Fed heating up?
August brought us the second consecutive month of lacklusterperformance in the municipal market. The Bloomberg Barclays Municipal Bond Index posted a 0.14% return for the month of August after a meager 0.06% return in July.
The unusually high level of new issuance in August (see discussion below) was one factor that dampened tax-free returns. Additionally, the fixed income market in general had a lackluster month with the Bloomberg Barclays Global Aggregate Corporate Bond Index returning only 0.18% for August. Despite the skimpy returns, interest in municipal bonds has not diminished. Fundamentally, a number of economic reports as well as Federal Open Market Committee (FOMC) member comments have led to an increase in the probability of a Federal Reserve (Fed) increase this year. As of this writing, the probability of a December hike has risen to 60% versus 36% at the beginning of August. We still believe Fed hikes for 2016 are off the table— time will tell. Negative and extremely low interest rates in Europe and Japan will continue to act as a ceiling for U.S. interest rates across the curve.
August sector performance was very similar to July’s. We saw flat returns over the month, which led to very tight performance among the various sectors of the municipal market. However, revenue bonds did outperform slightly as investors continue to search for any additional yield, squeezing quality spreads tighter. For example, the Bloomberg Barclays
General Obligation Bond Index returned 0.06% while the lower quality Revenue Bond Index returned 0.20%. Keep in mind that these total returns come from coupon return and price
return. Only one sector in the Bloomberg Barclays Municipal Bond Index had a positive price return for August; the Hospital sector. The coupon of the Hospital index returned 0.35% and the price return added 0.09% for a total return of 0.44%. We credit the positive price performance of the lower quality hospital sector to investor demand lowering hospital bond yields. The municipal high yield sector did not fare much better than the broad muni index, returning 0.36% for the month. The only “bright” spot in the high yield market was the Puerto Rico bond sector, which returned 2.10% for the month. Before you dive in, the average quality of the Puerto Rico Index is approximately CC+.
Supply and demand
New money and refunding bond volume surged to the highest August total over the past 30 years. Volume for August rose 50% to $39 billion from $26 billion in July. Year-to-date total supply is $289 billion, down 2% from this time last year. At this pace, we expect annual issuance to be over $400 billion—an amount we have not seen since 2010. New money is running about 5% ahead of last year and is expected to continue that trend through year-end. It’s nice to see an uptick in new project funding at these low interest rates: cheaper financing for taxpayers. Refunding issuance continues to be strong in this low interest rate environment. Refunding deals have accounted for 42% of this year’s issuance versus 41% for all of 2015. Demand for municipal bonds remains solid with net fund flows—including Exchange-Traded Funds (ETFs)—for August totaling $7.7 billion, a 13% increase from July but in line with this year’s monthly average inflow. Municipal bond weakness in July and August has yet to slow investor interest in munis. Year-to-date, $51 billion has flowed into tax-exempt bond funds and ETFs.
Municipal yields were largely unchanged over the month. There was some weakness in the 1- to 10-year portion of the curve with yields moving 5 to 10 basis points higher (see chart). For example, the 3-year spot rose from 0.52% at the end of July to 0.61% at the end of August— an increase of 0.09 of a percentage point (or 9 basis points). This led to underperformance on the short portion of the municipal curve for the month. The best returns were on the long end of the curve where yields were flat or slightly lower over the month. The 20-year spot had the best monthly total return at 0.41% according to Bloomberg Barclays Municipal Bond Index.
Election year and munis
This year’s presidential election is one for the history books—a political outsider riding a populist wave versus a Washington insider who happens to be the first female nominee for President of the United States. Historically, Republican presidential wins are negative for the municipal market as many times in the past these candidates ran on platforms of lower taxes to encourage spending. Lower income tax rates reduce the attractiveness of federally tax-exempt municipal bonds. Democratic wins have been favorable to the municipal market due to the traditional democratic stance that includes raising taxes on the higher income earners.
Donald Trump’s platform has at times lacked consistency on certain matters, but one item he has remained steadfast on is lowering taxes. His tax policy, reducing taxes for all, has been consistent and would likely reduce the attractiveness of municipal bonds. Although, his call for the elimination of the alternative minimum tax (AMT) would prove to be a positive for certain municipal bonds that are subject to the AMT. The Democratic nominee, Hillary Clinton, is proposing an additional tax for top income earners and capping itemized deductions. Obviously, this could make municipal bonds much more attractive for those in the highest tax brackets.
The nominee’s platforms are much closer on the topic of infrastructure spending. Both candidates are very supportive of repairing the nation’s crumbling infrastructure. Hillary Clinton is calling for increased federal funding through the establishment of an infrastructure bank and the reinstitution of the Build America Bonds (BABs) program. If you recall, BABs were first introduced in 2009 as part of the American Recovery and Reinvestment Act. BABs are taxable municipal bonds with federal subsidies for state and local government bond issuers to finance infrastructure projects. These taxable munis appealed to a much broader range of investors. The program also reduced the amount of tax-exempt debt that was issued over that period, perhaps having a positive impact on prices of tax-exempt bonds.
We do not believe at this time that the tax-exemption of municipal bonds is in jeopardy. The last time the tax-exemption of munis was put in question, the National League of Cities and the U.S. Conference of Mayors reported that the loss of tax-exempt bond issuance would result in less infrastructure funding and the loss of employment of anywhere between 300,000 to 900,000 jobs. The significant infrastructure needs and economic stimulus supported by the municipal market most likely takes the tax status of municipal bonds off the table for both candidates.
Opportunity knocking at disaster’s door
Climate change, a controversial topic, cannot be ignored in any aspect of business including our investment policies. According to a Pew Research Center survey, 69% of the Americans who responded agreed that climate change is, or will be, harmful to the environment. Municipal governments must also manage to the volatile climate through storm preparedness and upgraded infrastructure. In the U.S., flooding, tornadoes, hurricanes and earthquakes devastate towns and regions. Winter storms put economic activity on hold and the clean-up is costly. While all disasters are devastating, hurricanes are the costliest. Historically concentrated in the Gulf region, they can reach as far north as New Jersey, New York and Connecticut as was the case when Hurricane Sandy hit in 2012.
As we saw with Sandy, natural disasters can put large financial and operational pressures on state and local credits, but the impact can be uneven and short-term in nature due to outside assistance. The costliest hurricane, Katrina in 2005, had a significant impact on the Gulf region, particularly on the City of New Orleans with approximately 80% of the city under as much as 10 feet of water. The total cost of recovery for the city has been estimated at $125 billion. New Orleans saw its credit rating fall to Ba1 due to the uncertainty of recovery following Katrina. However, after two years of federal and state assistance, the city’s credit rating rose to Baa3. Today, the city is up another three notches to A3.
Once again, Louisiana finds itself embattled with Mother Nature. Recent flooding, referred to as a 1,000-year flood, has left 60,000 people homeless and the President declared 20 of the 64 parishes within the state as major disaster areas. The disaster is exacerbating fiscal stress as the state continues to reduce expenditures to deal with the downturn in the energy markets. However, the Federal Emergency Management Agency (FEMA) has already approved $127 million in assistance for 100,000+ applicants. Additionally, the state will ask Congress to approve a 90% reimbursement rate for recovery costs rather than the standard 75% rate. State officials are currently using one-time measures to address a $940 million gap in FY2016 and a projected $2 billion budget gap in FY2017. Lawmakers will likely turn to the budget stabilization fund with a balance of $358 million for help. The state has also received approval to issue up to $500 million in bonds in the municipal market. Moody’s recently issued a report indicating that while local governments may see near-term decline in assessed values and sales tax receipts could slump, rebuilding and recovery efforts will likely lead to higher sales tax collections.
Like New Orleans, the state should recover from the recent flooding as federal assistance flows in, prompting rebuilding. Ultimately, these investments should lead to increased property values and tax collections over the longer term. However, future prospects for recovery of the region ultimately fall on the timing of a robust recovery in the energy market. Municipal investors should keep in mind the importance of geographic diversification to manage exposure to natural disasters, but should also recognize opportunities to invest in municipalities that will likely recover strongly from nature’s hits.
Developments in the keystone state
Pennsylvania’s fiscal year 2016-2017 budget was passed only 12 days late, compared with a nine-month delay for the 2015-2016 budget. The comparative speed with which the current budget was passed generated a sense of ease about Pennsylvania’s fiscal picture. Perhaps too much ease as the market seemed to be caught off guard by the Commonwealth’s need to draw $400 million from a $2.5 billion credit line to meet short-term cash needs. Addressing short-term cash needs is a common practice among municipal governments given the sometimes “lumpy” nature of tax receipts. The Commonwealth’s 2016-2017 budget contained new taxes, including an increase in cigarette and liquor taxes and expansion of online gambling, where the benefit will not be seen for months. However, continued cash short-falls and budget deficits are possible in the short-term if these new revenue sources come in under projections. Longer term, the Commonwealth will continue to be challenged by slow growth in its tax revenues, population, economy and jobs, as well as its large pension burden.
As is the case with a number of states, Pennsylvania has a program that supplements bondholder security for local school district bond issuers. If a school district misses a payment on any debt, the Commonwealth will withhold (intercept) state aid due to the school district in an amount equal to the missed debt service.
This “intercepted” money is then used to reimburse the holder of that debt. There have been several instances in which the mechanism worked to prevent defaults by Pennsylvania school districts. However, a significant flaw in this program was that state-aid to school districts was not able to pass to them without an approved state budget. This was an issue during the fiscal 2016 budget impasse. The Commonwealth recently cured this failing by passing a new law: “School District Intercepts for the Payment of Debt Service During Budget Impasse.” The end result of this aptly named law is that funds will always be available to prevent or cure defaults, regardless of whether the Commonwealth has passed a budget. The passage of this law is significant as Pennsylvania has a history of late budget adoptions. Moody’s Investors Service responded by raising its rating on the intercept program to A2 from Baa1, positively impacting the rating on 400 Pennsylvania school districts. S&P will likely review the program pursuant to the new law and revisit its December 2015 decision to withdraw the intercept rating when the Commonwealth was in the midst of its budget impasse. When all is said and done, it turned out to be a positive outcome for the credit quality of the Commonwealth’s schools.
Duration: Maintaining neutral duration as investor inflows continue. We expect investor interest in municipal bonds to remain healthy over the next several months of global uncertainty. Meager returns in the municipal market over the past two months may slow inflows.
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.
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.
Sector: Adding to revenue overweight when attractive bonds are available. Continue to find value in smaller, local general obligation bonds. Cheaper bonds can be found from select issuers in Illinois with required input from research staff.