We would like to briefly address the municipal headlines that come across your screen (or printed paper for some of us) from time-to-time. Fortunately, there have not been many over the past quarter and we like it that way.
Municipal bonds have been a reliable and largely worry free investment for decades and we believe they will continue this course. However, as the headlines point out, mismanagement is not unknown to public entities. Despite the struggles of a handful of highly publicized tax-exempt issuers over the past few years, we would argue that the overall quality of municipal debt is significantly higher than in the corporate world. As such, problems in repayment of debt have become and continue to be drastically lower.
For example, a June 2017 report by Moody’s showed that municipal defaults are still a rare occurrence. The report encompassed their rated universe of municipal issues from 1970-2016. The municipal default rate over the entire period was 0.07% while the five-year municipal default rate since 2007 was 0.15% — an uptick, but still a rarity. Compare this to the corporate default rate of 6.92% for the same five-year period. Additionally, Moody’s rated municipal issuers have a significantly higher average rating than rated global corporate credits. Looking at the rating distribution of municipal versus corporate issuers, only 1.4% of all municipals are rated Baa3 and lower compared to 49.6% of global corporate credits.
Over the past few years, the growth in revenues from personal income taxes, sales taxes, and the recovery of property valuations has supported state and local governments, providing political leaders the ability to offset growth in fixed costs and rebuild reserves. The flexibility afforded municipal officials to manage budgets is evidenced by the continued favorable rating actions. For example, Moody’s reported that, for the third year in a row, rating upgrades (774) exceeded downgrades (461) in 2017. Albeit, on a dollar value basis the amount of debt downgraded exceeded that of debt upgraded due to rating downgrades on several large issuers including the State of New Jersey, the Commonwealth of Puerto Rico, the State of Illinois and the State of Connecticut.
We are not arguing that life in Muniland will be all peaches and cream. There will be winners and losers. Moody’s cites growth in government leverage (borrowing) as the single largest factor in rating downgrades. Municipal borrowing is a growing percentage of governmental fixed costs and is crowding out essential services as revenue growth fails to keep pace. Unfunded pension liabilities for state and local governments were minimal fifteen years ago; today, it’s a primary concern for municipal credit analysts. However, a government’s ability to cut expenses and adjust revenues has provided the sector the ability to avoid significant rating erosion.
As in all investments, you need to be vigilant. Our approach is to maintain a high level of diversification in combination with a seasoned staff of credit analysts.
U.S. fixed income markets remain focused on the policy moves of the U.S. Federal Reserve. Last month, the Fed hiked its Fed Funds target rate by 25 basis points for the sixth time this cycle (now 1.50-1.75%). This was the first meeting under new Chairman Jerome Powell. We saw a mix of investor reactions, both hawkish and dovish reads on the overall meeting and comments. The Fed’s “dot plot” did project a steeper path for the target rate over the next two years, however, inflation remains under the Fed’s 2% target and wage increases are not signaling undue stress on that front. Two additional hikes this year appear likely, with the potential for a third if inflation perks up. For now, we would say business as usual with gradual and data-dependent hikes, as has been the case for the past two years. With short rates moving higher, the U.S. Treasury yield curve continued to flatten and municipal bonds largely followed suit. The U.S. Treasury yield curve’s spread between 2 and 10 year rates, at about 50 bps, is at its lowest level in over ten years. The Bloomberg Barclays Municipal Bond Index was able to eke out a positive 0.37% for March, but was unable to offset losses in the first two months of the year. The first quarter return for the Index was -1.11%, leaving trailing twelve months returns at 2.66%. This compares favorably to the total return of the primary taxable fixed income benchmark, the Bloomberg Barclays Aggregate Bond Index, which returned -1.46% for the quarter and 1.20% for the last twelve months.
With a supportive technical situation of limited new issuance and positive flows into the asset class, negative first quarter municipal returns were disappointing. Broadly, domestic fixed income returns were challenged as inflationary fears forced bond yields higher. After the record supply in December 2017, the first quarter saw municipal bond issuance down approximately 30%, well below its ten-year average. Despite negative returns over the quarter, municipal bond funds saw over $10 Billion in net flows during the period — only two weeks saw outflows over the quarter. However, most of the inflows occurred in the first few weeks of the quarter and were attributable to investor reallocations out of equities and into muni bond funds. This was tempered to some degree by decreased demand and selling by banks and insurance companies which saw their income tax rate decline to 21% as a result of last year’s tax reform legislation. Bank and insurance companies hold approximately 30% of outstanding municipal bonds. While we don’t expect heavy selling, early indications are that there is diminished demand from corporate buyers. We will continue to monitor this, particularly if retail muni fund flows turn negative.
For retail investors, municipal bond yields continue to look very attractive on a taxable equivalent basis. For example, an investor in the 35% income tax bracket could currently realize a tax adjusted yield of about 3.75% for a ten-year, AAA rated muni—about 100 basis points over the ten-year Treasury yield. And with the volatility we have been seeing in the equity markets, all the more reason to revisit overall portfolio diversification.
- We will continue to be shorter duration than our benchmark and peers.
- Fixed income markets have been driven to higher yields by heightened concerns of inflation, potential for increased Treasury issuance, and an active Fed. US Treasury 10-year yields have risen 35 basis points year-to-date.
- 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 a continuation of policy normalization and has steepened the two-year forecast for rate hikes via the “dot plot”.
- The weekly municipal floating rate index (SIFMA rate) is at 1.60% (4/4/2018) versus 0.88% a year ago. SIFMA has been climbing as we go into tax season, a seasonal occurrence in the municipal market. Look for this weekly rate to decline over the next month.
Credit and structure
- The only notable outlier for credit returns last month was municipal high yield. The Bloomberg Barclays Muni High Yield Index returned 1.46% in March driven, higher by tobacco bonds and some recovery in Puerto Rico bonds.
- We continue to be wary of BBB and lower quality bonds with quality spreads at very tight levels.
- We like prepaid gas bonds at this time. These 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.