A rare June swoon
Normally, June represents a month of heavy reinvestment demand in the municipal bond market. This year was expected to be no different, as investors were estimated to collect nearly $35 billion in coupon and principal payments. Instead, municipal bond mutual fund investors have pulled money out of the market for eight consecutive weeks as measured through the last week of the month. How unusual is this? This year is only the second time in the last decade when the overall asset size of municipal bond mutual funds has shrunk since the beginning of a June month (per Lipper fund flow data).
Despite the redemption activity seen in municipal bond mutual funds, it appears recent individual investor activity has shifted toward direct bond ownership. Retail individuals still comprise approximately 60% of all municipal bond ownership per Federal Reserve reports, and direct retail buying activity is near a 5-year high.
Why does a retail investor buy individual bonds when indirect mutual fund investors sell? During a sell-off, the yields of some individual bonds have likely increased faster than the returns of a fund. The temptation/inclination of investors is to buy bonds directly in a knee-jerk reaction when seeing declining fund net asset values. The reality of retail behavior shows time and time again an overwhelming tendency to sell bond funds as interest rates rise and buy funds as interest rates fall, the opposite of a long-term successful fixed income strategy.
According to Barclays, June total returns for municipal bonds ranged from approximately 0.23% for a 3-year maturity bond to -0.32% for the longest maturities. Higher quality bonds slightly outperformed lower quality bonds, with the Barclays Baa Index showing a -0.38% return. Revenue bonds in the resource recovery and housing sectors eked out positive returns for the month.
Although any periodic Greece-related flight-to-safety in the bond market will generally cause municipal bonds to underperform Treasuries across the yield curve, overall demand for tax-free income has led to outperformance versus comparable duration taxable government bonds for the month. During June many important economic releases exceeded consensus estimates, including housing starts, leading economic indicators, new home sales, construction spending, vehicle sales, unemployment claims, retail sales and newly created jobs. Second quarter economic acceleration was undeniable, creating an impetus to move Fed rate hike expectations forward and Treasury yields higher. For example, a 10-year Treasury moved up in yield by 40 basis points in the quarter to 2.33%, which drove performance to -3.0% for the period. In contrast, the Barclays Municipal 10-year GO Index was also down, but a much less painful -1.2%.
Looking back at Q1, the amount of municipal bonds outstanding increased by $41.7 billion per Fed data. A big reason for the higher level of outstanding issuance was the increase in both current refunding and advance refunding activity. By the very nature of advance refunding activity, for a period of time an issuer has both old bonds and new refunding bonds outstanding at the same time. With Q2 in the books, we expect the balance of 2015 will see a slowdown in advance refunding activity such that the total market value level of outstanding municipal bonds may stabilize near current levels.
The growing cost of unfunded pension liabilities
Even as state economies continue to improve, revenue growth has been modest since the recovery began.
According to the National Association of State Budget Officers, revenue collection is forecasted to increase by 3% in fiscal 2016, slower than the 3.7% gain expected this year. Of particular concern is that state revenues have not grown as fast as some costs, especially pension costs. In recent years, the largest increase in claims on current and future state revenues has been for pension plans. The gap between what states have promised in pension benefits and the funding to meet those obligations continues to widen and promises to be a major determinant of ratings downgrades for several states.
State long-term liabilities include bonded debt, pensions and other post-employment benefits (OPEB). S&P has shown that just between 2008 and 2013, state unfunded pension liabilities have grown to account for more than half of all state long-term liabilities. In aggregate, state pension and OPEB liabilities are greater than $1.4 trillion and now account for 75% of total long-term liabilities. While almost every state has enacted some degree of pension reform, some of the reforms such as reducing benefits for newer workers will take many years to make a meaningful impact.
A good example of pension funding problems is the recent development in the state of New Jersey. The New Jersey Supreme Court decided that the state is not required by law to make pension contributions while in financial distress.
Instead of relying on some sort of government obligation, legislators and the governor will have to find a long-term solution on their own. Thus far, Governor Chris Christie has not budgeted to pay into the pension plan anything close to what Moody’s estimates to be a $3.9 billion annual required contribution. Don’t be surprised if Moody’s decides to downgrade the rating of New Jersey to BBB. That would represent the lowest rating of any of the 50 states.
Want a higher credit rating? Pick one!
We are seeing a disconcerting trend as an unintended consequence of the “Issuer-Pay, Issuer-Decide” ratings model. Some municipal bond issuers are discontinuing the use of a lower and/or more costly credit rating. In addition, a larger percentage of issuers are moving ahead with single-rated transactions. From an issuer perspective, why pay for a rating you don’t like, don’t want and don’t need? From a retail buyer’s perspective, this trend serves to reduce the flow of relevant credit information accessibility. As a result, institutional buyers and professional credit analysts have the advantage of creating their own views concerning credit quality and may demand higher yield levels if credit risk is determined to be greater than implied from a single rating.
The chief financial officer of a recent Florida health care issuer recently remarked that the cost of obtaining a Moody’s rating was 30-40% higher than others. The cost differential combined with Moody’s more cautious view of credit has allowed S&P to gain credit rating market share. In the long run, this may be a case where any cost savings on the part of an issuer is actually a detriment to investors.
ACA: Here to stay (at least until 2017)
On June 25th, the United States Supreme Court handed down a ruling regarding a key provision of the Affordable Care Act (ACA). Effectively, this ruling allowed for federal subsidies to remain intact for low-income Americans to buy health insurance in all states, even those that had not set up their own healthcare platforms known as exchanges. The ruling provides additional time for the main components of the ACA to become more entrenched into American life prior to any changes that might occur if control of the White House changes hands in 2017.
Another aspect of ACA where changes are being proposed concerns the so-called 1115 Waiver program. This program provides federal matching dollars for spending to states testing new approaches to providing medical care not currently matched under Medicaid. The current administration is indicating that some of the existing matching programs will not be renewed. The resulting burden on state finances would significantly grow without the federal matching dollars to maintain these programs.
Margin pressure on hospitals will continue as more funding reductions occur. The speed at which hospitals are providing delivery and payment system reforms varies greatly among hospitals, especially for hospitals that are not part of larger networks. We continue to monitor hospitals to uncover any margin and balance sheet deterioration.
How do you say “default” in Spanish?
Coincident with the failure of Greek debt negotiations during the last week of June, we hear from the governor of Puerto Rico who now proclaims that the island’s $72 billion in debts are “not payable.” No shock that the value of outstanding Puerto Rican debt took a hit after that comment.
Puerto Rico does have something in common with Detroit. Both areas have poor economies and budgets supported by bloated debt issuance for a period of decades. Overspending in Puerto Rico is a bipartisan legacy left behind by at least five different government administrations. Just recently, as the crisis was growing, so was the budget…$713 million more than four years ago. When the bond market becomes unreceptive to rolling over maturing debt and hedge funds swoop in to buy existing debt at distressed levels, you know something will inevitably change. Forced austerity may look less appealing than bankruptcy to much of the populace of Puerto Rico, but existing laws don’t allow for bankruptcy to be used by a commonwealth territory (at least not yet).
Meanwhile, we see an island without natural resources, strong tourism or financial services. There are few island economies that thrive without at least one of these. Since it is doubtful that Congress will bail out Puerto Rico, it is just a matter of time before we see missed payments of interest and principal. From a technical legal perspective the island can’t file for bankruptcy, but for bondholders it may feel like it.