The United States has been mired in a long period of underinvestment in its infrastructure as federal, state and local governments deal with escalating costs, slow revenue growth and a bias against raising taxes and user fees.
President Donald Trump has proposed infrastructure investment as part of his pro-growth agenda, which dovetails with a growing political will to improve this country’s infrastructure. Further, this year the American Society of Civil Engineers’ (ASCE) assigned a D+ grade to American infrastructure. Given the confluence of these conditions and infrastructure’s importance to economic growth, infrastructure spending is likely to rise over the coming years. Much of this investment will be financed via the municipal bond market, and a rising share will likely come from public-private partnerships (P3s). Essentially, P3s are long-term contractual agreements between a public agency and a private sector entity that allow for private development and/or management of infrastructure for a public purpose.
The Congressional Budget Office reported that in 2014 federal, state and local governments spent a total of $416 billion on infrastructure. Most of this is financed in the municipal bond market, which, via tax-exempt financing, provides the lowest cost structure to finance America’s infrastructure. Given this advantage, the municipal market will continue to be the primary financing vehicle, and a critical factor in support for the preservation of the municipal tax exemption.
President Trump has announced a ten year $1 trillion infrastructure plan. It is not a detailed proposal, and a related legislative package likely will be unveiled later in the year. Currently the plan contemplates that $200 billion of the $1 trillion would come from increased federal spending on infrastructure. The remaining $800 billion of funding would come from state and local governments financed through the municipal bond market, as well as through increased P3s.
As the burden of financing and funding the nation’s infrastructure needs fall on to state and local governments, the municipal bond market is expected to play a significant role in financing future infrastructure projects. P3s are likely to increase in use given President Trump’s desire to have more private-sector participation in the financing of these projects. However, despite the political will, the D+ grade on America’s infrastructure, and President Trump’s $1 trillion infrastructure plan, the primary obstacle to be hurdled is the ability to generate dependable revenue streams to fund projects and the related financings.
Tale of two states with budget woes
A handful of states started the new fiscal year beginning July 1 without a budget. Two states that stand out are Connecticut and Illinois. Connecticut, the wealthiest state in the nation based on income levels, will continue to operate but will most likely not see a formal budget until the end of July with lawmakers returning to the capital July 18. The State of Illinois having no budget for the past two years and facing the threat of a downgrade to “junk” status by the rating agencies and growing voter unrest with the political leaders in the state rallied to overturn the Governor’s veto on a budget plan for the first time in three years.
Connecticut: money can’t buy a balanced budget
For the first time since 2009, the State of Connecticut started its fiscal year beginning July 1, 2017 without a budget. The State is grappling with a two-year $5.1 billion deficit as it continues to negotiate its fiscal 2018-2019 biennial budget. The primary issues revolve around tax hikes, proposed cuts to social services and wage and pension concessions. The State and its employee union leaders have signed a tentative contract to change pension and benefit costs. The contract calls for a 3-year wage freeze and more employee contributions for pensions and health care. The deal still needs approval by the rank and file union members and by the State legislature. On Friday June 30, 2017 Connecticut Governor Dannel Malloy signed an executive order which will keep the State’s government operating until a budget is passed, which is not likely until July 18, 2017 when the State’s House has proposed to vote on the budget.
On a median household income basis Connecticut is one of the nation’s wealthiest States. However, it has struggled over the past few decades as manufacturing jobs have migrated out of the State. Aetna Inc. recently announced that it is moving its headquarters to New York City, a year after General Electric left for Boston. However, in both cases the companies only relocated a fraction of its total jobs from Connecticut to the new headquarters.
The loss of high paying finance jobs has led to tax revenue shortfalls, which have resulted in budget imbalances and dwindling reserves as over 50% of the State’s general fund revenues are derived from personal income taxes. The State also has a high $26.6 billion unfunded pension liability. These factors led to rating downgrades in 2017. Connecticut is now rated A1 by Moody’s, A+ by S&P, and A+ by Fitch. Its ratings are among the lowest of all States — higher than only Illinois’ Baa3/BBB-/BBB and New Jersey’s A3/A-/A ratings. Further downgrades are likely if the State does not adequately address its budget deficits and weak pension funded levels.
Illinois: a step in the right direction
State of Illinois residents can begin enjoying their summer knowing that schools, community colleges and universities will open in the fall. Ten republicans jumped the party line voting for the proposed budget plan overturning Governor Rauner’s veto. Governor Rauner vetoed the budget plan citing continued tax increases without more significant spending reforms will continue to hinder the State’s long-term economic prospects. It all came to a head with the rating agencies threat of a downgrade to junk status, a court ruling requiring the State to place greater priority on the payment of past due Medicaid bills and concerns over the opening of schools and universities this fall. This budget is a step in the right direction but it will take years before the State recovers from the damage these past two years has caused.
The much needed revenue to finance the State’s spending habits will come from a personal and corporate income tax hike that will provide an additional $4.8 billion in revenue. The personal income tax rate will increase to 4.95% and the corporate tax rate increasing to 9.5% from 7% for an additional $460 million in revenue. On the surface Illinois now has one of the highest income tax rates; however, according to a 2014 report from the Center for Tax and Budget Accountability only 303 out of 110,557 companies within the state paid over $1 million in taxes with the many exemptions, credits and deductions available.
Regaining the confidence of investors and rating agencies will take multiple budget cycles, elections and continued effort by lawmakers. State of Illinois tax-exempt bonds realized some gains following the budget agreement but continue to trade weaker than any other state credit. We continue to view the State more favorably than the rating agencies due to the State GO bond’s strong priority of payment for debt service combined with the strength and diversity of the economy.
An unexpected bond sell-off over the last week of June took quite a bit of steam out of the U.S. fixed-income markets, including the municipal market. The total return for the Bloomberg Barclays Municipal Bond Index over the last month of the quarter was 0.36%. This was a highly unusual negative return for the muni market in the seasonally strong month of June which historically has above average demand from maturing bonds and coupon payments. Despite a dismal June, second quarter muni returns were relatively strong. The Index returned 1.96% for the second quarter and 3.57% year-to-date. The muni market followed Treasury bond prices lower due to continued talk from the Fed about tighter monetary policy and the planned reduction of the Fed’s balance sheet. Another fear starting to grip the bond market is that the global economy is improving and therefore central banks around the world will start to reign in easy money. That appears to be the theme developing for the third quarter. We will keep our sights on U.S. Fed as well as statements from global central bankers.
The municipal 10-year yield jumped about 15 basis points over the last week of June. However, the yield ended the quarter at 2.00%, 25 basis points lower than the beginning of the quarter. The Bloomberg Barclays’ 10-year Muni Index posted a total return at -0.35% for the month of June and 1.39% for the quarter. The best total returns for the quarter were on the long-end of the curve as yields fell.
Not much discernible difference between high and low quality bonds over the month. However, lower quality bonds continued to outperform higher quality for the quarter. The Bloomberg Barclays Muni BBB-rated Index returned 2.09% while the AAA-rated index returned 1.73%. For the year-to-date, the BBB index outperformed higher quality bonds by well over 100 basis points. This relative price appreciation was due to investors stretching for yield in a very low interest rate environment. High yield munis underperformed BBB-rated bonds slightly for the quarter, but remain well ahead on a year-to-date basis. Puerto Rico bonds hindered high yield as that sub-index was down 7.33% for the quarter.
The Illinois Index also had a rough month as the budget stalemate continued through the end of June. The index returned -1.08% as the State approached a non-investment grade level. If it goes there, it will be the first U.S. state to be rated “junk.”
Supply and demand
June’s bond volume fell 24% from the same period last year. With 10- to 30-year municipal yields 50 to 80 basis points higher. A decline in refunding deals is the primary cause of the reduced issuance. For example, refunding deals in June were down about 50% from June 2016. Last year, issuance totaled $227 billion at this point versus $195 billion this year. This reduction has helped support municipal bond prices. As in the past couple months, we expect the municipal market to have net negative supply in July and August. More bonds are maturing and being called than are being issued — a reduction in municipal bonds outstanding.
Investor demand led to another good month of flows into municipal bond funds and ETFs. Over the past month, $3.8 billion flowed into municipal funds and ETFs. Year-to-date we are at a $17 billion of net inflows. This is only half of the net inflows we saw last year, but still a historically solid number for the municipal market.
Despite yields moving 5 to 15 basis points higher over the month of June, municipal yields were significantly lower over the second quarter as investors scaled back how much impact the Trump administration’s fiscal policies could have on inflation. Yields from 5 years on out were 20 to 30 basis points lower over the quarter leading to very good total returns. The best returns were on the 22+ year portion of the curve which returned 2.75%. The Bloomberg Barclays 10 Year Index was not far behind and returned 2.34% over the past quarter.
- We went shorter in June as the market hit this year’s low yields. The media is starting to focus on globally “improving” economies. We will have to see how this thought in the market develops before making additional duration changes.
- The Fed’s monetary policy tightening continues. The market expects one more hike this year. The Fed is also discussing ways to reduce their balance sheet of $4.5 trillion in bonds. With moderate inflation at this time, most of our concern for higher interest rates is for maturities eight years and shorter. As such, we have a significant amount of short, floating rate notes in the funds.
- Retaining barbell structure with municipal floating rate notes on the short-end of the curve and fixed coupon bonds on the longer end of the fund’s investment horizon. We earn more incremental credit spread on the longer end but remain duration neutral. We will continue to monitor inflation expectations for a reduction to our long-end exposure; however, the latest reports suggest a continuation of this strategy.
- Daily and weekly tax free floating rate notes remain at elevated yields providing attractive yields to interest rate sensitive investors. The weekly municipal floating rate index (SIFMA rate) is at 0.91% versus 0.41% in June 2016. Tax-exempt money market and ultra short funds are at very attractive yield levels for risk-averse investors.
Credit and structure
- Lower-quality bonds posted the best performance year-to-date. With the help of our seasoned analysts, we continue to look for undervalued A and BBB rated bonds. The higher yield of the lower quality bonds helps the long-term performance of these bonds. Also, price appreciation on undervalued bonds helps longer-term performance as well.
- We have been focusing on 5 percent coupon bonds for intermediate positions and 2 to 3 percent coupons on the shorter end of the curve. These are premium coupon bonds and are more defensive in a rising interest rate environment.
- Repeal and replacement of Obamacare has been unsuccessful to date in the Senate. We have seen no evidence of weakness of bond prices in this sector due to these efforts. The Senate has pushed the vote off to after the July 4th holiday. We will continue to monitor the political situation, but we are very comfortable with our hospital bond holdings.
- We continue to look for opportunities to invest in the State of Illinois GO bonds and bonds issued by the City of Chicago for our diversified mutual funds. The future credit rating of the State of Illinois is still uncertain due to political unwillingness to reach a budget compromise. We do not believe the State will default on any payments.