Asset Class: Municipal Fixed Income

Midterm elections

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November elections will be a great weather vane for the public’s mood. We will be voting on 470 seats in the U.S. Congress, 35 Senate seats and all 435 House seats. Additionally, 36 states and three territories will vote for a Governor. Let’s not forget the state legislature and mayoral elections.

The winners of the gubernatorial elections will have a significant impact over the next congressional redistricting drawn up after the 2020 census. The new congressional maps will play a large role in the course of U.S. politics for the next decade. More specifically for the municipal market, do voters have enough confidence in their current and future financial position to open the purse strings a bit wider for new schools, roads, water projects, etc.? It will be a busy year end for analysts trying to discern the impact of the midterm elections. We currently see 271 bond elections totaling about $44 billion on the November 6th ballots. On one database we queried, we saw 157 statewide ballot measures in 38 states. These included measures for higher educational funding, Medicaid expansion and healthcare, restrictions on taxes and minimum wage increases. All in, there could be a variety of impacts on municipal market issuers.

Before we get overwhelmed with the November election results, we think it’s important to remind our readers that municipal bonds have been a relatively stable investment through many uncertain times. Generally, credit quality has improved over the past few years for municipal issuers as the economy has grown. Recent rating changes by S&P has left every U.S. state with a stable or positive rating outlook. At this time, 45 states are rated in the AA and AAA categories. More broadly, we have seen 21 defaults year-to-date through September this year versus 35 for the same period last year. In 2016, we had 53 over the same period; a nice decline for municipal issuers in that statistic. While defaults have increased in the wake of the Great Recession, they are rare compared to corporates. A Moody’s Investors Service study in 2017 showed a default rate of all rated municipals at 0.17% versus 10.24% for global corporates.

We’ll be back with results after the election. However, unlike market movements, credit changes in the municipal market typically develop slowly. This gives professional money managers with experienced municipal analysts the opportunity to avoid troubled waters.

Market commentary

Interest rates barely moved over the first two months of the quarter, then came September and yields rose across the fixed income markets. For example, the 10-year AAA municipal yield rose from 2.45% to 2.60%, or 15 basis points higher in yield; Treasury yields moved higher by about the same amount. Not a complete rout, but enough to post a negative monthly return of -0.65% for the Bloomberg Municipal Bond Index. For the quarter and year-to-date periods, the Index returned -0.15% and -0.40%, respectively. Returns were mixed across the curve over the quarter, ranging from a positive 0.06% for the intermediate portion to -0.48% for the long end. Broadly, with higher interest rates, short maturity municipal funds outperformed longer funds. Ten-year Treasury yields now seem firmly set above the 3% hurdle that investors had been watching closely and perhaps anticipating. Over the past month, hedge funds have had a record net-short position on 10-year notes and appear to be looking for yields to continue to move higher.

The Fed is anticipating higher interest rates as well. The Federal Open Market Committee (FOMC) raised short-term rates for the third time this year at their September meeting, pushing the target Fed Funds rate higher by a quarter-percentage point to a range between 2% and 2.25%. The hike is notable in that it’s the first time the target rate has been above 2% since 2008 and also the first time in many years it has been above the core inflation rate. Projections from the meeting show that Fed officials expect to raise rates by a percentage point through 2019; but the economy is a moving target with many drivers in play at this time. The Committee also removed the “accommodative” language from the description of their rate stance. Perhaps a nod that interest rates are closer to a neutral positioning, or maybe an acknowledgement that rate setting is an imprecise tool. The next meeting is around the corner in December and the market is currently implying about a 70% chance of another quarter-percent hike.

September municipal issuance totaled $24 billion, bringing year-to-date issuance to $249 billion, a 15% decline versus the same period last year. As has been the case this year, new money deals are significantly outpacing refunding deals. With early estimates, municipal flows reversed in September as investors pulled about $240 million from municipal funds and ETFs, likely due to the back up in yields. However, year-to-date net inflows are still strong at about $19 billion.

AAA government obligation yield curve 12-31-17 to 9-30-18

 

Strategy overview

Duration

  • Maintaining shorter portfolio duration than our benchmark and peers.
  • Federal Reserve Bank of Atlanta’s running GDP estimate currently tracking 4%.
  • Probability of additional rate hike in December is about 70%.
  • Increased Treasury issuance continues to weigh on the bond market.
  • Inflation in line with Fed expectations, but we are closely watching wage pressure.

Curve

  • Municipal bonds across the curve cheapened to Treasury bonds over the past month, but longer bonds are more attractive than the short end.
  • Maintain barbell positioning in intermediate portfolios.
  • We like the longer end for intermediate portfolios. The municipal curve is much steeper than the treasury curve, providing relatively higher yields out long. Additionally, the callable municipal bonds have a much shorter duration than other long-dated taxable bonds.
  • Overweight variable rate demand notes.
  • The weekly municipal floating rate index (SIFMA) is 1.56% (9/26/2018) versus 0.94% last year.

Credit and structure

  • As always, yield continues to be an important driver of total return, but attractive opportunities to add it are limited.
  • High Yield Munis were down in September as the Bloomberg Muni HY Index returned -0.40%. We do not believe the decline is due to credit concerns; more likely that the price appreciation of sectors driving HY performance (e.g., tobacco bonds) has peaked.

Geography and sector

  • We continue to favor revenue bonds and have been focusing on hospital bonds, higher education, 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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