal and political maneuverings.
- On a more positive note, according to Municipal Market Advisors, the number of municipal defaults declined in 2015 for the fifth straight year, to 55. They compared this to corporate defaults of 107, the highest total since 2009.
Difficulties in Illinois
Illinois and Pennsylvania enter 2016 in a difficult fiscal position, but they are not alone. Pressured energy prices also hit several other states as lawmakers look to the end of FY2016 and the start of FY2017.
Illinois is expecting to sell $480 million of new debt in January and, once again, we note the differing viewpoints of the two major rating agencies. S&P affirmed an A- rating and removed the state from CreditWatch while assigning a negative outlook; meanwhile, in October, Moody’s downgraded the state’s rating to Baa1 with a negative outlook. These outlooks reflect the rating agencies’ views for the credit trend over the next 18 to 24 months.
Illinois benefits from a diverse and wealthy economy. In addition, the state provides strong legal protections for general obligation (GO) bondholders. Holders of the state’s GO bonds benefit from a clearly defined legal commitment to set aside funds for debt service on a monthly basis. Furthermore, the state’s monthly deposits to the fund held for debt service payment may be made from any and all revenues and funds of the state. The law creates an irrevocable and continuing appropriation for GO debt service and provides for bondholders to sue the state to compel payment. The state has never failed to make a timely deposit to its GO debt service fund. The state’s cash balances available to make deposits into the debt service fund are currently about $4 billion, providing ample coverage of GO debt service.
Nevertheless, these intrinsic strengths do not provide a credit quality “floor” that will keep the state’s ratings at investment grade.
“There is no floor for U.S. state ratings, despite states’ inherent credit strengths and typically very high ratings,” Moody’s VP-Senior Credit Officer Ted Hampton says. “The majority of states are rated either Aaa or Aa1, and this concentration at the top of our rating scale reflects states’ powers — such as the ability to cut general spending — and positive features that include prudent governance practices, moderate debt burdens, and stable, diverse economies.”
The factors that have eroded Illinois’ credit standing in recent years could drive the state’s credit closer to speculative grade, Moody’s says. These interrelated factors are governance weaknesses, bill payment deferrals, chronic structural budget gaps and soaring unfunded pension liabilities.
Even though Illinois has no budget, and may not until after the March primary election, it still pays state school aid because a small portion of the pending budget was separately passed and signed in June. Illinois also continues to pay about 90% of its other bills, including state employee salaries, because of court orders and consent decrees.
…and in Pennsylvania
Pennsylvania schools have not been so fortunate. Finally, after six months of no state support, on December 29 Governor Wolf signed a partial budget that included $5.3 billion in funding for schools. Over the previous six months, in which Pennsylvania lawmakers had broken the state’s own record for longest budget impasse, set in 2003, school districts had been forced to borrow money. This funding will prevent any possible school closures.
In mid-December, S&P responded to the state’s budget impasse with the withdrawal of the A/A+ rating on the Pennsylvania State Aid Intercept for School Districts. The rating agency cited the combination of the lack of funding flowing to local districts and the lack of information flow between the state and the agency with respect to funds available for debt service during past budget standoffs. This rating action affected 59 school districts and community colleges across the state.
Moody’s followed with a downgrade and a rating cap on the state aid intercept program, a move it does not “intend to undo or revise” after the stopgap budget. (Moody’s cites the “habitual nature of Pennsylvania’s budget stalemates.”) In addition, the agency eliminated the distinction between pre-default and post-default for the program. The rating for a district participating in the intercept program now will be the district’s underlying rating plus one upgrade, subject to a ceiling rating of Baa1. The outlook remains negative. Moody’s noted that, on average, state aid provides a debt service coverage ratio of 4x for participating school districts.
Pressure from lower oil and gas prices
Lower oil and gas prices are pressuring several other states to reduce revenue projections, sending lawmakers back to the budget drawing board.
- In Alaska, Governor Walker proposed instituting a personal income tax and reducing the annual oil royalty received by Alaskan residents. The state is facing a $3.5 billion budget gap in the next fiscal year. Alaska benefits from financial reserves that are more than three times the size of the budget but a long-term revenue solution is more favorable to a continued drawdown of those limited reserves.
- Louisiana, Oklahoma and New Mexico, states already facing budgetary stress, are also looking at mid-year adjustments as oil prices remain pressured.
- Oklahoma is expecting to miss its FY2016 forecast by nearly 8%, a number that allows lawmakers to draw on the $385 million rainy day fund.
- For North Dakota and Texas, two other energy-reliant states, alternative income sources such as sales tax receipts and income tax revenues helped to offset lower energy revenues.
- West Virginia and Wyoming budgets shrink along with the coal mining industry. West Virginia is now projecting a $250 million state budget deficit with $190 million of that the direct result of the shrinking coal industry. West Virginia is reporting that coal severance tax dollars are down 40% since July 1. In Wyoming, where 70% of general fund revenues are directly linked to energy production, the state is looking at $215 million in budget cuts for the upcoming two-year funding cycle. This reduction follows a $159 million reduction in FY2016. Wyoming produces 40% of U.S. coal.
Brighter western skies
States in the West and Southwest are experiencing greater-than-projected revenues in their current budgets.
- Arizona is benefiting from a strong economic rebound following the recession with a second month of double-digit gains in sales tax revenues. State revenues increased 23% in November or by $84 million more than originally projected. Year to date, Arizona has collected $207 million more than originally projected in the budget. Corporate income taxes, sales tax dollars and individual income taxes are all higher than originally projected.
- California’s three major revenue sources beat expectations in November. Sales tax dollars increased 5.4%, personal income tax revenues were up 1.3% and the corporate income tax received was double the estimated amount. For the current fiscal year, overall revenues are up 1.4%.
U.S. infrastructure flunking
The current overall condition of the infrastructure in the U.S. is a near-failing grade of D+, following standard school grading, as determined by the American Society of Civil Engineers (ASCE). The investment required to raise the grade to B is extensive and beyond the capacity of state and local governments to address solely through the issuance of tax-exempt bonds. Yet, state and local governments are historically the chief source of U.S. public infrastructure investment. State and local governments must regularly invest in infrastructure in order to attract and retain businesses, but new money debt issuance for infrastructure has decreased recently, despite a period of historically low interest rates. The need is apparent, the cost is large, and the stress to the budgets of state and local governments that address their infrastructure will increase.
If state and local governments do not address their infrastructure needs, however, they may be unable to attract and retain businesses, and this inability may create its own stress on budgets. In the future, ratings agencies may begin to incorporate infrastructure investment deficiencies into their determination of ratings. If such deficiencies translate into negative ratings actions, the budgets of those state and local governments with larger deficiencies will be affected by the higher cost of tax-exempt bond issuance.
The ASCE regularly assesses U.S. infrastructure by assigning a letter grade, such as the overall D+ the U.S. received in 2013. The ASCE provides individual grades on 16 separate systems across the four categories of water and environment (six systems), transportation (seven systems), public facilities (two systems) and energy (one system). In the 2013 assessment, individual grades ranged from a high of B- for solid waste to a low of D- for levees and inland waterways. The ASCE estimates that the U.S. needs to invest $3.6 trillion from 2013 to 2020 to maintain the infrastructure in a state of good repair, which equates to a letter grade of B. In its 2009 report, the ASCE estimated that the U.S. would need to invest $2.2 trillion to maintain the infrastructure in a state of good repair. The ASCE also provides an assessment of infrastructure for most states individually. Current grades are mostly in the C range, with no state assigned a grade higher than C+.
Area Development, a magazine focused on corporate site selection and relocation in the U.S., annually surveys corporate executives in the manufacturing, construction and service sectors on their location and expansion plans. The survey includes questions about important factors considered when deciding to leave or choose locations. In the most recent survey, taken in 2014, 24% of respondents cited poor infrastructure as a primary reason for leaving their current location, while highway accessibility (88.3%), energy availability and cost (76.3%), accessibility to a major airport (62.4%), water availability (44.0%), railroad service (30.9%), and waterway and ocean port accessibility (27.3%) were cited as primary factors for selecting a location. If states and local governments do not invest adequately in their infrastructure, they may lose opportunities for employment and economic growth that are not offset by other factors such as low taxes, low labor costs, availability of skilled labor and expedited permitting.
State and local governments are the source of 85% of public infrastructure investment in the U.S. The major source of funding for state and local governments is tax-exempt municipal bonds. There is currently about $3.71 trillion of municipal debt outstanding. This amount may seem large when compared to the ASCE estimate that $3.6 trillion is needed between 2013 and 2020 to raise the infrastructure grade to a B. However, the ASCE estimate implies that an additional $3.06 trillion of municipal debt would need to be issued in a relatively short period of time to properly address the infrastructure needs of the country. The municipal bond market clearly could not absorb this level of additional issuance.
Total annual municipal bond issuance has ranged from $198.3 billion to $433.1 billion from 2000 to 2014. In 2013 and 2014, total issuance was $335.2 billion and $337.5 billion, respectively. More important than the level of issuance is the level of new money issuance versus refunding issuance. Of the total issuance in 2013 and 2014, $161.5 billion (48%) and $144.7 billion (43%), respectively, was new money issuance.
In recent years, rates in the municipal market have been at or near historically low levels. While state and local governments took advantage of low rates to refund and refinance higher-yielding bonds, they did not accelerate the new money issuance to address their infrastructure needs. Many state and local governments have been reluctant to issue infrastructure debt for various reasons: the need to rebuild reserves following the recession; the need to respond to constituents’ desire to reduce government spending and taxes; uncertainty over federal and state funding levels in support of their municipality; and the conservative philosophical beliefs of elected officials.
Municipal bonds can play a large role in the infrastructure updating that the U.S. so sorely needs, but the level of investment required would overwhelm the market. Private-public partnerships (PPP), which are used extensively in other parts of the world to fund infrastructure, could be expanded to provide investment capital to state and local governments. In addition, the federal government will need to play a larger part in addressing this challenge, perhaps offering the leadership it showed in creating the interstate highway system. Failing to aggressively address the infrastructure needs of the country causes inefficiencies and wastes money; ironically, this money could be invested in updating the infrastructure.
A continued supply and demand imbalance for municipal bonds led to solid price performance over most of the curve in December. Traditional retail demand for tax-exempt bonds remained strong with over $4 billion in December inflows to muni funds. January is typically a strong month for municipal bonds due to the seasonally large amount of coupon payments and the amount of maturing bonds, the cash from which is typically reinvested into the muni market. The historical average for munis is strength in January with weaker February and March performance. So far, all indications point to a repeat of this pattern, though the start of Fed normalization could shake this up. We remain focused on economic data releases looking for any signs that may influence the Fed’s future decision-making process. We are structured to outperform the benchmark in a rising-rate environment with duration shorter than the benchmark and a healthy allocation to floating-rate notes. We are maintaining our lower-quality overweight — a key component of income — but are focusing purchases on A-rated bonds.