Asset Class: Municipal Fixed Income

Illinois makes the grade

Chicago skyline

Last month, Moody’s revised the outlook on the state of Illinois from negative to stable. The state has been given a reprieve from concerns that it may be the first state to fall below investment grade in recent history. State officials have the recent income tax hike and continued economic strength to thank. The outlook is now stable by both Moody’s and S&P with a low triple-B rating. Immediately after the upgraded outlook, trading of Illinois bond issues jumped and prices appreciated relative to national bonds.

Only five states currently have a negative outlook by Moody’s and/or S&P — Louisiana, Mississippi, New Mexico, North Dakota and Oklahoma. There is no single theme across these states for the negative outlooks. New Mexico is faced with significant pension liabilities. Louisiana and Mississippi have been left behind in the nation’s economic recovery with further complications by lower-than-average wealth levels. Lastly, North Dakota and Oklahoma contend with the volatility of energy dependent economies.

Apart from these few, states across the country are posting stronger financial performance with better-than-expected income tax receipts as well as strong sales tax revenues due to low unemployment and faster growth. The National Association of State Budget Officers reported that general fund revenues grew by about 5% in fiscal 2018, a result that was at or above estimates in 39 states. Additionally, states have been building reserves (rainy-day funds) steadily since the Great Recession (see below). Despite the overall stronger financial positioning, states are approaching the 2019 budget season with conservative growth rates for revenues, having not forgotten the lessons from the last recession. States with recent upgrades include Michigan (AA from AA-) and Minnesota (AAA from AA+). One important development we are watching is the impact that tariff-related export reductions may have on revenues. We expect progress on this front after mid-term elections later this year, but escalations could be troublesome.

Median rainy-day fund balance over time chart

Back-to-school special

Municipal investors can still look to the higher education sector for investment opportunities. S&P reported that 91% of the rated private and 88% of the public higher education universe maintains stable credit outlooks. Large state flagship universities with strong strategic niches (e.g., health care, technology and engineering) have continued to see solid enrollment growth and financial support. However, some colleges will continue to be challenged by stagnating and declining enrollments as well as reductions in state funding. Investors should avoid institutions with substantial declines in enrollment, rising acceptance rates and those with low or weakening academic criteria. More broadly, higher education institutions in the Midwest and Northeast will be demographically challenged by declines in high school graduates. Problems will be more acute for small, private colleges that lack strong strategic positioning.

Over the past decade, successful higher education institutions have worked to raise their “brand value” to attract prospective students. Athletic and recreational facilities have seen significant upgrades and, more recently, we have seen an increase of bonds issued for new student housing and dining facilities. As institutions develop their brand value, we will likely see increased emphasis on research labs with strong ties to the corporate world and associated internship programs.

Schools that fail to increase their brand value will find it increasingly difficult to compete for shrinking federal and state dollars. Many will be forced to redefine themselves by narrowing course offerings or establishing a niche that offers value to students. Some institutions may choose to focus on pre-professional training. Other schools are looking for ways to realize savings by increasing the utilization of existing facilities through year-round course offerings instead of the traditional fall-spring academic year. Online learning will also play a significant role in cost savings while enabling students expanded learning opportunities and flexibility.

We think the majority of higher education institutions will adapt to the demands of current and future students. It’s a sector where investors can find value by focusing on institutions that demonstrate strong demand characteristics, rising application levels, consistent acceptance and matriculation rates and broad geographic reach. We favor schools with good academic reputations, large state flagship universities and schools with strong strategic niches. We avoid schools experiencing substantial declines in enrollment, high or appreciably rising acceptance rates and those with low or weakening academic criteria. Additionally, a bit more caution is exercised in states with declining numbers of high school graduates, more common in the Midwest and Northeast.

Market commentary

The best returns for municipal bonds in July were once again the shorter maturities, which have seen the only positive performance this year. While we did see positive returns across the curve in July, it was muted. The best performance was in the seven- to 10-year portion of the curve at about 0.40% return. The long-end of the curve eked out a 0.02% return for the month. Year-to-date, the one- to three-year portion of the curve returned about 1.15% versus a loss of 0.60% out long. Municipal bonds yet again outperformed other fixed income with the Bloomberg Municipal Bond Index returning 0.24%, besting the Bloomberg Treasury Index by about 60 basis points and the Bloomberg Aggregate Index by about 20 basis points. Low municipal bond issuance and ample demand continue to drive municipal outperformance.

July municipal issuance totaled $25 billion, bringing year-to-date issuance to $190 billion, a 15% decline versus the same period last year. The decline is due to the absence of pre-refunding deals disallowed by last year’s tax law changes. One positive note for supply was a monthly increase of almost 70% in new money issuance. Perhaps a sign that municipal issuers are less reluctant to fund new projects and take on more debt as financial conditions improve. Municipal fund flows continued their positive trend with about $3.8 billion of inflows in July, bringing year-to-date total inflows to $17 billion. Taxable bond funds posted strong inflows as well, while equity funds saw about $12 billion in outflows. The municipal supply and demand imbalance may continue through August as projections show the amount of money available from reinvestment of maturing bonds and coupons to be about $17 billion greater than the amount expected to be issued by municipalities.

The second quarter GDP estimate came in at 4.1%, within the range of expectations. As such, the bond market reacted with little fanfare. It did, however, reinforce the Federal Reserve’s (Fed) thoughts on steering short-term interest rates higher over the rest of the year. At their August meeting, the U.S. central bank held the Fed Funds target rate steady at 1.75 to 2 percent as widely expected. However, they had a bullish assessment on the state of the U.S. economy. With this strength and slightly higher inflation, the current probability of a September rate hike is over 90% and the probability of an additional December hike is over 60%. While we continue to monitor the potential for trade wars to negatively impact future growth, we see few signs of that at this time. In the face of further rate hikes, we remain defensively positioned.

AAA government obligation yield curve 12/37/17 to 7/31/18

Strategy overview

Duration

  • Maintaining shorter portfolio duration than our benchmark and peers.
  • Solid economic growth with 2Q GDP at 4.1% and July unemployment rate down to 3.9%.
  • Increased Treasury issuance to fund the federal deficit continues to be a concern.
  • We continue to scrutinize reports for any guidance on foreign central bank actions.

Curve

  • The short end of the curve is very rich relative to taxable bonds due to good retail demand and low supply.
  • At the early August meeting, the Fed reiterated its intent to gradually increase interest rates. The market probability of a hike in September is over 90% at this time. The probability for an additional hike in December is over 60%.
  • As such, we continue to buy municipal floating-rate notes with mandatory puts of about three years.
  • The three-year spot of the municipal curve is up 1.09% in year-to-date total return while the 10-year is down 0.35% in total return.
  • The weekly municipal floating rate index (SIFMA rate) is at 1.29% (8/1/2018) versus 0.79% a year ago.

Credit and structure

  • Lower quality, investment-grade bonds posted the best returns in July with the Bloomberg BBB Index returning 0.55% for the month.
  • Year-to-date, the index has returned 0.95%, easily outperforming the Municipal Bond Index, which returned -0.01%.

  • With historically tight lower quality spreads, we continue to be very selective in our purchases of BBB rated bonds.

Geography and sector

  • We continue to favor revenue bonds and have been focusing on hospital bonds, higher education (see above) and transportation bonds. We are watching for fallout from recent tariff actions, but have not noted any excessive stresses on credit quality at this time.

 

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