Fixed income market slips
The fixed income markets slipped in October as investors priced in the growing probability of a Fed hike in December.
While few investors expected a hike at the recent November meeting, the Federal Open Market Committee’s post-meeting statement seemed to seal the deal for a higher Fed funds rate barring any negative surprises. The probability of a hike is currently 76%, up from 67% prior to the report. So what changed from earlier meetings? Concerns of slowing global growth earlier in the year have faded. The U.S. economy expanded at a 2.9% annualized pace in the third quarter. Core inflation has edged higher since the Fed’s last meeting. And, the jobs market continues to show improvement with payrolls climbing by 161,000 last month following a 191,000 gain in September.
Municipal yields moved significantly higher over the month. For example, the 15-year AAA spot rose from 1.91% at the end of September to 2.16% at the end of October — an increase of 0.25 of a percentage point (or 25 basis points). Still lower than the 2.30% we saw at the start of the year, but not by much. Higher yields led to the weakest month for munis since the Taper Tantrum of 2013. The Bloomberg Barclays Municipal Index returned a disappointing -1.05%. The year-to-date Municipal Index return dropped to 2.92% from 4.01% at the end of September. Much of the move to higher yields was in sympathy with higher Treasury yields, with the 15-year U.S. Treasury yield moving higher, from 1.87% to 2.12% over the month.
However, we’d like to remind investors that the municipal bond market has a significantly long history of providing investors with positive total returns and tax-exempt coupon income. As seen in the figure below, the 10-year Municipal Bond Index has posted positive returns for 31 of the past 36 years. Keep in mind, coupon income is a major component to municipal bond total return and can offset a major portion of price declines. For example, in 2015 the price return of -0.41% was more than offset by a coupon return of 4.17% for a total return that year of 3.76%. Also, these returns are not adjusted upward for the tax-exemption of the coupon return.
Lower quality bonds underperformed for the month as outflows from high yield municipal funds weighed on the low quality sectors. The high yield funds’ most liquid holdings are BBB-rated bonds. When they need to raise cash, they sell these first and yield spreads to higher quality bonds widen as the additional supply of BBB-rated debt hits the secondary market. The Bloomberg Barclays BBB-rated Bond Index returned -1.28% versus -0.90% for the AAArated Index. The Bloomberg Barclays Muni High Yield Index returned -1.24% for the October. The worst performing sub-sector was the HY Tobacco Index which returned -2.28%. This is a more liquid sector in municipal high yield and is typically the first sector to see underperformance when high yield funds experience outflows.
Supply and demand
October municipal bond volume surged to $53 billion, the highest October issuance over the past three decades. This is a 51% increase over October 2015 and contributed to the higher yields we saw over the past month. Issuance year-to-date is $339 billion and is trending $450 billion for the year if we have an average November and December. At that level, we would break the all-time high of $433 billion set in 2010 with inflated issuance from the Build America Bond program. Refunding deals increased 60% from October 2015 as issuers rushed to market before the election and a likely Fed hike in December.
Demand for municipal bonds weakened over the month. October saw the first net outflows from municipal funds after a year of positive weekly inflows. Outflows were driven by weakness in high yield and long municipal funds. Outflows are likely being driven by lackluster municipal performance since July. Other factors weighing heavily on fixed income investors include a likely Fed hike in December, speculation that central banks may pull back plans for monetary easing, and increasing noise on the inflation front. It is yet to be seen if recent weakness in flows will turn into a sustained trend of outflows. We last saw that in mid-2015 with approximately $4 billion in outflows over four months. Despite recent weakness, $57 billion has flowed into tax-exempt bond funds and exchange traded funds (ETFs) year-to-date.
Over the month of October, municipal yields spiked 25 basis points higher from the 10-year spot on out. The only spot on the curve lower over the month was the one-year spot, which fell as crossover taxable buyers purchased cheaper tax-exempt bonds. Total returns across the curve grew progressively worse the longer the maturity. For example, the Bloomberg Barclays 5-Year Index returned -0.45% while the Long Bond Index was over three times as bad at -1.56%. The 1-Year Index eked out a positive 0.07%. Obviously, yield curve positioning and duration management were primary drivers of municipal returns over the past month.
Money market fund reform
In an effort to reduce investor risk and assure liquidity following the financial crisis of 2007-2008, the SEC voted to modify the rules regarding money market funds effective October 2016. Traditionally, money market funds have maintained a stable $1.00 net asset value (NAV). During the crisis, a money market fund found itself in a liquidity crisis, which spooked investors of other money market funds who rushed to redeem their holdings. The Federal Reserve and the Treasury acted quickly to stem the crisis by temporarily providing insurance for the funds similar to that which is provided for bank deposits.
The new rules differentiate between retail and institutional investors. The changes aim to maintain an orderly market in the event of a significant market disruption. Retail money market funds may continue to offer the stable $1.00 NAV under the new rules, but the fund’s Board of Directors has the ability to temporarily prevent withdrawals or impose fees on any withdrawals from the funds in times of market disruptions. If the money market fund only invests in federal government debt and debt of its agencies, then the restrictions on withdrawals do not apply.
The new rules for institutional money market funds are mixed. If the institutional money market fund only invests in federal government debt and debt of its agencies, the rules are the same as the retail government-only money market funds—a stable $1.00 NAV with no withdrawal restrictions. If the institutional fund is not a government-only fund, it is subject to a floating NAV based on the underlying securities. The Board of Directors of the fund has the ability to temporarily prevent withdrawals from the fund or impose fees on withdrawals.
As a result of these changes, many investors have transferred to the stable NAV, government-only money market funds. Bank of America Merrill Lynch reported that municipal money-market assets have shrunk nearly $110 billion in the first nine months of 2016. Over time, investors could return to non-government money market funds once they become more comfortable with floating-rate NAVs and the new liquidity gates.
Crisis in healthcare insurance exchanges?
The sky is falling on insurance exchanges is what recent headlines would lead one to believe with the repeated stories of insurance companies dropping from the exchanges and rate hikes from those remaining. The open enrollment period for the health insurance marketplaces began on November 1st and continues through January 31st and all eyes are on the numbers. Over the past year, Aetna and UnitedHealth have dropped from some exchanges, leaving people concerned that they will have very limited options on the exchange. News stories suggest participation on the exchanges could remain flat, leading to greater rate hikes.
Contributing to the negative headlines was the Health & Human Services Department’s announcement that the weighted average unsubsidized rate hike on the individual exchange market was close to 25%. Despite the headlines, the sky is not falling. The overall number of uninsured is less than 10% of the U.S. population and those participating on the exchanges is about 3% of the U.S. population. Approximately 11 million people have purchased individual exchange-based health insurance. Of those, 70% receive full subsidies for the issuance premiums and another 8% receive partial premiums. That leaves 22%, or 2.5 million people, without any subsidies. While the rate hikes are unfortunate, the premium rate hikes affect less than 3% of the population and are not considered a significant negative credit event for the healthcare industry.
Healthcare under the Affordable Care Act continues to evolve. Following the exit of several large market participants, smaller players may enter the marketplace providing more choices and competitive pricing. The significant rate hike and departure of certain insurers was primarily due to miscalculations on costs associated with health risks of the new enrollees. Many insurers entered unchartered territories and priced aggressively to obtain market share. The marketplace needs a diversified mix of enrollees, a number of younger healthier members as well as some with greater health risks.
As more states expand their Medicaid programs, the marketplace will grow. Healthcare institutions will benefit from a growing number of insured. Overall, the healthcare sector remains stable with some synergies to be gained going forward. BMO GAM continues to find opportunities in the healthcare sector with a focus on medium to large hospital systems with strong market share.
New Jersey’s tax switch
Moving to the front of the line, that is what New Jersey will be doing on November 1 when the state’s gasoline tax is raised to 37.5 cents per gallon from the current 24.5 cents. New Jersey will have the distinction of having the sixth highest gas tax in the nation after having been ranked 49th. No worries: New Jersey drivers will maintain the advantage over neighboring New York and Pennsylvania. Governor Christie has long opposed tax increases and only agreed to raise the gas tax if it corresponded with tax cuts in other areas. As a result, sales taxes will be reduced in two steps from 7% to 6.625% by 2018, the estate tax will be eliminated, and the earned-income tax credit will be raised.
There are winners and losers in this tax switch, infrastructure wins and the state’s general revenue fund loses. The state’s gas tax, along with other transportation taxes and fees, funds road and rail projects via the New Jersey Transportation Trust Fund. The revenue from the increased gas tax will provide an additional $940 million annually, supporting an estimated $14 billion of spending over eight years for New Jersey bridges, roads and railways. The tradeoff is a clear negative for state revenues. The tax cuts above will result in reduced revenues for the state’s general fund. Current projections show a $385 million decline in 2018, settling in at a $1.2 billion decline by 2022. Revenue losses are expected to total $8.4 billion over the next eight years. The state’s fiscal year 2015 general fund revenues were $36.8 billion, so the lost revenues are significant.
The State is already struggling with slow economic growth, chronic budget deficits, a high debt burden, and mammoth sized pension obligations. Lower revenues from the reduced taxes that were swapped for the increase in the gas tax will further pressure the state and raises the chances of future rating downgrades. New Jersey is rated ‘A2’ by Moody’s and ‘A’ by both S&P and Fitch.
Everything is coming up green
Environmental awareness has come a long way from the first Earth Day in 1970. Since that time, a $100 billion market directed to socially responsible investing has emerged. The term “green bond” is often used generically when referencing a bond issued to fund a project tied to some environmental benefit, for example, water and wastewater projects. The green bond market has seen significant growth globally. A recent report by Moody’s stated that in the first quarter of 2016, there were $17 billion in green bonds sold globally, a quarterly record.
Today, with climate change at the forefront, investment in green bonds is reaching historic highs. The issuance of green bonds in the municipal market reached $4.7 billion in 2015, an increase of 47% over 2014. With $1.3 billion in municipal green bonds issued in the first quarter of 2016, the muni market is on track to reach a record level this year. In the municipal market, the state of Washington is the largest issuer of green bonds with over $1 billion sold. The Seattle Transit Authority issued the largest green bond to date: a $923 million bond issue for a light rail project.
As the demand for green bonds increases, the market will continue to evolve and grow. The U.S. has significant infrastructure needs ranging from energy, water, transportation, and pollution control. Investors can expect the issuance of green bonds to remain robust as the world’s attention focuses on environment sustainability, providing both the investor and the issuer greater and more diverse investment opportunities.
Duration: Favoring neutral to short duration as we begin to see investor demand slowing. Municipal fund flows starting to experience weekly outflows after a year of inflows. Negative returns in the municipal market over the past four months is the likely cause. Four months of record high bond issuance is dampening muni market performance. Additionally, the probability of a Fed hike in December has risen to ~70% from 60% last month as concerns of a global slowdown fade.
Curve: Retaining barbell structure with floating rate notes on the short-end of the curve and fixed coupon bonds on the longer end of the fund’s investment horizon. Maturing bonds are being invested in tax-exempt floating rate notes as daily and weekly rates are still elevated at about 0.50%. This is largely due to money market fund reforms pushing up supply of municipal money market eligible notes. Crossover taxable investors have soaked up additional supply causing rates to decline from about 0.90% just a few weeks ago. This trend may continue over the quarter.
Credit: While our lower-quality overweight continues to provide above-average yields, the performance of lower quality bonds, particularly BBB-rated bonds, lagged higher quality bonds over the past month. Quality spreads widened out in October due to the backup in interest rates as well as cheaper prices on lower quality, new issue deals to enable them to clear the market.
Sector: Adding to revenue overweight when attractive bonds are available. Continue to find value in smaller, local general obligation bonds. Took advantage of recent spread widening in A-rated and BBB-rated hospital bonds to add to exposure in that sector. We have a favorable outlook for the healthcare sector despite recent negative headlines concerning healthcare insurance exchanges, however, maintaining diversification is very important.