Municipal market starts fourth quarter on a positive note
After a pass in September, the market held its breath again in the last week of October awaiting the Federal Reserve’s (Fed) decision on interest rate liftoff. The difference this time around was the widely held belief that the Fed will hold rates steady as it awaits updated U.S. economic numbers and continues to monitor global economic and financial health.
Though the October meeting — the Fed’s second-to-last meeting in 2015 — did not bring a rate hike, it clearly left one on the table for December. The statement weighed a slower pace of job gains and unimproved unemployment against “solid” increases in household spending and business fixed investment rates and reduced concerns of the restrained economic activity the Fed noted in September, after a volatile August. The implied probability of a December hike, judging from federal-funds futures as of the end of October, was on the rise.
The Barclays Municipal Bond Index (the broad municipal index) returned 0.40% for October, continuing positive price action we saw at the end of the third quarter (set off by September’s Fed inaction and dovish comments). The gain is meager, but it represents the third consecutive month of positive returns for the muni market. Investors focused on new issue deals, which picked up substantially from September. Secondary market activity was at its lowest levels since 2009, a result of low yields and tight spreads.
Lower-quality bonds (BBB) outperformed higher-quality bonds in October as investors stretched for yield in the current low-interest rate environment. This led to general market outperformance of lower-quality sectors, particularly in the corporate-backed and tobacco sectors, which both outperformed the broad municipal index, by 55 and 45 basis points, respectively. The outperformance of low quality was more prominent in the high-yield sector, which returned 1.22% over the month versus 0.40% for the broad index. The driving force in this sector was non-investment-grade tobacco bonds, which have posted returns of over 13% year to date.
Supply & demand
Gross issuance rebounded significantly from September’s depressed level, ending October at $32 billion. This uptick in issuance was easily absorbed by a revitalized retail investor looking to put cash to work after the Fed inaction in September. It has been quite a high year for issuance — we’re on track for a near-record year — driven in part by refunding activity by issuers. High issuance has been partly responsible for the lackluster year of returns for municipal bonds, though the relatively low level of municipal yields is still conducive to refunding deals, which we expect issuers to take advantage of over the remainder of the year.
On the demand side, net flows for municipal funds reversed course over the month. We’ve seen four consecutive weeks of net inflows into municipal funds, totaling over $1.9 billion and bringing year-to-date net inflows to over $5 billion. This reversal was driven by renewed retail investor interest (municipal bonds posted positive returns over the past several weeks), the inaction of the Fed on interest rates, and the attractiveness of municipal bonds as a relatively stable and safe asset class in a volatile global market.
Municipal yields were a bit lower across the curve over the month; however, some of the best total returns were posted on the short-intermediate portion of the curve, returning 0.56% for the month versus 0.40% for the broad municipal index. Year to date, we have seen similar outperformance with the Barclays 10-Year Municipal Bond Index returning 2.54%, versus 2.17% for the broad index. From the peak in early June, municipal yields in this portion of the curve have fallen 25–30 basis points.
Despite the drop in municipal yields over the past few months, AA-rated and A-rated municipal bonds continue to look attractive to retail investors. They’re offering higher yields than those found in the Treasury market — the market is still not fully pricing in the benefit of tax exemption from purchasing munis, particularly in the intermediate-to-long end of the municipal yield curve.
Late in the month, the Chicago City Council passed Mayor Rahm Emanuel’s 2016 fiscal budget, which should boost tax and fee revenues by $755 million over the next few years. Most of the money will come from the city’s biggest-ever property tax increase: a jump of $543 million annually to be phased in over four years. The budget does not entirely solve the city’s growing liabilities and budget imbalances, but it does take a step toward steadying city finances. Over the past few weeks, Chicago general obligation bonds rallied by approximately 80 basis points on the positive news, though they remain on the cheap side of historical trading levels.
One for the road
U. S. Congress passed a temporary funding bill for the Highway Trust Fund just ahead of the October 31 deadline. Expectations are that a long-term funding bill will be on the President’s desk by Thanksgiving. The country’s aging transportation network — airports, ports, toll roads, highway programs, railway corridors and transit systems — depend upon federal funds from the Highway Trust Fund, and long-term funding is needed to provide for its repair and expansion.
More than just smooth roads, strong infrastructure is needed for the U.S. to compete in the global marketplace. The World Economic Forum’s 2014–15 Global Competitive Index placed the U.S. 16th in the world in the overall quality of infrastructure. And according to a report issued by the Business Roundtable, the current state of our infrastructure costs businesses an additional $177 billion in traffic delays, longer transportation routes, and inefficiencies at airports and ports. If we want to remain competitive we cannot continue to absorb these lost opportunity costs.
States competing against each other for business opportunities know that to be competitive a strong infrastructure base is a must. Sixteen states have taken action to increase gasoline tax revenues since 2013 — at least six officially so far in 2015 — while Congress has only toyed with the possibility. To provide for future costs, 10 states now have variable-rate motor fuel taxes that are adjusted at specified times and are based on an index or formula. The American Association of State Highway and Transportation reports that $58 billion annually is needed through 2020 to address problems with roadways, bridges and tunnels across the country.
The House Committee recently passed the six-year, $325 billion Surface Transportation Reauthorization and Reform Act of 2015, while the Senate passed a six-year, $360 billion bill in July. Parties have indicated the two bills are similar enough to be reconciled without much difficulty.
Today’s lower gas prices and consumer confidence have Americans taking to the roadways in record numbers. Tourism and economic activity across the country is on the rise. The Bureau of Economic
Analysis reported that total tourism output was $1.6 trillion in the second quarter of 2015. Total tourism-related employment was 8 million jobs, with 5.6 million direct tourism jobs. From large urban centers to small rural communities, everyone benefits from a strong transportation network.
Medicaid expansion showing fruits
The Patient Protection and Affordable Care Act’s (ACA) open enrollment period to obtain insurance through the state health insurance exchanges for 2016 opened on November 1. Popularly known as Obamacare, the ACA is important to the municipal bond industry for two reasons: first, it affects many nonprofit entities, especially nonprofit hospitals, which issue a good amount of debt through the municipal bond market. Second, the flow of funds from the federal government to the states to help with the cost of ACA implementation affects the overall economy and tax receipts of state and local governments. Let’s take a quick look.
The ACA legislation was signed into law in 2010 with the mission of providing affordable health care to all legal residents. One key provision was to expand access to Medicaid to a larger percentage of the population. Previously, Medicaid’s availability had been limited by eligibility thresholds for states to receive federal assistance for the cost of Medicaid. Each state was allowed to increase the population it covered or the assistance it provided, but largely at its own cost. Under the ACA, citizens under the age of 65 whose income does not exceed 138% of the federal poverty level are eligible for Medicaid. But there’s a slight catch: the Supreme Court allows each state to decide whether or not to expand Medicaid. Some are expanding access, others are not.
Another key provision of the ACA is the creation of state health insurance exchanges under which legal residents whose income is between 100% and 400% of the federal poverty limit can get premium payment assistance on a sliding scale. All states must provide a health insurance exchange.
Sure enough, uninsured rates in the U.S. have declined (from 13.3% at the end of 2013 to 10.4% at the end of 20141), and the top 10 states in which the uninsured rate declined are all Medicaid expansion states. Seven of the 10 states (including the District of Columbia) with the lowest decrease in uninsured rates were non-expansion states. Of the 10 states with the highest level of uninsured, eight were non-expansion states. All had uninsured levels greater than about 14% (ranging from 14.2% to 19.1%). Today 30 states and the District of Columbia have expanded Medicaid under the provisions of the ACA. To help with the cost of expanding Medicaid, the federal government reimburses states for 100% of the cost of covering newly eligible legal residents through 2016. This aid drops to 90% by 2020. While it’s difficult to measure the impact of the additional federal funds flowing to expansion states, considered alongside the economic activity already created by more people obtaining insurance through exchanges in those states, its effect should be meaningful.
The ACA is clearly having an effect on nonprofit hospitals. Charity care and bad debt write-offs have declined. The percentage of patient revenues from Medicaid in hospitals in Medicaid expansion states has increased compared to that in hospitals in non-expansion states.
In 2014, S&P observed little difference in rating changes among hospitals in expansion versus non-expansion states. Not so in 2015: S&P sees a 2:1 upgrade ratio of hospitals in expansion states to those in non-expansion states in 2015, and observes a slight positive impact to the bottom line in many cases. With Disproportionate Share Hospital payments (which aid hospitals that serve a disproportionate amount of low-income patients through charity or Medicaid/Medicare) scheduled to decrease in the near future, the difference in operational performance may become more apparent.
Soon the positive financial impacts of the ACA to the nonprofit hospital sector and to state and local governments should be more apparent too, especially in Medicaid expansion states. This would complement nicely the positive social and health benefits the act intends for all residents.
Illinois still sings the blues
October was a busy month for a couple of the credit rating agencies: both Fitch and Moody’s recently downgraded State of Illinois debt, citing financial/budget/pension issues:
- Fitch downgraded Illinois general obligation bonds to BBB+ from A and appropriation bonds to BBB from BBB+, but raised the rating outlook to Stable from Negative.
- Moody’s downgraded the state’s general obligation and sales tax bonds to Baa1 from A3, appropriation bonds to Baa2 from Baa1, and maintained the Negative rating outlook.
Market reaction to the downgrades was nearly nonexistent, as Illinois debt has been trading at levels consistent with lower ratings for some time. We continue to believe that the state is appropriately rated at the BBB level given budget uncertainties, pension reform, and the growing burden of fixed costs. Further, our belief is that Illinois debt will remain exposed to increased price volatility, as well as headline and downgrade risks. Importantly, despite the state’s serious credit quality problems, we believe its general obligation bonds are structurally sound, and point to Illinois statutes that provide for an irrevocable and continuing appropriation of all amounts necessary for the payment of debt service.
As we look ahead, the state is on pace to spend billions of dollars more than it will bring in this fiscal year. Guesstimates are that the state will be $8.5 billion behind on its bills by the end of the year, and that it could run out of money by early spring 2016 without a formal budget agreement. The comptroller’s office has already stated that the state does not have enough money in the bank to make its November 2015 and December 2015 monthly pension payments. In addition to the budget difficulties, the state’s debt is above average and pension liabilities are very high. The state’s pension funding ratio, in fact, is just below 40% — the worst in the country.