This article was released on October 14, 2015. Find our latest municipal fixed income insights here.
September ends 3Q on a positive note
Investors once again found safety in the municipal market amid the volatility and uncertainty in the U.S. equity and global markets. September registered the second consecutive month of positive returns. Market performance was supported by historically low issuance levels, general concerns for China’s weakening economy and the uncertainty of a Fed rate hike. The Federal Reserve’s pass on raising interest rates this month—surprising many market participants—highlighted concerns over global weakness and the potential for spillover into the domestic economy. The aftermath of the Fed’s dovish statement saw Treasury bonds rally strongly. Municipal yields declined at a more modest pace, but fell to levels last seen in April. The broad risk-off sentiment taking hold in the financial markets has pushed expectations for the first Fed hike into 2016. However, the timing and magnitude of future Fed tightening is still fiercely debated.
As for municipal sector performance, lower quality bonds (BBB-rated) slightly outperformed in September. Municipal spreads in general remain at historically tight levels and have shown relatively little weakness. In fact, high yield municipal spreads tightened significantly over the month. The high yield sector significantly outperformed the general market with tobacco bonds leading the charge providing a 9% return year-to-date according to Barclays. The majority of the trading in the high yield space belonged to Puerto Rico after some progress on the debt restructuring was made. There is some discussion that the Commonwealth’s constitutional support for the G.O. bonds will be honored. On this news, Puerto Rico bonds yields fell nearly 50 basis points and returned almost 5% for the month.
Supply & Demand
September municipal bond volume fell the most in 17 months, declining 40% from August and 27% from the same period last year. While this helped support muni prices over the month, year-to-date issuance remains elevated—35% greater than last year— largely due to elevated refunding activity as issuers rush to market ahead of Fed interest rate hikes. We expect issuance to recover in the fourth quarter as refunding deals resume with the recent drop in interest rates to levels last seen in April. On the demand side, flows for municipal funds continued the negative trend from the second quarter with $1.3 billion in outflows. Year-to-date totals are still positive at $3.4 billion net inflows. We are hopeful that investor demand will pick up in the coming months with renewed interest from recently posted positive returns and the attractiveness of our relatively stable and safe asset class in a highly volatile and uncertain global market.
Yields fell across the curve over the month; however, the best total returns were posted on the intermediate portion of the curve, returning 0.94% for the month versus 0.72% for the Barclays broad muni index. Year-to-date, we have seen similar outperformance with the Barclays 10-year muni index returning 2.12% versus 1.77% for the broad index. Despite the movement in rates we saw over the month, the front-end of the yield curve remains relative steep and rolling down this portion of the curve continues to offer potential price outperformance versus flatter portions of the curve. With the Fed still reluctant to tighten, we see this continuing over the next few months.
Municipal credit outlook—strength in numbers
State and local government revenues continue to exhibit positive trends. Despite this good news, budgetary revenue forecasts are indicating state officials are cautious on future growth rates. The recent round of state budgetary planning indicates lawmakers are maintaining their conservative stance, holding the line on expenditures and boosting reserves—good news for municipal credit quality. Lawmakers in two states, Pennsylvania and Illinois, have not been able to reach a budget consensus and are currently operating in the new fiscal year without a formal budget. The September Rockefeller Institute’s State Revenue Report indicated that state tax revenues have grown 7.6% in the second quarter of 2015, supporting signs of economic strength. Ten states reported double-digit growth. The largest components of state revenues include personal & corporate income taxes and sales tax receipts. Corporate income taxes have exhibited the most uncertainty due to their dependency on corporate profits. Personal income tax growth grew by double-digits in 18 states while only five states—Arkansas, Delaware, Illinois, Kansas and Nebraska— experienced a reduction in income tax receipts primarily due to self-imposed income tax-cut programs. The Great Lakes Region showed the greatest revenue growth with a 7.7% increase. Supporting signs of consumer confidence, sales tax collections have now registered 21 straight quarters of positive growth with an average quarterly growth rate of 4.7%. Sales tax collections are above pre-recessionary levels on an inflation-adjusted basis, but in nominal terms, collection rates have not quite recovered. On-line sales and weaker wage growth have adversely affected the growth rate of sales tax dollars. Motor fuel taxes have increased over the past eight quarters as a result of lower gas prices, reversing a declining trend due to changing consumer habits and more fuel efficient cars being purchased. States are actively seeking an alternative revenue source for a growing backlog of bridge and highway infrastructure spending—a topic which will continue to hit the headlines over the next few years. Local government financials have experienced continued improvement over the past several years with the recovery of the real estate market and improving economy. Local governments tend to lag states in part due to the states’ ability to push down financial obligations to the local level in efforts to balance their own budgets. The National League of Cities’ annual survey of city officers indicates that financial conditions continue to improve at the local level. Demonstrating growing optimism across the field, 82% of the finance officers answering the survey reported that their cities were better able to meet financial needs. General Fund revenues increased 1.3% in 2014 with expectations of a slower, but still positive, 0.31% increase in 2015. Additionally, property tax revenues increased 1.2% in 2015 with expectations that revenue growth will remain flat. Officials answering to the survey reported that new revenue sources and greater growth are needed to meet future infrastructure needs, pension payments, and health care costs. Finding new revenues have led many governments to increase tax rates, expand the tax base to include tax-free, non-profit institutions, and implement a growing number of user fees. Public officials, having struggled through the recent “Great Recession”, have built reserves to a 30 year high, at approximately 25% of expenditures—comforting levels for municipal bond investors.
It’s always the children who pay
Despite weeks of negotiations, the Pennsylvania budget is three months late. The Republican Legislature and the Democratic Governor are at odds on funding for schools, pension reform, liquor-sale privatization and a severance tax. In the meantime, lack of state school aid has become a major cause of concern for school districts who must figure out how to cover operational costs before knowing what funding they will receive and when they will receive it—a challenging dilemma. Cash reserves are quickly running out and some schools are borrowing to keep their doors open. At least 10% of the state’s 500 school districts have resorted to borrowing. For example, the Erie, PA School District Superintendent says they “are running out of money because of the state budget impasse…and “they haven’t paid any of the vendors since July 1st”. He says that the millions of dollars they receive from property tax collections “just isn’t enough”. A school district shutdown is a possibility. Although the state’s budget impasse has not resulted in a change to its credit rating—the Commonwealth is rated Aa3/AA-/AA- with stable outlooks—Moody’s took action on the state’s school program. Moody’s downgraded the enhanced ratings on most school districts in the Pennsylvania state aid intercept program by one notch and placed them on review for further downgrade. For the post-default intercept, this translates to a rating of A3. The pre-default ratings are now A2. Moody’s called the action “…a consequence of the commonwealth’s chronically late budgets (9 in the past 13 years) and the lack of clarity surrounding its ability to honor intercept obligations in the absence of an approved and implemented budget. While we expect the commonwealth to cover any missed debt service payments on enhanced bonds, the current lengthy budget impasse has heightened risks to bondholders.” S&P rates this program A/A+ and has placed the rating on CreditWatch with negative implications.
Change blowing through the Windy City?
Mayor Emanuel released his proposed City of Chicago budget on September 22nd, almost a month before its due date. Budgetary challenges included closing a $230 million corporate-fund gap and finding money to pay for the required statutory increase in funding for the City’s pensions of approximately $428 million. Under the proposed FY 2016 budget, a total of $978 million will be contributed to the City’s four pension funds. Of that contribution, $786 million will come from property tax revenue and $192 million from other sources, including $75 million from the City’s enterprise and special revenue funds. As a consequence, the Mayor has proposed a $543 million property tax increase to be phased in over four years, with most of the money going to police & fire pensions. This increase would be more than 50% greater than the city’s 2014 property tax levy and would represent a 12-13% increase to the total tax levy, which includes overlapping taxing districts. Beginning this year, property taxes would increase by $318 million, then by $109 million next year, $53 million in 2017 and $63 million in 2018. In addition, a special property tax for school modernization would raise another $45 million. The Mayor proposes to fill the corporate budget gap with a new $9.50-a-month garbage-hauling fee to raise $62.7 million, a combination of ride-sharing and taxi fee hikes to generate $48.6 million, building permit fee increases to bring in $13 million and a new tax on electronic cigarettes to capture $1 million. The balance is addressed through lowered costs and efficiencies. While generally considered a step in the right direction, the Mayor’s plan has generated concern because the plan relies on help from the gridlocked Illinois Legislature. Senate Bill 777 would authorize yearly payment reductions and a 15-year extension for 90% funding of the police and fire pensions. In addition, the Mayor is seeking authorization for an increase in the homeowner property assessment exemption in order to protect taxpayers with home values of less than $250,000. State assistance, however, doesn’t seem likely at this point. In fact, the Governor has virtually promised to veto Emanuel’s homestead exemption proposal if it reaches his desk. Fitch called the budget proposal a “positive development”; however, S&P stated that an adopted budget that “fails to cover the larger pension payments with an identifiable and reliable revenue source, would likely strain the rating–potentially resulting in the rating being lowered by multiple notches.” Stay tuned for more.