Third quarter recap
Economic indicators turned weaker at the end of the quarter versus July-August, so the market will be closely watching October and November data releases to gauge if the Fed is on track to raise interest rates in the fourth quarter.
After a sluggish 1.2% annualized growth rate for real GDP in the first half of the year, economists are expecting an increase of about 2.1% for the third quarter. Still lackluster versus historical growth, but it may be enough to prompt a Fed hike. Not many prognosticators expect a move at the November FOMC meeting, right before the election, but the odds for a December hike have been increasing.
Municipal yields moved significantly higher over the third quarter, particularly in September. For example, the 15-year AAA spot rose from a 1.66% at the end of the second quarter to 1.91% at the end of the third quarter — an increase of 0.25 of a percentage point (or 25 basis points). Much of that move was in September. However, this is still about 40 basis points lower than where we started the year. Higher yields led to a weak quarter for the tax-exempt bond market as the Bloomberg Barclays Municipal Index returned -0.31%; quite weaker than the 2.61%return in the second quarter. The year-to-date Municipal Index return dropped to 4.08% from 4.33% at the end of the second quarter; still a very respectable return versus other domestic fixed income markets, particularly on a taxable equivalent basis. While much of the move to higher yields in September was in sympathy with higher Treasury yields, the seasonally heavy pace of new municipal issues was also a factor.
Not much differentiation between various sectors of the municipal market over the past month or quarter. Over the quarter, A and BBB rated bonds held in better than higher quality bonds. For example, the Bloomberg Barclays A-rated Bond Index returned -0.10% versus -0.47% for the AAA-rated Index. The municipal high yield sector did fare better than the broad muni index, returning 1.29% for the quarter. The Puerto Rico bond sector continued to be a driver of positive price movement in the high yield index returning 6.75% for the quarter as the Commonwealth continues to wind its way through the restructuring process. We are closely watching demand for high yield bonds which has been slipping over the past few weeks with outflows from municipal high yield funds. Continued outflows will pressure the municipal high yield sector.
Supply and demand
An unexpected surge in new money issuance pushed bond volume in September to its highest level over the past 30 years. Volume for
September came in at $36 billion, a 50% increase from the same period last year. Year-to-date total supply is $334 billion, up 16% from this time last year. At this pace, we expect annual issuance to be over $400 billion—we could break 2010’s record issuance of $433 billion. New money issuance was 45% of September supply with refunding deals accounting for the balance. Demand for municipal bonds was strong with net fund flows (including ETFs) for September totaling $4 billion. Municipal bond weakness over the past three months is starting to slow flows into municipal bond funds. The market has seen its first outflows from high-yield municipal funds. Year-to-date, $55 billion has flowed into tax-exempt bond funds and ETFs.
Municipal yields moved higher over the quarter, by 25 to 30 basis points higher over a large portion of the curve. Somewhat surprisingly, the best total returns for the quarter were on the 5-10 year portion of the municipal curve where yields only increased by about 10 basis points. For example, the Bloomberg Barclays 7-Year Index returned a positive 0.07% for the third quarter while the Long Bond Index returned -0.87% and the 3 Year Municipal Index returned -0.25%. Yield curve positioning and duration management relative to the benchmark were the primary drivers of municipal returns over the quarter. Credit quality exposure was a secondary driver of performance.
A recent report by S&P highlighted some positive news for the municipal market. The rating agency’s activity in the first half of 2016 showed 550 municipal upgrades versus 331 downgrades of municipal obligors. However, it’s not all coming up roses in the muni market. Moody’s rating actions during the second quarter turned negative after three straight quarters of upgrades exceeding downgrades. The negative turn was due largely to certain areas of the country continuing to be challenged by low energy prices and the continued uneven economic recovery across the country.
Negative rating actions for both agencies were concentrated among a few municipal issuers, but one in particular—the State of Illinois. Rating changes associated with the State of Illinois impacted the number of downgrades by both agencies. Moody’s downgraded the state’s general obligation bonds to Baa2 from Baa1 in the second quarter as politicians continued to place political agendas ahead of strong budgetary principles. When a state’s general obligation bonds are downgraded, we almost always see associated credits with financial ties to the state downgraded. That was the case with Illinois. For example, after downgrading the state’s general obligation bonds, Moody’s downgraded a total of sixteen Illinois institutions of higher education that had their financial positions compromised due to interrupted state and student financial aid.
Alaska, Connecticut, Louisiana and New Jersey also experienced a greater number of downgrades to upgrades of issuers in their respective states. Each of these states face their own unique challenges, from weak energy prices and diminishing wealth levels to lagging economic growth and the lingering effects of high-cost labor contracts. States experiencing financial or economic weakness often push their troubles down to the local level. On the positive side, strong population growth and economic activity pushed California, Texas and Florida to the top of the upgrades list as these three states accounted for nearly one-third of S&P rating upgrades in the first six months of the year.
But we should put these changes in a broader context. Overall, only 2.5% of all municipal obligors in the U.S. experienced a rating change in the second quarter. To us, this indicates that overall credit trends are stable. This supports the common thought that the U.S. municipal market is a relative safe haven for conservative investors. As always, we continue to monitor the credit outlook of troubled states and seek opportunistic investments while selling negative trending obligors.
The ballot box
Taxpayer initiatives give voters a voice in their local government and the opportunity to help develop public policy. Twenty-four states allow citizen initiatives, however, voters in California are the most prolific generators of taxpayer initiatives. The California Secretary of State reported that over 1,900 initiatives have been put forward between 1912 and 2015. Of those, about 360 made it on the ballot with 123 approved by voters. In 2016, there are 17 statewide measures that will be put before California voters in November. Of these, six will have a direct impact on the municipal market and are reflected below in the table.
These ballot measures can support or restrict government spending. We are closely watching the following:
• Proposition 51 — a ballot measure approving $9 billion in bonds to fund improvement and construction of school facilities for K-12 schools and community colleges. Passage of Prop 51 would be a credit positive for local school and community college districts.
• Proposition 52 — requires a two-thirds majority vote of the California Legislature to end the hospital fee program and requires voter approval to change the dedicated use of certain fees from hospitals. The impact would be credit positive for the not-for-profit healthcare sector providing more predictable state funding for hospitals.
• Proposition 53 — requires voter approval on the issuance of $2 billion or more in public infrastructure bonds that dedicate an increase in taxes or fees for repayment of the bonds. This Prop would limit governmental spending.
• Proposition 55 — supports extending a tax increase. This Proposition is of particular importance as it extends the personal income tax on incomes over $250,000. The defeat of Prop 55 would be a credit negative as the state stands to lose $4 to $9 billion a year in tax revenues per year (4-9% of total operating revenues) if it is defeated.
• Proposition 56 — Increases the cigarette tax. Healthcare institutions may see an increase in funding through the additional tax on a pack of cigarettes. However, increased funding may be limited as an increase in cigarette taxes would likely cause declining sales.
• Proposition 61 — regulates drug prices by requiring each state agency to pay the same price for a drug that the U.S. Department of Veteran Affairs (VA) pays. This one is tricky. For example, what happens in the event the VA pricing is higher than the existing state pricing? This Prop seeks to enhance public policy within the state, but may not ultimately contribute to the efficiency of the government. The costs of implementing this ballot measure may outweigh the benefits.
Mega mall — the American Dream?
A mega-mall once dubbed “the ugliest damn building in New Jersey, and maybe America” by New Jersey Governor Chris Christie moved a step closer to completion. The State recently approved $1.2 billion of municipal bonds and $390 million in state grant funds to help finance the completion of a partially built mega-mall now called the American Dream. Projects for non-essential purposes are often frowned upon by municipal investors looking for safety in essential purpose tax-exempt paper. Public officials often cite the job creation, tax revenue generated and ripple effect economic development projects can have. For good reason many taxpayers are weary. However, there are times when these projects provide the municipal investor a unique opportunity with strong revenue streams and legal protections along with a return slightly above traditional municipal debt.
The mall project is located in East Rutherford, New Jersey, about ten miles west of Manhattan, just off of the New Jersey Turnpike, in close proximity to MetLife Stadium. When completed the mall will be a nearly 3 million-square-foot facility. In addition to 500 stores, restaurants, and food shops, it will include indoor amusement and water parks, an 800-foot ski slope, a 300-foot Ferris wheel, performing-arts and movie theaters, and an aquarium. After ten years and several failed attempts, the mall is now owned by Triple Five Worldwide, a Canadian developer, with the intent to revive the mall in a similar fashion to the Mall of America in Minnesota. Mall of America has 40 million visitors per year, employs 11,000 people, and has generated nearly $1 billion in tax revenues for the State since opening in 1992. Triple Five expects American Dream to open in 2018 and expects an estimated 40 million visitors annually from all over the region and world. The nearly $5 billion price tag makes this the “most expensive retail project on earth.”
There are concerns surrounding the financial support of New Jersey, a state already fiscally pressured. Many question whether grants to a private developer for a non-essential project is the best use of New Jersey’s already stretched resources. The state has significant infrastructure needs, unfunded pension liabilities, budgetary pressures, and the need to support struggling locals governments, such as Atlantic City. This debate is emblematic of the challenges that many communities face balancing the need to fund pensions and balance budgets while attempting to ignite growth. The State views this project as an attempt to spur economic activity, which has been tepid throughout the Northeast given slow population growth and the shrinkage of the region’s manufacturing base. It is anticipated that the American Dream will create about 11,000 jobs, in addition to the 5,800 construction jobs that will be needed to complete construction. Further, the Mall is expected to generate $340 million in state tax revenues over the next 20 years. However, others counter that the American Dream will only be taking a slice of an already shrinking pie from the existing businesses. Build it and they will come?
Duration: Favoring neutral to short duration as we begin to see investor demand slowing. Municipal high yield funds and long funds starting to experience outflows for the first time in many months. We need a couple more weeks of data to verify the negative trend. Meager returns in the municipal market over the past three months is the likely cause. Two months of record high bond issuance is dampening muni market performance. Additionally, the probability of a Fed hike in December has risen to ~65% from 50% last month.
Curve: Retaining general 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 floating rate notes as daily and weekly rates have risen to over 0.80%. This is largely due to money market reforms and may not last through year-end.
Credit: Lower-quality overweight continues to provide above-average yields and is additive to performance. Quality spreads remain relatively tight and we expect spreads to remain tight over the next few quarters. We are finding value in lower quality continuing care retirement communities and charter schools.
Sector: Avoiding new purchases of debt issued by the State of New Jersey. Will lighten up opportunistically. Cautious on higher education sector, particularly in the northeastern US. Recently added to modest position in State of Illinois general obligation bonds at spreads approximately 200 basis points above municipal AAA yields.