Asset Class: Municipal Fixed Income

January jitters

healthcare

Historically, January has been an above-average month with regard to total returns for municipal bonds. We usually see solid demand for munis as heavy coupon payments and maturing bonds get reinvested; not this year, for the first time since 2011. Many thought the past month would be particularly strong due to historically low supply ($16.8 billion) as many deals were pulled into last December due to tax reform. Additionally, municipal funds and ETFs saw inflows of approximately $10.5 billion, but to no avail.

Overwhelming the supportive technical state was growing concern surrounding higher inflation, increased Treasury issuance and a restrictive Fed. The result was a bearish breakdown in the fixed income markets as the U.S. 10-year Treasury yield jumped 30 basis points over the month (2.41% to 2.71%). Municipal yields were dragged higher as well, but for the very short end of the curve.

The sell-off in the bond market has not paused as we enter February. Despite stock market volatility, bond investors are facing positive economic reports which may point to more certainty of Fed hikes in 2018. For example, the January jobs report was above expectations with a reported 200,000 jobs added in the month — 88 consecutive weeks of growth, the longest on record. Additionally, the tight labor market appears to be impacting wages. Employee compensation in the fourth quarter came in at 2.6%, the largest twelve-month gain since 2008. This type of strength makes the bond market jittery, which impacts the equity market as we witnessed. We should start to see some support as we approach relatively attractive yields investors have not seen in years.

aaa govt obligation yield curve muni 02 2018The Federal Open Market Committee’s January meeting ended the month with a bit of news. While the Committee left rates unchanged, the tone of their statement pointed to increased confidence that inflation will rise and meet their 2% objective this year. As a result, the market expectation for a March rate hike rose and is currently at 93%. In light of the relative strength of the economy, the total return for the Bloomberg Municipal Bond Index in January was -1.18%. However, the very short end of the curve held in much better. For example, the Bloomberg Short (1-5 year blend) Municipal Index returned 0.05% for the month.

Credit commentary

Healthcare outlook

Our credit outlook for the municipal healthcare sector in 2018 has turned a bit more negative from last year due to the expectation of tighter margins. Margins are expected to tighten somewhat due to a number of factors.

Four years after the implementation of the Affordable Care Act (ACA), hospital volume increases have slowed. Volumes are expected to continue to increase in 2018 but not at the levels that occurred prior to 2017. In additional, uncompensated care costs have recently ticked up after years of decreases immediately following the ACA implementation. The main reason is the proliferation of high-deductible health plans which will likely continue to expand.

The rise in healthcare “consumerism,” with patients choosing when and how to obtain care, may negatively impact hospital volumes. For example, urgent care centers in retail stores as well as unaffiliated outpatient facilities draw consumers away from hospitals.

We expect hospitals to have difficulty negotiating higher reimbursement rates from insurers. Nursing shortages have increased expenses as hospitals offer higher salaries to attract and retain nurses or use more expensive temporary nurses to fill the void.

Medicaid expansion costs were 100% federally-funded through 2016. Beginning in 2017, states were required to provide 5% of the cost of the Medicaid expansion, rising to 10% by 2020. With many state budgets constrained, Medicaid reimbursements to hospitals may be reduced to help states balance budgets.

The recent tax bill signed into law included the repeal of the penalty for not obtaining health insurance coverage. We do not believe many individuals who signed up for coverage due to ACA will drop as there is little or no cost to maintain coverage. There will be an impact to hospitals, but the financial effect for most providers will not be meaningful.

There are also a number of factors that offset these margin tightening concerns. Most hospital systems have completed implementation of electronic records systems. As management gains comfort with their new systems, they should benefit from the ability to better analyze data, reduce treatment costs and thus improve margins.

Significant increases in borrowing are not expected as hospitals focus on outpatient and urgent care facilities, which are typically much cheaper than traditional hospital buildings. Most mature markets have an excess of traditional acute-care beds.

Overall, hospital liquidity is good and management is nimble as hospitals have become adept at preparing for, addressing and reacting to many changes in the healthcare industry over the last few years.

We continue to focus on larger hospitals and hospital systems that have a strong market share and have readily adapted to changes in the healthcare industry over the past few years. We are cautious when reviewing rural standalone hospitals as they typically are much smaller in size, have less flexibility, have higher levels of overall government reimbursement and have more burdensome levels of uncompensated care.

Strategy overview

Duration

  • We continue to be shorter duration than our benchmark and peers.
  • Fixed income markets are being driven to higher yields by heightened concerns of inflation, potential for increased Treasury issuance, and an active Fed. U.S. Treasury 10-year yields spiked 30 basis points over the past month.

Curve

  • Overweight municipal floating-rate notes. Avoiding fixed-coupon bonds on the shorter end of the yield curve due to expected Fed rate hikes. Continue to monitor inflation and expectations. Fed has indicated more confidence in attaining their 2% target this year.
  • Daily and weekly tax-free floating rate note yields have retreated from the spike higher we saw at the end of 2017, but still attractive versus a year ago. The weekly municipal floating rate index (SIFMA rate) is at 0.98% (2/7/2018) versus 0.65% on 2/18/2017 and 1.71% on 12/27/2017.

Credit and structure

  • Lower-quality bonds performed in line with higher quality bonds in the January sell-off. Bonds rated BBB continue to offer little additional spread over higher quality bonds on a historical basis. As such, we are finding very few opportunities to invest in the lower quality sector. We are looking for opportunities in AA-rated bonds.

Sector

  • We like prepaid gas bonds at this time. These somewhat unique tax-exempt bonds can be issued as floating rate notes with credit support from financial institutions. These institutions are in strong capital positions and benefit from rising interest rates.

 

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