Flight to quality
The recent referendum in the United Kingdom to leave the European Union caused a massive flight-to-quality in the financial markets. In times of uncertainty and volatility, investors move their capital to U.S. treasury securities and secondarily to municipal bonds, and this time was no different. As a result, tax-exempt yields fell by about 25 basis points after the vote. Municipal bonds have historically been viewed as a relatively safe asset class, and rightly so given the extremely low default rate of municipals relative to corporates due in part to a significantly higher average credit quality rating.
As for global central bank risk appetite, it’s likely that easing monetary policy will be the soup du jour. Domestically, the Fed has four meetings left this year; July, September, November, and December. The probability of a December hike based on Fed Funds Futures fell from 50% before the UK referendum, to less than 10% after the vote. At one point, the implied probability of a cut to Fed Funds was higher than a hike. Looking forward, we think Fed tightenings for 2016 are off the table.
Over the second quarter, municipal yields declined with the continuation of strong net flows into municipal bond funds. You can see in the chart on the next page the relationship between positive municipal fund flows and lower yields. As was the case last month, municipal yields are at generationally low yields as global interest rates plummet into negative territory.
It was a remarkably strong second quarter for the tax-exempt bond market as the Barclays Municipal Index returned 2.61%; the twelfth consecutive month of positive return putting year-to-date return at 4.33%.
Revenue bonds outperformed general obligation bonds over the quarter. The Revenue Bond Index returned 2.92% as the GO Bond Index returned 2.41%. The best performing investment-grade revenue sectors were the Hospital and Transportation sectors returning 3.13% and 3.02%, respectively. The extra yield of lower quality bonds helped propel A-rated and BBB-rated bonds past higher quality bonds. For example, A-rated bonds returned 3.14% over the quarter versus 2.20% for AAA-rated bonds. Modest quality spread tightening also helped lower quality bond performance over the quarter as investors clamored for additional yield. Geographically, Illinois bonds continued to be one of the best performing states returning 3.24% for the quarter despite their budgetary problems and political infighting. The State of Illinois sold $550 million of general obligation bonds in June at rates well above what most other states pay. That additional yield can help performance.
Municipal high yield bonds posted the best tax-exempt performance over the quarter with the Barclays Muni High Yield index returning 5.10% for the quarter. As has been the case, one of the best noninvestment grade sectors was Tobacco returning 6.16% for the quarter and a whopping 29.44% over the past year. The Tobacco sector accounts for 21% of the Barclays Muni High Yield index.
Supply and demand
Wrapping up a strong quarter of supply, issuance surged by 9% in June. This was the highest issuance for that month over the past eight years. Municipal issuers borrowed $119 billion in the second quarter, slightly ahead of the same period in 2015. Year-to-date, we continue to run behind 2015 issuance, although the difference has diminished with two consecutive months of above average volume. Refunding deals played an important role in the increase in issuance as municipalities took advantage of historically low yields to refund older, more expensive debt.
As mentioned above, flows into municipal bond funds has been unusually strong. Net fund flows for the second quarter totaled $22 billion, a 40% increase from the first quarter and one of the largest quarterly totals over the past few years. Year-to-date, $38 billion has piled into tax-exempt bond funds. This demand has more than offset the pick-up in issuance over the past couple months.
Municipal yields moved significantly lower over the quarter and year-todate. For example, the 15-year spot fell from a 2.40% at the end of 2015 to about 1.70% at the end of the second quarter of 2016 — a decline of 70 basis points. Almost half of this decline came after the Brexit vote. Accordingly, the best total returns for the quarter and year-to-date were on longer municipal bonds. The Barclays Municipal Long Bond Index returned 4.51% for the second quarter as the 5-Year Municipal Index returned 1.16%. Heavier exposure on the longer end of the municipal curve would have helped portfolio performance and was the primary driver of municipal returns over the quarter and year-to-date.
Down the drain: Leaky water pipes across the U.S. lose trillions of gallons of water a year
The Environmental Protection Agency estimates that cities in the U.S. lose over 2 trillion gallons of drinking water per year — about one-sixth of the water the nation treats — due to water-main breaks and leaks. This cost cities as much as $2.6 billion annually. The American Society of Civil Engineers estimates that the U.S. experiences approximately 240,000 water main breaks per year, or about 660 breaks per day.
New York City loses about 58 billion gallons of water per year due to leakage. Cities such as Chicago and Houston each lose about 22 billion gallons of treated water per year through leaky pipes, an amount that could meet the needs of about 700,000 people in a year.
In a notable episode, a 90-year-old water main burst near the University of California, Los Angeles campus. At a rate of about 75,000 gallons a minute, it is estimated that the break shot out as much as 8 to 10 million gallons of water before it was shut off, only four hours after it burst. This was enough water to serve a town of about 150,000 people for a day. In Los Angeles, it is estimated that about 27% of the City’s approximate 5.2 million feet of pipeline is at least a century old.
Further, it is estimated that Los Angeles loses about 8 billion gallons of water per year due to leaky pipes, enough to supply about 50,000 households for a year.
As is the case with other infrastructure nationwide, much of the problem with water-mains arises from underinvestment. The Congressional Budget Office has reported that in 1959 public spending on transportation and water infrastructure was 3.0% of GDP, while in 2014 it was only 2.4%. Repairing decaying water infrastructure has been hampered by an “out of sight, out of mind” mentality. Collapsing bridges and deteriorating roads can be seen, but cracks in water infrastructure are not observable until a water main breaks. Slow economic growth, broad resistance to rate and tax increases, and significant claims on already stressed municipal resources (e.g., growing pension obligations) will likely lead to governments kicking the can down the road for water infrastructure improvements.
Canary in a coal mine
Recovering oil prices will provide relief for some energy producing states like Louisiana, North Dakota and Alaska. However, some states are rich in an out-of-favor fossil fuel, namely coal. Recovery from the changing coal industry will be more challenging for states rich in coal like Wyoming, Montana, Utah and West Virginia. The Clean Power Plan is a game changer for the coal industry as it establishes state-by-state targets for reducing carbon emissions. In the first quarter of 2016, coal production was down 28% from the prior year, while coal exports have fallen for 12 consecutive quarters. By 2030, coal production in Utah is expected to be eliminated.
According to the National Mining Association, the average number of workers in coal mining fell to 103,000 in 2015 from 143,000 in 2011; a loss of 40,000 jobs in four years. Even more jobs were lost in services that support the mining industry. This past May a loss of 157,000 jobs in activities supporting the mining industry was a blow to local economies.
However, employment loss is only one of several side effects due to the shift from coal-fired generation to clean energy. Utility bills will be on the rise as power producers build out renewable generation. For example, analysts have estimated that the cost of replacing power lost by the retirement of the Diablo Canyon nuclear unit in California alone could reach $15 billion. And consumers will have to pay a good portion of that in the form of higher future utility bills. Experts have predicted that renewables will be the leading power source by 2027. We continue to monitor the economies and finances of energy-dependent states, as well as our public power holdings, in light of the changing emphasis on clean power.
Up in smoke
California is the second state, following Hawaii, to increase the age for purchasing tobacco products to 21. This move is expected to provide the state with long-term healthcare cost savings. California contains about 11% of the nation’s smokers. The Institute of Medicine reports that increasing the age to 21 for tobacco products could lead to 250,000 fewer premature deaths and 50,000 fewer deaths from lung cancer for individuals born between 2000 and 2019. The higher age enforcement is gaining traction across the country; over 100 cities currently enforce the 21 year age limit.
The reduction in smoking is primarily aimed at long-term health care savings. However, a side effect of limiting potential smokers is a drop in sales tax receipts from tobacco products. California has estimated the loss in tobacco tax revenue to be approximately $68 million a year. To offset this loss in revenue, California is putting a new tobacco tax on the November 2016 ballot that would raise the price of a pack of cigarettes by 43% from $5.89 to $7.89.
As governments across the country adopt higher age standards for tobacco products, cigarette sales could head back to negative territory following last year’s 1.9% increase in shipments. This news may not bode well for municipal tobacco bonds, the best performing tax-exempt sector for the past year. Over time, this stellar performance record could go up in smoke as negative pressure on sales and consumption grinds down the revenue stream securing the payment of tobacco bonds.
Duration: We have been extending duration as investor inflows continued and as we enter the seasonally strong July reinvestment period. We expect investor interest in municipal bonds to remain healthy over the next several months of global uncertainty.
Curve: Retaining general barbell structure but continuing to reduce floating-rate note position (particularly in the intermediate products) as the probability of near-term Fed hikes diminishes. We have been buying longer bonds in each fund’s respective investment horizon.
Credit: Lower-quality overweight continues to provide above-average yields and is additive to performance. Quality spreads remain relatively tight and we expect spreads to remain tight over the next few quarters.
Sector: Adding to revenue overweight when attractive bonds are available. Continue to find value in smaller, local general obligation bonds. Cheaper bonds can be found from select issuers in Illinois with required input from research staff.