Asset Class: Municipal Fixed Income

And the bar is raised, again?

Standard & Poor’s recently released a report on the risks to local issuers of deferring maintenance on critical infrastructure assets. S&P noted that they view high deferred maintenance levels as a credit weakness, but that quantifying the maintenance backlog is difficult. Postponing needed repairs reduces the asset’s life, increasing capital costs and reducing future financial flexibility.

Deferred maintenance has other knock-on effects. For example, Louisiana paid out $42 million to plaintiffs after the courts found that poorly maintained roads contributed to accidents, resulting in deaths and injuries. In addition, deferred maintenance can weaken economic growth, as businesses look to relocate to vibrant areas.

Concern has risen over the years as maintenance has been crowded out by fixed costs, including pension funding, Medicaid and debt service. Additionally, deferring maintenance has risen as issuers looked for ways to balance budgets during the financial crisis and the slow recovery since. As a result, the topic is high on a list of factors to be monitored when assessing future credit quality. However, infrastructure spending cannot remain sidelined indefinitely. The decentralized nature of maintaining infrastructure and the lack of solid data makes this problem difficult to measure and tackle. In addition, we have yet to see any assistance at the federal level.

In our municipal review process, deferred maintenance is heavily factored into issuer analysis when looking at sectors with limited revenue raising capabilities, such as hospitals and continuing care retirement communities. By comparing the age of the issuer’s facilities, relative to the average age of other entities in the sector, the likelihood of future debt issuance or use of liquidity may be factored into the internal rating or outlooks. As deferred maintenance continues to grow, this type of analysis will be increasingly important for many local issuers.

Bond insurers

In a recent periodic review, S&P affirmed its AA stable ratings of the two active municipal bond insurers, Assured Guaranty (subsidiaries AGM, MAC, and AGC) and Build America Mutual Assurance Co. (BAM). Combined, the insurers wrapped about 6% of 2018 new issuance through June, which is what the insurers have averaged over the past nine years, but nowhere near the 50% plus the insurers wrapped before the 2008 financial crisis. It appears that investors have learned to live without municipal bond insurance, particularly in light of the sector’s extremely low default rate. S&P noted BAM’s market acceptance since its inception in 2012. BAM has $43 billion of gross par outstanding with no Puerto Rico exposure. The three subsidiaries of Assured Guaranty insure $265 billion of net par.

Internet sales tax

In late June, the U.S. Supreme Court ruled in support of South Dakota’s e-commerce law, striking down the need to have physical presence in a state to be taxed. It’s been estimated that state and local governments would have seen $9 to $13 billion in additional revenues in 2017 if they had been able to collect sales tax on remote sellers. Many government officials were pleased with the ruling and the prospect of increased revenues in coming years. Issuers across the country have faced budgetary gaps, as the existing sales tax streams from traditional brick and mortar facilities have dropped significantly in light of changing consumer shopping habits. It’s difficult to quantify at this time, but definitely a positive for all issuers, particularly those more heavily reliant on sales taxes.

Union dues

In a much anticipated decision, the U.S. Supreme Court recently ruled that non-union members have a constitutional right to not pay union fees. This ruling is estimated to affect over five million workers and will make a significant impact on the financial health of various labor unions. Union leaders are obviously concerned that members will decide to stop paying dues and take a free ride on contract negotiations paid for by dues paying members. This reverses a 1977 Supreme Court ruling that non-union employees could be required to pay an administrative fee based on the benefit they receive from the union bargaining. There are 22 states that permitted administrative fees, 26 states that did not (right-to-work states) and 2 that allowed the fees under certain circumstances. Ultimately, this could be positive for the credit quality of state and local issuers as it could give them more leverage when negotiating pension and other post-employment benefits. Time will tell.

Market commentary

Municipal bond yields were relatively stable over the second quarter, with some movement in the 5- to 7-year portion of the curve where yields fell by about five basis points. Municipal yields were more subdued than the Treasury yields, which rose across the curve, particularly on the short-end as 2-year yields rose by about 25 basis points — from 2.30% to 2.55%. With stable muni prices, most of the municipal return was from the income of the coupon. The Bloomberg Municipal Bond Index returned 0.87% for the second quarter, outperforming the Bloomberg Treasury Index by about 80 basis points and the Bloomberg Aggregate Index by over 100 basis points. The lack of municipal bond issuance and ample retail demand were the main drivers of municipal outperformance over the quarter.

June municipal bond issuance came in at $32 billion, bringing the year-to-date total to $161 billion. This is a 20% decline versus the same period last year. The large drop is mostly due to the disappearance of prerefunding deals, disallowed by last year’s tax law changes. Refunding deals accounted for 14% of year-to-date volume versus a 37% annual average over the past five years. The crimped supply has helped offset an increase in the sales of muni bonds from bank and insurance company portfolios as the tax-exemption is significantly less attractive due to this year’s drop in the corporate tax rate. Flows into municipal bond funds and ETFs have been steady with about $1.4 billion of inflows over the second quarter. The year-to-date total is $12.6 billion of inflows, with most of that seen in January due to asset reallocations out of equities and into munis.

The economy continues to chug along, keeping future Fed hikes at the forefront of many investors’ concerns. While we will not see the first 2Q GDP estimate until the end of July, economic releases to date are suggesting it could be in the 4% range. We shall see. In the meantime, concern over tariffs and trade wars has been the driving force for yield curve changes. For example, in a flight to quality, the 10-year Treasury yield has fallen by about 25 basis points from mid-May on these worries. The sell-off in emerging markets is adding to the cautionary tone of the markets. Despite these concerns, we will maintain our short duration positioning.

Strategy overview

Duration

  • Despite recent strength in the Treasury market due to trade war concerns, we are keeping portfolio duration shorter than our benchmark and peers.
  • The Federal Bank of Atlanta’s GDPNow model is forecasting 4.1% for 2Q GDP. While this is a dip from earlier in the month, it’s a strong forecast. Consensus estimates have been climbing through the month of June on strong data releases including home sales, personal income and spending, and construction spending.
  • The potential for increased Treasury issuance to fund the federal deficit continues to be a concern for many fixed income investors. More supply could drive yields higher, but as we have seen, fear and uncertainty can quickly drive demand higher and rates lower in the flight to quality.

Curve

  • On the short-end of the curve, we continue to buy municipal floating-rate notes. Market participants continue to expect the Fed to move forward with rate hikes later this year despite tariff concerns and emerging market dislocations.
  • The 3-year spot of the municipal curve has risen 20 basis points year-to-date and is up 0.76% in total return while the 10-year spot has risen 46 basis points year-to-date and is down 0.72% in total return. However, it was a good second quarter across the curve, with the 3-year and 10-year indices returning a positive 0.64% and 0.90%, respectively.
  • The weekly municipal floating rate index (SIFMA rate) is at 1.51% (6/27/2018) versus 0.91% a year ago.

Credit and structure

  • As investors search for yield in what is arguably a still low interest rate environment, high yield municipal bonds continue to perform well. The Bloomberg Muni High Yield Index returned 3.06% in the second quarter, while BBB-rated bonds returned 1.41%.
  • Historically, lower quality bonds underperform in economic slowdowns. We have seen more news around predictions of a US recession starting in 2020, but it’s too early for us to change our allocation. Albeit, we have reduced our purchases of BBB rated bonds.

Geography and sector

  • Illinois passed a budget on time at the end of May and New Jersey just passed their budget before the beginning of the next fiscal year. Investors took note and both state indices outperformed the broader market on a year-to-date basis.
  • The recovery in oil prices has definitely flowed through to the outlook for energy dependent states. Oil-rich states have been some of the best performers of the Bloomberg Municipal Indices. Year-to-date, the Bloomberg Municipal Bond Index is down 0.25% while the Alaska, North Dakota and Wyoming indices all posted positive returns.
  • We like prepaid gas bonds at this time. These tax-exempt bonds can be issued as floating rate notes with credit support from financial institutions. These institutions are in strong capital positions and benefit from rising interest rates.

 

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