Asset Management: Municipal Insights

May 2016 Municipal Insights

2016-05 train-chicago

Market commentary

Good times continue

The municipal market maintained its positive trend as investors continued to seek lower volatility investments, relative credit safety, and tax-exempt income. Municipals yields fell modestly through the month and ended approximately 10 basis points lower from the five-year spot and longer. Strong positive flows into tax-exempt funds continued despite a significant drop in global market volatility and investor caution. Municipals ended the month on a strong note aided by the Federal Open Market Committee (FOMC) decision to leave rates unchanged.

Municipal market technicals aided in the outperformance with the continued decline in municipal bond issuance for the eighth straight month while municipal bond funds experienced the 30th consecutive week of inflows. Municipal bond funds reported $5.2 billion of inflows for the month, putting year-to-date inflows at about $20 billion. Municipals ended the month on a strong note aided by the FOMC decision to leave rates unchanged.

Sector performance

The Barclays Municipal Index yet again posted a positive total return of 0.74% for April; the 10th consecutive month and putting year-to-date total return at 2.42%. In general, municipal bonds outperformed Treasuries. For example, the U.S. Treasury Index returned -0.11% for the month.

In April the best performing investment-grade revenue sectors were IDR/PCR, returning 0.89%, and transportation, with a return of 0.87%. In the high yield market, the non-investment grade tobacco sector returned 2.15% for the month and 9.35% year-todate. The tobacco bond sector has been strong over the past year up 20.78% and performance was driven by a reversal in cigarette sales. Put simply, these bonds (issued by state entities) are secured by payments from certain cigarette manufacturers. These payments rise and fall with cigarette sales. For the first time in over a decade, cigarette shipments increased 1.9% in 2015. Cigarette shipments have declined on average 3% between 2001 and 2014.

Healthcare institutions took advantage of low rates with several notable deals. For example, Ascension Health Alliance (Aa2/AA+/NR) in Wisconsin issued $1.1 billion in bonds last month and Loma Linda University Medical Center (NR/BB/BB+) in California brought a $947 million deal to market. Both deals were well received by investors despite the large issuance amount for the municipal market. The high grade hospital sector returned 4.09% in 2015 and returned 2.52% so far this year.

Supply and demand

We saw $35 billion in supply in April bringing year-to-date total to $133 billion. April’s supply is down 20% month-over-month and 18% year-over-year. Fund flows remained very strong causing some imbalance at times between supply and demand. Supply is expected to increase over the next month as we reach June, typically one of the largest supply months.

Net fund inflows peaked at $1.9 billion in the last week of April with total inflows for the month at $5.2 billion and $19.7 billion year-todate. The current weekly inflow streak is the longest since January 2009 when the market experienced 64 weeks of positive inflows. We see no reason at this time for investors to reverse the trend of inflows into municipal bonds, although a pullback from the current above average levels is likely.

Yield curve

Municipal yields continued their march lower over the month as the entire tax-exempt curve shifted down by about 10 basis points. Yields continue to hover around generational lows, but could go lower if market technical conditions remain intact. We are extremely close to all-time low levels we saw in late 2012.

Credit

Death and taxes

While it’s no surprise to the folks in Chicago, Illinois, has been identified as having the highest median property tax rate in the nation according to a recent study by CoreLogic. Chicagoans can expect to maintain that title for some time following Mayor Rahm Emanuel’s $755 million increase in property taxes to fund fire and police pensions. Additionally, the Chicago Teachers Union will expect similar treatment, so future property tax rates may be on the upswing to fund those costs. The average property tax rate of 2.67% in Illinois is 103% higher than the national average. This translates into a $5,340 tax bill on a $200,000 home. The national average was 1.31% or $2,620 on a $200,000 home. Also, no surprise that the east coast states of New York (2.53%), New Hampshire (2.40%) and New Jersey (2.37%) rounded out the top four with Illinois. Hawaii nabbed the lowest property tax rate at 0.31% followed closely by South Dakota, Alabama and Wyoming.

Moody’s March madness!

Moody’s Investors Service identified a new credit metric in evaluating college admissions. In a recent report, the rating agency noted that universities that do well in the NCAA Men’s Division I Basketball Tournament often experience a surge in applications that outpaces growth for other universities. For example, the University of Connecticut experienced a 35% increase in applications over the twoyear period after winning the tournament in 2011, compared to a 2% aggregate increase for all rated, four-year public universities over the same time frame. The University also saw a 27% increase following the 2014 tournament win. The study shows you don’t have to win it all either. In 2013, Wichita State University lost to the University of Louisville in the Final Four. In the two subsequent years after this loss, Wichita State saw a 29% increase in applications versus an 8% increase nationally. Finally, in 2010, Butler University lost the title to Duke University, but subsequently saw a 43% increase in applications over two years versus 16% nationally. This year’s Villanova Wildcats’ buzzer-beating victory over the North Carolina Tar Heels bodes well for both schools!

The energy impact

Weak energy prices are leaving their mark across the economy and contributing to the spotty economic recovery across the states. Moody’s Investors Service announced that for the first time in three years, the number of non-financial sectors that have a negative outlook outnumber those with positive outlooks. Of the 53 global and regional sectors, 25% are negative while 15% are positive. The materials industries are to blame for most negative outlooks while sectors supported by the consumer have maintained positive outlooks. The U.S. newspaper & magazine sector is the one negative sector not directly tied to commodity prices.

Sin taxes

Sin taxes, including alcohol, cigarettes and gaming taxes, draw the least amount of public criticism. As such, they are often the “go to” taxes when governments need to raise revenues. Gaming (casinos, video poker and lotteries) has become a zero sum game. A recent report from the Rockefeller Institute of Government illustrated that gambling has reached a saturation point across the country. The report noted that New Jersey, one of the first states to approve casinos, has seen its gambling revenues decline 54% since 2008 as nearby states allowed casinos to open in order to keep their residents’ money at home. Nationally, gaming revenues totaled $27.3 billion in fiscal year 2014 according to the report — a sizable number that states want to tap into. The report also notes that states do not benefit from state sponsored lotteries as much as many people believe. According to the North American Association of State and Provincial Lotteries, states receive approximately 26% of sales after all costs and prizes are paid out.

Smoking at the pump

Lower gas prices have led to an unintended consequence — increases in cigarette sales as consumers find extra change in their pockets after filling the tank. For 2015, cigarette shipments increased 1.9%, the first annual increase in over a decade. Cigarette shipments have declined on average 3% between 2001 and 2014. The increase in cigarette sales combined with the investor demand for higher yields has driven returns in the $34 billion high-yield tobacco bond sector. The bonds are up about 9% so far in 2016 and up a whopping 51% since the start of 2014, beating more than 80% of the stocks in the S&P 500. While these high-yield bonds (most are non-investment grade) still yield significantly more than investment grade bonds, the yield spread has collapsed significantly over the past year.

Ivy League woes

Cash strapped Connecticut contemplated taxing Yale University’s $2.6 billion in investment gains for 2015. Yale’s endowment is the second largest in the nation at $25.6 billion, trailing Harvard’s $37.6 billion endowment. The state is looking for ways to fill a $266 million shortfall for fiscal 2016 and tapping the endowment’s tax-exempt endowment earnings seemed like a good idea. The state dropped the endowment tax bill (which only affected Yale) but is moving forward to tax commercial properties at certain colleges. The state is looking to tax any business on campus with revenues of $6,000 or more. The bill would not affect educational buildings or dormitories. University officials and business leaders are criticizing the move. One thing everyone can agree on is that Yale University is a substantial asset and contributor to the local economy.

Chicago water purified

Chicago water revenue bonds got a vote of confidence with an upgrade by Standard & Poor’s Global Ratings Service. The senior lien bonds were upgraded to A+ from A and the second lien bonds were upgraded to A from A-. The upgrade was due to the elimination of any swap transactions as well as the refinancing of all variable-rate debt to fixed-rate debt. The rating also incorporates a sizable customer base that extends beyond the City of Chicago’s borders and has a strong financial history. However, future upgrades are limited due to the water system’s debt profile and the City of Chicago’s financial stress. The system’s credit metrics will also be stressed with a much needed $1.7 billion, five-year capital program, which is expected to be financed through bonding.

Strategy

Municipal bond yields fell modestly over the month as strong positive flows into municipal funds continued for the 30th consecutive week. We did see some out flows from tax-time selling, but this occurred primarily in short and ultra short municipal funds. For the 10th consecutive month, the municipal market posted positive returns with the Barclays Municipal Index returning 0.74% for April. Municipal total returns were positive across the curve with the long-end (1.05%) outperforming the five-year spot (0.49%) by about 50 basis points. We extended duration looking forward to a strong July reinvestment period which should support current price levels. Global financial markets face a number of hurdles over the next few months — UK’s EU referendum, U.S. presidential election, China slowdown, oil market jitters, European and Japanese negative interest rates — which may add volatility into global markets. Municipal bonds have typically been a safe haven in times of volatility.

 

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