The slower pace of economic growth that unfolded in the first several months of 2015 was confirmed recently with just a 0.2% pace of growth in 1Q. In fact, the first quarter of seven of the last 10 years has been slower than the other quarters each year. It appears that those who officially track the economic data may need to revisit their seasonal adjustments to account for this odd 1Q pattern. Almost as consistently, however, has been a rebound in the pace of growth in the second quarters of recent years, which we expect to occur this year as well. A good indication of this will be in the April payroll report, which unfortunately won’t be released until after this goes to print. If this and subsequent payroll reports rebound back near the 260,000 average pace of the past six months, then the winter blahs will be chalked up to “transitory” factors, as the Federal Reserve (Fed) seems to believe. If instead the pace of hiring has truly slowed, then the Fed and investors may be looking at the first rate hike in 2016 rather than later this year.
Despite the modest pace of growth year-to-date, the trend for interest rates last month was clearly higher. In both the Treasury and municipal markets, intermediate and longer-term rates rose more than short rates, leading to a steeper slope to the yield curve. Among higher quality tax-free issues, 10-year yields and longer rose between 15 and 25 basis points (bps), while shorter yields rose just 5 bps. A steeper curve enhances the relative value of the tax-free market in several ways, particularly the intermediate maturity segment. First, it offers greater incentive from those holding cash and short-term bonds to extend and receive a higher yield. In addition, particularly in the seven to 12 year maturity range currently, the positively sloped curve allows bonds to appreciate in value as they age (or “roll”) along the curve. If the curve were to maintain its current slope over the next 12 months, this roll benefit may add as much as 100 bps to the return an investor receives.
Macro-economic issues played a part in the April rise in yields as inflation expectations rose, thanks in part to higher oil prices. West Texas Intermediate Crude, for example, rose over 20%, from $49/bbl to nearly $60/bbl. At the same time, the U.S. Dollar Index slipped last month, reversing some of the recent strength relative to other currencies. Among other factors, these contributed to a modest increase in future inflation indicators.
Away from those macro issues, the tax-free market faced its own headwinds due to less favorable technical conditions. As for the demand for municipals, it was clear that some investors pulled money from tax-free funds in order to make April tax payments. The fund withdrawals were primarily among money market and short-term funds, which have traditionally served as a convenient placeholder for these monies. The modest outflows appear to have been just a temporary break from the steady pace of inflows that has been the norm since early 2014. From a supply perspective, a continued heavy pace of new supply, particularly refunding issues, placed upward pressure on yields. The heavy dose of refunding supply—approximately 70% of all new supply has been refunding related—adds to the overall duration of the tax-free market. The bonds being refunded, typically higher coupon issues that are pricing to a short-term call date (i.e., low duration), are refinanced with bonds with a similar final maturity, but a longer, typically 10-year, call date and on average a lower coupon. Both the longer call date and lower coupon lead to a longer duration replacement from the refunded debt. In the vacuum of outside influences, which is rarely the case, adding duration to a bond market tends to push yields higher, as occurred last month.
For investors, however, modest upward pressure on rates is a good thing—if they are invested appropriately for their respective time horizons. While the transition toward higher rates leads to near-term price pressures, over time it is essential in order to achieve higher returns from a fixed income portfolio or fund. The underperformance of tax-free debt relative to taxable sectors of the market also enhances the value of municipals as an asset class. The ratio between tax-free yields and taxable yields continues to strongly favor the municipal market, particularly for higher tax bracket investors. For example, at month-end, a 10-year AAA rated tax-free bond had a higher yield than comparable maturity Treasury, even before factoring in the tax-exemption benefit. Investors take note!
Value in insurance
For several reasons, we believe having an above average weight in insured bonds is currently warranted. Prior to the financial crisis and Great Recession of 2008/09, over one-half of new municipal supply was insured. Those who were involved in the market at that time will remember both the pros and cons of the commoditization of the market that occurred as a result of the abundance of insured debt. For some, trading and managing municipals was easier when it was just a “rates market,” meaning your interest rate posture was essentially your only decision as an investor. But some investors grew overly complacent, trusting the “depression scenario stress tests” that the rating agencies alleged to justify the AAA ratings of the insurers, rather than analyzing the underlying credit.
Today is a much different story for the market and for the insurers. First, investors and rating agencies are significantly more skeptical of the insurers, which is healthy. The rating agencies have made their stress scenarios much more rigorous than pre-crisis for the insurers, and are significantly stingier with their ratings. Currently, none of the municipal monoline insurers carry a AAA rating (for that matter, neither does the U.S. government from S&P’s perspective). Second, the insurers have been tested in a handful of municipal bankruptcies and have proven their worth, so far. In the Detroit bankruptcy, for example, insured general obligation bond holders received 100% of par value, despite the insurers accepting as little as 30% of par in the grand bargain agreement, which the bankruptcy judge accepted.
A third reason is scarcity. The percentage of new issues that carry insurance today is less than 5% of total supply, and that’s up from the near-disappearance of insured issues in 2009. The market penetration of insurance reached its peak roughly 10 years ago, but most of those bonds are now either currently callable, or are nearing their call date.
Rates today are much lower than 10 years ago, leading to the heavy refunding supply mentioned above, and more insured bonds are being called away or pre-refunded than are being reissued, shrinking the outstanding supply of insured bonds relative to the total market. We believe that investors will place greater value on the insurance over time than has been the case since the turmoil of the recession.
Finally, insurance enhances the liquidity of a bond. Insured bonds are still very appealing to many retail investors, which broadens the number of potential buyers when selling an insured bond relative to uninsured bonds. Increasingly, institutional investors are also recognizing the liquidity benefits of insured bonds as well. While the insurers will unlikely never regain the dominant position they once held in the municipal market, they do seem to be here to stay and continue to play an important role for a segment of the market.