Asset Management: Municipal Insights

March 2017 Municipal Insights

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February continues January rebound

Source: ICI and Thomson
Source: ICI and Thomson

Another decent month for municipal bonds with the Bloomberg Barclay’s Municipal Bond Index returning 0.69% for the month and 1.36% year-to-date. As discussed in previous issues, the municipal market faces a number of hurdles over the coming year. However, changes are moving more slowly than many thought.

These unknowns are causing investors to proceed with caution, some of which is justified. However, we continue to believe that fears of municipal underperformance are overblown. We argued in our last Insights that, historically, there is little correlation between income tax rates and the value of municipal bonds. Additionally, many municipal investors are in tax brackets lower than 30%. There is no infrastructure plan at this time, so a potential muni-bond supply surge from increased spending is an issue for 2018 or later. Also, at this time, the funding of infrastructure improvements is not likely to be in the form of tax-exempt bonds. Lastly, repeal and replacement of the Affordable Care Act will not have a widespread effect on municipal bond prices.

On the macro front, we are starting to see more concerns about rising interest rates over the coming year. In a well-communicated and widely expected move, the Fed did hike interest rates on March 15th by 25 basis points — putting the Fed Funds’ target range at 0.75%-1.00%. There was very little change in the dot plot, signaling that the Fed still plans to raise interest rates two additional times over the year. Many are speculating mid-year and December. To be defensive, we are maintaining duration shorter than our benchmark and maintaining a healthy allocation to floating-rate notes, the coupon of which floats higher with rising interest rates.

Market commentary

Sector performance

We saw a second month of spread tightening leading to outperformance of lower-quality bonds, particularly BBB-rated bonds. As in January, strong positive flows into high-yield municipal funds drove up demand for lower-quality, higher-yielding bonds. The Bloomberg Barclays BBB-rated Bond Index returned 1.00% versus 0.66% for the AAA-rated Index. However, the best returns in the muni world were in high-yield space. The Bloomberg Barclays Muni High Yield Index returned 2.38%. The best performing subsector was the HY Tobacco index which returned 6.75%. One of the strongest performing states was Illinois. While spreads remain wide due to continued state fiscal and budgetary problems, they did tighten resulting in the Illinois Index returning 1.15% for the month.

Supply and demand

After an unusually strong month of issuance in January, supply plummeted 35% in February as refunding activity dried up with high-interest rates. Total issuance came in at $21 billion in 660 issues. Through the first two months, municipal issuance is now about 4% behind last year’s record pace.

Flows into municipal bond funds and ETFs continued to be positive, albeit, slowing significantly as we head into March. In February, we saw about $2.9 billion of net inflows. With January’s $4.5 billion inflow, it is a substantial chunk of the $27 billion we lost last November and December. All-in-all, a solid start to the year, particularly with some of the headwinds we are facing from proposed Trump Administration policy changes.

Yield curve

Source: Thomson Municipal Market Monitor
Source: Thomson Municipal Market Monitor

We saw a bit of movement on the municipal curve over the past month, but only on the short end. The muni curves for the past three months are virtually on top of each other but for seven years and on where strong retail demand has driven yields lower. For example, the yield on five-year munis has fallen by about 30 basis points since the beginning of the year. The best returns over the month and year-to-date were on the five-year spot of the curve. The Bloomberg Barclays Five-Year Index returned 1.87% versus 1.36% for the overall index.

Credit

Bond Insurance has it benefits

Before the financial crisis in 2008, municipal bond insurers were prevalent in the municipal market. Many mutual funds were labeled Insured municipal bond funds. At one point, new issue deals coming with bond insurance comprised about 60% of the new-issue market. Currently, only about 7% of the municipal new-issue market comes with bond insurance. However, municipal bond insurance at this time does offer investors a solid layer of protection, enhanced liquidity, price stability and knowledge the security is under ongoing surveillance. The bond insurance mitigates credit risk and maintains price stability in the event an issuer suffers credit deterioration or in the worst case, default. If there is an event of default by the municipality, the insurer supports the debt service payment for the life of the bonds. Another benefit to investors is the positioning of bond insurers as proponents for creditors’ rights. The insurers push municipalities for greater disclosure which enhances the liquidity for all market participants.

Sources: Moodys.com; ratingsdirect.com; krollbondratings.com
Sources: Moodys.com; ratingsdirect.com; krollbondratings.com

There are currently three active-bond insurers in the municipal market; Assured Guaranty (AG), National Public Finance Guarantee (National) and Build America Mutual (BAM). Following the Great Recession, market participants were concerned that the municipal bond insurance industry was broken—it almost did break. Many bond insurers failed — all due to exposure to structured subprime securities. They strayed away from the safety of the municipal bond market. When the mortgage market collapsed, the bond issuance companies followed. One of the newer entrants, Berkshire Hathaway Assurance Corp (BHAC), left the industry about a year after starting the business. Assured Guaranty was the only bond insurer that maintained the ability to write new business through the Great Recession. In 2012 with stronger financial markets Build America Mutual (BAM) entered the market.

Since the Great Recession, the bond insurers have boosted their capital and raised the quality of their insured-bond portfolio. All three bond insurers report that over 80% of their insured portfolio has a rating of “A-“ or better. Assured Guaranty strengthened their balance sheet through the acquisition of several smaller insurers, FSA in November 2008 and CIFG in 2016, while at the same time minimizing nonmunicipal exposure. BAM entered the market with focus on high-quality, essential-purpose municipal bonds. Investors are attracted to BAM due to the lack of legacy debt and focus on higher quality essential purpose debt. National, following the bump in ratings, has more than doubled its book of business over the past two years. The financial success of these three firms comes from the strength of the municipal market that continues to enjoy minimal default rates.

Strategy overview

Duration

  • Favoring slightly shorter duration and defensive positioning due to potential turmoil surrounding President Trump’s tax reform efforts. Also, fiscal policy stimulus and trade restrictions could increase inflation expectations. There may be better opportunities to buy munis over the next several months than currently exists.
  • We had the Fed call wrong, but the fixed income markets did not react much and our positioning is appropriate for a rising-interest-rate environment. As mentioned above, the Federal Open Market Committee (FOMC) raised the federal funds target rate 25 basis points to 0.75%-1.00%.The committee also appears to be prepared to carry through with two more tightenings this year. We will see if global financial and political events allow the Fed to continue this gradual tightening plan.

Curve

  • 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.
  • 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 currently at 0.71%.
  • The front end of the municipal curve (10-15 years) continues to exhibit steepness and good roll-down.

Credit and structure

  • We continue to look for undervalued A and BBB rated bonds which could outperform this year if we see sustained positive flows into municipal high-yield funds.
  • The higher yield (wider spread) of the lower-quality bonds also helps performance.
  • We continue to focus on bonds with 4% and 5% coupons due to their defensiveness.

Sector

  • We have reviewed our hospital holdings in light of efforts to repeal and replace the Affordable Care Act. We found no significant exposure to issuers at risk of undue credit deterioration. We may selectively reduce exposure to this sector over the quarter. The Republicans have initiated a repeal and replace of Obamacare. We will review in the next Insights. If spreads widen across the hospital sector, we will look for solid credits at cheaper spreads.
  • We are being more selective in the higher-education sector. National demographic trends are working against this sector, with fewer high school graduates, particularly in the Northeast and Midwest. Also, strained state budgets are squeezing the funding to public higher education schools. Look for institutions with good demand due to name recognition or a niche, like a good engineering school.

 

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