February chill for munis
After an explosive start for February, municipal bond prices began declining after mid-month. At that time, benchmark 10-year municipal yields were hitting their lowest levels since 2012 and equities were hitting two-year lows. While recovering equity markets played an important part in falling muni bond prices, a pickup in municipal issuance was also a significant factor in the reversal. New issuance totaled $32 billion, up 29% month-over-month with net issuance at approximately +$7 billion. Despite this supply-induced weakness, munis posted their eighth consecutive month of positive total returns. The Barclays Municipal Bond Index returned a paltry 0.16% for the month but still posted a healthy 1.35% total return for the first two months of the year.
Differences in sector performance were mostly unremarkable for the month. General obligation and revenue bonds performed similarly for the month. Of the revenue sectors, hospital and industrial development bonds were the weakest performers, but for no particular reason. Our outlook for hospital bonds is promising and you can read more on the positive impact Medicaid expansion has had on the sector below. Lower-quality bonds outperformed high grades slightly over the month primarily due to the higher yield they provide. The 0.21% return on BBB-rated bonds was only nine basis points higher than the 0.12% return on AAA-rated bonds. However, high-yield municipal bonds (up 1.10%) did significantly outperform the investment-grade sector (up 0.16%) over the month. This outperformance came largely from a price recovery in some of the Puerto Rico bonds as well as strength in tobacco bonds. These two sectors account for 43% of the Barclays Municipal High Yield Index. Once again, a couple of the energy-dependent states (Alaska and Louisiana) also lagged in performance with negative rating actions and outlooks weighing heavily on prices of bonds issued in those states.
Supply & demand
The late month sell-off in municipal bonds was largely attributable to unexpectedly heavy issuance in the last two weeks of the month. Municipal bond issuance totaled $32 billion for the month, which was up 29% month-over-month but down 4% from last February. Last year was a near-record year for issuance, so the slight tick down from last year’s level is still a solid number and heavier than an average year. Also weighing on the market was a positive $7 billion in net issuance. Net issuance is total monthly issuance less maturing bonds, redemptions, and coupon payments. A positive number indicates more bonds were issued than those leaving the market; that is, the amount of municipal bonds outstanding increased.
We ended the month with 21 consecutive weeks of inflows into tax-exempt funds, benefiting yet again from the flight to safety out of the volatile equity markets. Tax-exempt bond funds saw inflows of approximately $5 billion in February and have seen almost $10 billion year to date. We will see if flows slow with recovering equity markets and rising tax-exempt yields.
While sector selection and quality exposure had little impact on municipal performance last month, yield curve positioning did have a noticeable impact. Shorter bonds in the two- to six-year maturity range held in much better than longer maturities in the sell-off toward the end of February. For example, the Barclays Municipal 5 Year Index returned 0.38% versus -0.01% for the 15 Year Index.
Medicaid expansion: A positive for the muni market
The not-for-profit health care sector has performed better than expected over the last couple years. This despite industry pressures related to health care providers transitioning from the current fee-for-service model to a value-based model (quality over quantity) with new health care reimbursement methodologies. In recent reports, Standard & Poor’s maintained a stable outlook for the sector while Moody’s upgraded its outlook for the sector to stable from negative. Operational improvements and efficiencies have been driven by the Affordable Care Act’s (ACA) Medicaid expansion; states that have not expanded may feel pressure to expand to both capture these efficiencies and collect a share of the federal dollars available to expand Medicaid programs. This may lead to a growing acceptance of Medicaid expansion and should have a positive financial impact on health care providers in states that choose to expand. Since 2014, 32 states adopted Medicaid expansion or an alternative form of expansion approved by the Department of Health and Human Services. Governors in three states (Wyoming, South Dakota and Virginia) had their proposed expansion programs rejected by state legislatures.
Under the ACA, the federal government picks up 100% of the costs of newly eligible Medicaid recipients from 2014 to 2016; the subsidy then declines until it reaches the minimum federal subsidy of 90% in 2020. States that have not yet expanded are concerned that the federal government could reduce the 90% subsidy, thus resulting in a greater burden on the state. To encourage further Medicaid expansion, the current administration is considering a plan to provide 100% funding for the first three years of any new state expanding Medicaid, with the federal subsidy dropping to the minimum 90% subsidy after the third year.
Regardless of what the holdout states choose to do, Medicaid expansion has helped health care providers in all states by improving payer mix, albeit, to a much larger degree in expansion states. Payer mix improvements are due mostly to reductions in uncompensated care provided to uninsured patients. The reductions are a result of providing health care coverage to the uninsured either through expanded Medicaid or exchange-based insurance products. As a result, the uninsured portion of the population has dropped from 15.7% in 2009 to 9.1% at the end of 2015. According to a recent study, the reduction in uncompensated care in expansion states has been as much as double the amount of decline in uncompensated care in non-expansion states — a significant boost to hospitals in those states. Despite recent data suggesting there has been an uptick in uncompensated care due to the increasing use of high-deductible plans, the current level is still well below the levels prior to ACA implementation. With most health care providers targeting break-even on government payers like Medicaid, any reduction in uncompensated cost has a direct impact on the provider’s bottom line.
If studies continue to show similar positive impacts for health care providers in states that have expanded Medicaid, it will make it more difficult for holdout states to ignore the benefits of expansion. We believe additional states will likely expand Medicaid in some form over the next two years, positively affecting the income statements of hospitals and other health care providers in those states.
Improving credit quality
The municipal market continued to improve in 2015 with rating upgrades outpacing downgrades as reported by S&P and Moody’s. While this was the fourth year in a row that S&P reported upgrades outpacing downgrades, it was the first year for Moody’s. S&P reported rating upgrades were two-to-one in 2015; 1,100 issuers were upgraded while 570 were downgraded. Moody’s registered 550 upgrades to 520 downgrades. Overall credit quality in the municipal market remained stable as rating changes only affected 9% of all Moody’s-rated entities. California and Texas represented a significant number of upgrades with S&P reporting 338 upgrades in California and 134 in Texas. Puerto Rico, Illinois, New Jersey and Kentucky accounted for the majority of downgrades. The strong credit picture is representative of a strong real estate market, the growth in sales tax revenues, and cost savings achieved during the recession.
Municipal market bankruptcies remain rare but some recent cases have led investors to question the general obligation (GO) pledge in the event of bankruptcy. The State of California, in an effort to clarify the strength of the GO pledge for local issuers, passed a law (SB 222) aimed at reinforcing the statutory lien on GO debt. The law clarifies that GO bondholders of California local issuers are considered a secured creditor in bankruptcy, dramatically decreasing the risk of nonpayment. After passing the law, Fitch rated four California school districts AAA due to the additional clarity the law has provided. Moody’s and S&P have stated that the law will not affect ratings because the importance of it only comes into play in the event a credit has significantly deteriorated and is contemplating bankruptcy. Ultimately, we believe the passage of SB 222 is a credit positive and is a show of support by the State of California for local issuers.
State and local governments are currently in the budgeting process for fiscal year 2017. While revenues have improved since the recession they have yet to reach prerecessionary levels for most governments.
Balancing revenues against growing fixed costs, including pension and health care benefits, has governments searching for ways to take advantage of the growth of e-commerce over the past few years. For example, last year’s online sales of $342 billion accounted for 8% of total retail sales. Unfortunately for states, taxing online sales has been restricted since a 1992 Supreme Court ruling that determined sales of a retailer with no physical presence in a state could not be taxed. The court was concerned that multiple jurisdictions would adopt varying sales tax requirements, ultimately restricting interstate commerce. The court stated that only Congress had the ability to grant the authority to tax internet activity. Local governments hoped that Congress would address the internet sales tax this year, however, a recent act signed by President Obama made the ban on taxing internet transactions permanent. The inability to tax internet sales is a significant loss to governments and puts brick and mortar establishments at a disadvantage. States continue to look for ways around the ban. For example, a Colorado appeals court upheld a law that requires online companies to provide customers with a year-end notice of taxes owed and forward that statement to the state revenue department. Time will tell if this workaround becomes a permanent solution for states.
Maintaining low energy prices is a high priority for states that are focused on providing business-friendly environments, but so is the growing use of renewable energy and reducing carbon footprints. Many coal-fired plants are expected to close due to tougher emission standards and the cost of installing required pollution control technology. One coal-fired plant expecting to beat the odds is the Prairie State Energy Campus in southwestern Illinois. The facility’s state-of-the-art pollution controls produced emissions well below those of existing coal-fired plants and meets standards set by the Environmental Protection Agency. After costly construction delays and a weak start, the plant demonstrated strong operating performance in 2015, confirming its position as a long-term, competitive power source for participating utilities.