Trump agenda hits headwinds
The wheels in Washington are turning slowly for the Republicans led by President Trump. The big three policy concerns for the municipal market (tax reform, healthcare reform and infrastructure spending) are mired in politics.
Changes to the nation’s tax code have run up against interest-group lobbying and voter discontent over losing precious tax breaks. Rewriting the tax code is a difficult process. The American Health Care Act, meant to repeal and replace Obamacare, remains stuck in the Senate after struggling to make it out of the House. And the President’s infrastructure plan remains just that, a plan that will take years to fund and implement. The bottom line for the muni investors is business as usual as the market has signaled decreasing concerns of fiscal policy impacts to the economy. The signal, a significant decline in yields in U.S. fixed income securities. U.S. ten-year treasury yields have fallen about 50 basis points through mid-June after peaking in mid-March. Municipal yields have fallen by about 60 basis points. On the other hand, monetary policy continues to lean towards tightening, pushing yields on the short end of the curve higher.
At the end of April, the White House released its tax reform “plan,” which is basically a two-page document of bullet points; one page is devoted to the actual proposed reforms. A list of changes meant to promote investment and create jobs. There is no concrete proposal at this time. The document is intended to be a starting point for discussions. Below, we have listed the major points of the tax reform plan.
Hurdles for passage
- Increases the deficit and public debt, although Freedom Caucus members have conceded they’re willing to accept some deficit expansion to get tax cuts done.
- Not revenue-neutral tax reform — may need to go through reconciliation process in the Senate to avoid filibuster, which may also limit tax cut to 10 years.
- Creates a tax shelter for pass-through businesses (wage income will become business income taxed at the lower 15% rate) — a significant loss in revenue.
It’s difficult to determine the exact impact of the tax reform plan on the economy or deficit as there are no details. The goal of tax reform is to spur growth; however, the impact of tax policies on growth is highly debated amongst experts. Various studies have determined that the plan could increase the deficit by trillions of dollars over the next ten years. The Administration’s argument is that increased growth, and associated revenues, will more than offset the cost of the plan. All of these questions will be major topics of discussion in negotiations.
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Our thoughts to date
- Reduction of top tax bracket to 35% is less than the 33% suggested during campaign; this is good for municipal bonds.
- Many investors in tax-exempt bonds are in tax brackets below 30% and will likely continue to buy with proposed tax cuts.
- Elimination of AMT will increase the price of municipal bonds subject to the AMT. This is already being priced into the market.
- A corporate tax rate reduction to 15% would likely crimp demand from banks and insurance companies for tax-exempt bonds. However, many think the House and Senate are unlikely to agree to that level — look for 20-25%.
- As for timing, a formal proposal is a ways off. Market participants are letting other factors drive the market. Many don’t believe fiscal stimulus will come in the next twelve months and tax reform will not happen before the end of 2017.
- The potential loss or capping of federally tax-exempt interest on municipal bonds is very remote.
SEC Rule 15c2-12: Potential changes to continuing disclosure of municipal issuers
Municipal market technical indicators continue to play a significant factor in the performance of municipal investments. Limited supply combined with solid demand and record maturities this summer may hold down yields as investors look to reinvest. However, over the past few years, one large player in the municipal market has exacerbated demand. Banks have more than doubled their municipal holdings since 2007; from about $200 billion in 2007 to $549 billion currently.
This increase in bank exposure to the municipal market is the result of a growing bank loan market that developed during the recession when it became very difficult for municipalities to obtain market access. Municipal issuers reached out to their local banks for direct lending and, over time, the two parties realized benefits. This direct loan market provides municipal issuers with cost savings by eliminating underwriter fees while providing banks stable, high quality investments. However, the problem for other municipal investors is that banks often negotiate municipal loans with covenants that place the bank in a senior position should a credit event occur. Additionally, municipal issuers were not required to disclose these transactions, putting investors of municipal bonds of some issuers in a weak position relative to the banks.
The growing bank loan market and hidden covenants have pushed concern over the disclosure of bank loans to a heightened level. In support of investor protection and financial transparency, the SEC has proposed amending Rule 15c2-12 to include two new events that would trigger a municipal disclosure to the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access (EMMA). First, any financial obligation undertaken by an issuer that would materially affect covenants, events of default, priority rights or any other items; and second, any default, acceleration of debt payments, termination event, and/or any modification of terms that could affect the issuer’s overall credit position. These two new triggers will improve investor protection and the financial transparency of municipal issuers.
BMO GAM credit analysts have been aware of the bank loan phenomenon and have used municipal issuer financial statements, rating agency reports and direct contact with issuers to monitor the use and covenants of bank loans for potential and current investments. BMO GAM supports greater transparency within the municipal market and encourages issuers to disclose bank loans and provide regular financial and operational updates with EMMA or a Nationally Recognized Municipal Securities Information Repository (NRMSIR).
There was quite a bit of news over the past several weeks for the financial markets to digest, causing volatility in interest rates. President Trump’s first hundred days in office, two Federal Reserve (Fed) interest rate meetings, a surprising election in the UK, passage of the Republican American Health Care Act in the House, and Puerto Rico filing for bankruptcy. However, as mentioned above, the main driver for U.S. fixed income markets was reduced concern over fiscal expansion policies and any inflationary impact they could have on the economy. As a result, the 10-year Treasury yield dropped from about a 2.40% yield in early May to about 2.10% as of mid-June. On the other hand, upward pressure is being exerted on the short end of the yield curve as the Fed continues their monetary tightening. In their latest meeting on June 14, the Fed delivered another quarter percentage point hike bringing the Fed Funds target rate to 1.00-1.25%. Expect interest rate volatility in the coming months as the market tries to determine what policies the Trump Administration can push forward as well as what plans the Fed has in mind for unwinding Quantitative Easing (QE) and their $4.5 trillion balance sheet.
The municipal 10-year yield followed roughly the same path lower as Treasuries, falling from 2.15% in early May to 1.85% in mid-June. The Bloomberg Barclays’ 10-year Muni Index posted a total return at 1.79% for the month of May. We saw positive total returns across the maturity spectrum with the best returns on the long end of the curve.
Over the month of May, lower quality bonds outperformed higher quality bonds. For example, the Bloomberg Barclays Muni BBBrated Index returned 1.83% while the AAA-rated Index returned 1.49%. Investors were stretching for yield as interest rates fell to their lowest levels of the year. Surprisingly, high yield munis underperformed BBB-rated bonds, returning 1.53% over the month. We did see some weakness in flows into high yield muni funds over the period. Yet again, the best performing high yield sub-sector was the Tobacco index which returned 3.85% for the month — 20.18% year-to-date. The average quality for this index is B-. The High Yield Puerto Rico index returned -4.59% for the month of May and -8.26% year-to-date.
Supply and demand
May’s bond volume fell 20% from the same period last year as new money deals failed to keep pace with a decline in refunding deals. Refunding deals for May totaled only $10.3 billion, down 38% from last year. Last year, issuance totaled $178 billion at this point versus $155 billion this year. The trend is pointing to reduced volume versus last year, which should help support municipal bond prices going forward. Also, all indicators are pointing to the municipal market experiencing net negative supply over the next few months. That is, more bonds are maturing and being called than are being issued — a reduction in municipal bonds outstanding.
Investor demand led to another good month of flows into municipal bond funds and ETFs. Over the past month, $2.4 billion flowed into municipal funds and ETFs. Year-to-date, we are at a solid $13.1 billion of net inflows.
Yields were lower over the past month as investors scaled back how much impact the Trump Administration’s fiscal policies could have on inflation. For example, a 10 year, AAA municipal bond’s yield fell by about 24 basis points — from a 2.14% yield at the end of April to 1.90% at the end of May. The best returns were on the 22+ year portion of the curve, which returned 2.25%. The Bloomberg Barclays 10 Year Index returned 1.79% over the past month.
- We went slightly longer in May due to forecasted net negative municipal supply and the seasonal increase in demand in June. Ten-year municipal yields dropped by about 35 basis points over the past month due to these favorable conditions. We think it is appropriate at this time to shorten duration due to potential Fed rate hikes as well as turmoil surrounding President Trump’s tax reform efforts.
- The Fed’s monetary policy tightening continues. The market expects one more hike this year. The Fed is also discussing ways to reduce their balance sheet of $4.5 trillion in bonds. With moderate inflation at this time, most of our concern for higher interest rates is for maturities eight years and shorter. As such, we have a significant amount of short, floating rate notes in the funds.
- Retaining barbell structure with municipal floating rate notes on the short-end of the curve and fixed coupon bonds on the longer end of the fund’s investment horizon. We earn more incremental credit spread on the longer end but remain duration neutral. Since the Fed began tightening, the curve is flatter with short rates higher and long rates lower. We will continue to monitor inflation expectations for a reduction to our long-end exposure; however, the latest reports suggest a continuation of this strategy.
- Daily and weekly tax free floating rate notes remain at elevated yields, providing attractive yields to interest rate sensitive investors. The weekly municipal floating rate index (SIFMA rate) is at 0.74% versus 0.40% in May 2016. Tax-exempt money market and ultra short funds are at very attractive yield levels for risk-averse investors.
Credit and structure
- Lower-quality bonds posted the best performance year-to-date. With the help of our seasoned analysts, we continue to look for undervalued A and BBB rated bonds. The higher yield of the lower quality bonds helps the long-term performance of these bonds. Also, price appreciation on undervalued bonds helps longer-term performance as well.
- We have been focusing on 5 percent coupon bonds for intermediate positions and 2-3 percent coupons on the shorter end of the curve. These are premium coupon bonds and are more defensive in a rising interest rate environment.
- Concerns about the municipal hospital sector have ticked up again with the AHCA passing the House. We do not believe there will be widespread underperformance of hospital bonds if the Senate and the House can pass a unified bill. If any weakness develops, we will look for undervalued securities in the healthcare sector.
- We continue to look for opportunities to invest in the State of Illinois GO bonds and bonds issued by the City of Chicago for our diversified mutual funds. The State of Illinois may suffer a downgrade to non-investment grade by the rating agencies if they do not reach a budget agreement by the end of June 2017. Prices on these bonds slid quickly after this news and offer value for institutional investors. We do not believe the state will default on any payments.