How low can you go?
The municipal rally that began in mid-March continued through May and into the first week of June. Skittish retail investors continue to drive municipal bond yields lower even as Treasury yields bounced in a 40 basis point range over the past four months and U.S. equities remained relatively stable. You can see in the chart below just how low municipal yields have fallen. The Bond Buyer 11-bond GO Index recently hit its lowest yield over the past 55 years. Surprisingly, municipal yields fell even as we saw the heaviest May issuance since 2008.
Strong demand has been one of the key drivers forcing yields lower. Retail investors, who hold about 60% of the $3.75 trillion of outstanding muni bonds, continued to pour money into municipal bond funds. Additionally, banks increased their holdings of municipal bonds by about 2% in the first quarter of 2016 to $508 billion, finding more relative value in munis than Treasury bonds. Finally, while municipal yields are hitting generational lows, they are still high relative to government bonds worldwide. We have been hearing anecdotal evidence that foreign investors have increased purchases of U.S. municipal bonds as they face extremely low or negative rates at home. While foreign investors held only $85 billion of municipal bonds at the end of 2015, any additional buying on the margin of strong domestic demand could have an exacerbated downward effect on muni yields.
May has historically been one of the weakest months for municipal bonds as new issuance increases. Despite this seasonality, the Barclays Municipal Index was able to eke out a positive total return of 0.27% for May; the 11th consecutive month of positive return putting year-to-date return at 2.70%. In general, municipal bonds outperformed most other domestic fixed-income sectors except for long Treasuries and high yield. For example, long U.S. Government returned 0.79% and U.S. Corporate High Yield returned 0.62% for the month of May.
Revenue bonds continued their year-to-date outperformance of general obligation bonds in May. The Revenue Bond Index returned 0.35% as the GO Bond Index returned 0.17%. The best performing investment-grade revenue sectors were the Hospital (0.54%) and Housing (0.68%) sectors. Geographically, Illinois bonds continued to outperform, returning 0.73% in May and 3.22% year-to-date. Over the past year, investors searching for yield have been able to find cheap Illinois bonds due to the ongoing political and financial stresses in the state and the city of Chicago. However, the cheapness of local Illinois issuers has been gradually disappearing.
In the high yield market, the non-investment grade Tobacco sector continued its strong run returning 2.01% for the month and 11.55% year-to-date as investors continue to stretch for yield in this extremely low interest rate environment. As we mentioned last month, the Tobacco bond sector has been strong over the past year (24.01%) with performance driven by a reversal in cigarette sales. Low prices at the pump gave consumers more discretionary income to pay for cigarettes. Puerto Rico was also a key driver of municipal high yield returns. Despite ongoing defaults of various Puerto Rican debt, speculators drove prices of select Puerto Rican bonds higher. The High Yield Puerto Rico Index returned 1.91% for the month of May.
Supply and demand
We saw about $40 billion in supply over the past month, the heaviest May issuance since 2008 and the first month of the year to post higher year-over-year total volume, up 8% from May 2015. Year-to-date, we still remain slightly behind 2015 with total issuance of $173 billion, down 8% from last year. A couple factors led to strong May supply.
First, persistently low interest rates have driven refunding issuance higher. May was the first month of the year that we saw an increase in refunding volume from last year. Secondly, new money issuance is up 20% this year. This may indicate that municipalities are feeling more comfortable with their financial positions to issue new project bonds. Looking forward, June is typically a strong month for municipal issuance and we expect that to continue this year.
Net fund flows for May totaled $7.2 billion, the strongest month of inflows over the past two years. Year-to-date, $27 billion has piled into tax-exempt bond funds. At 35 consecutive weeks of inflows, the market continues to chase the last streak of 64 weeks of positive inflows ended January 2009. We do not expect a quick reversal of the strong positive flows we are seeing for a number of reasons including; low and negative global interest rates; speculation on asset bubbles domestically and abroad; volatility surrounding the U.S. presidential election; and, a sluggish Federal Open Market Committee. However, we do expect diminished flows into the municipal market as relative value versus other asset classes dwindles with high demand.
Yield changes across the curve varied for the month of May as yields 10 years and in rose by 10 basis points while yields on the longer end of the curve fell by as much as 15 basis points. Accordingly, the best total returns for the month were on longer municipal bonds. For example, the Barclays’ Municipal Long Bond Index returned 0.87% for May as the 5 Year Municipal Index returned -0.21%.
AAA Municipal curve
Airports reach their cruising altitude
Strong consumer confidence and economic recovery has people taking to the skies. U.S. airports are registering strong enplanement growth resulting in rising revenues and improving financial measures, ultimately leading to positive rating trends. Historically, positive Gross Domestic Product (GDP) growth has led to positive enplanements.
Airports derive the bulk of their operating revenues from both aeronautical and non-aeronautical sources. Aeronautical sources, which generally can range from 35 – 65% of total airport operating revenues, include landing and terminal fees collected from airlines. Nonaeronautical sources include revenues from parking, rental cars, retail and restaurant operations. Higher passenger trends result in greater revenues from these sources. On the other hand, economic declines can lead to decreases in passenger activity and operating revenues. However, given their monopolistic nature, many airports maintain financial and rating stability utilizing their ability to pass through costs to the airlines pursuant to “use and lease” agreements. Airports also can adjust non-aeronautical revenues such as parking fees.
Enplanements at individual airports also can be influenced by airline activities, including strategic route and hubbing activities, as well as mergers and bankruptcies. This is less of a factor for airports that have large, diverse, attractive service areas and serve a high proportion of origin and destination traffic (the number of passengers that begin or end a trip at a particular airport). In such markets other airlines are more likely to enter the market or expand services to fill the vacated capacity. Airports with heavy connecting traffic or in smaller, less desirable service areas generally face more pressure if airlines reduce or cease activity.
Looking for a better night’s sleep?
Investors in the municipal market are aware of the stability and safety municipal investments offer. Municipal investors can sleep better at night according to a recently released Moody’s report, “U.S. Municipal Bond Default study 1970-2015.” The report discloses that there were only four Moody’s-rated municipal defaults in 2015. Additional support for the high quality of the municipal market comes from a Municipal Market Analytics report on default trends indicating that on a rolling 12-month count in April 2016 there were only 50 municipal defaults and holding steady since March 2014. This compares very favorably to the peak in 2010 at 210 defaults. This positive trend continues into 2016. Moody’s upgrades exceeded downgrades in the first quarter of 2016 for the fourth time in the past five quarters. However, rising debt, pension liabilities and funding for other post-employment benefits will likely financially strain certain municipal credits over the next several years.
Energy prices hit hard, but hope springs eternal
The recent failure by Organization of the Petroleum Exporting Countries (OPEC) members to reach an agreement on limiting production will continue to hold down oil prices and pressure energy dependent economies. States reliant upon oil production taxes and royalties have seen greater revenue volatility and are currently struggling to close current year budget gaps and balance FY2017 budgets. Alaska, Louisiana, North Dakota and Oklahoma have suffered the most dramatic revenue declines and economic losses. While oil prices have risen 80% over the past few months, they remain 50% below the 2014 peak. Crude oil futures are suggesting that prices will stabilize close to $52 per barrel. Low oil prices are also to blame for a year-over-year loss in employment of nearly 4% in North Dakota and Wyoming. This compares poorly to the national average employment growth rate of over 2%.
North Dakota’s economy has been hit particularly hard. In 2014, North Dakota was one of the fastest-growing economies in the country. Two years later, the economy has shrunk 3.4% in the third quarter of 2015 — the weakest in the country. In its heyday, more than 80,000 people came to North Dakota with many of them settling in the oil boomtown of Williston. Forecasters expected Williston’s population to climb to 50,000 by 2020; instead, the population has shrunk 16% to 26,500. However, hope springs eternal as some residents think the slump in oil prices will allow the region to recover from excesses of the boom.
Oil and gas gross production and oil extraction tax revenue
Real estate recovery supports long-standing revenue source
Government employment data supports that local governments are experiencing a strong rebound since the recession, maybe more so than state governments. A main source of revenue at the local government level is the property tax. The rebounding real estate market is providing a growing property tax base providing local governments with strong revenue growth. Improving local government finances has allowed local governments to rebuild their workforce.
General local government employment is now near pre-recessionary levels. State government employment (excluding education) has leveled off at 4% below pre-recessionary levels.
State and local government employment January – May
Duration: Maintaining neutral duration as investor inflows continue and we approach the seasonally strong July reinvestment period. We see no immediate reversal in investor demand or unexpected moves by the Fed.
Curve: Retaining barbell structure but reducing floating-rate note position marginally in intermediate products in recognition of a sluggish Fed.
Credit: Lower-quality overweight continues to provide above-average yields and is additive to performance. Quality spreads have tightened with above-average demand but should maintain current levels with no recession on the horizon and consumer-led economic growth continues. Focus purchases on A-rated bonds.