Navigating the cross-currents in municipal bonds
- Despite a better tone in the municipal bond market, we remain cautious on the near-term outlook.
- Supply and demand dynamics have improved but are still uncertain.
- Rising rates are the key threat to demand for munis; other risks include unfunded pension liabilities and legislative and regulatory changes.
- Despite lingering concerns about Puerto Rico and Detroit, credit quality isstill sound for the majority of issuers.
- In our view, municipal bonds may offer good value and attractive tax-equivalent yields when investing with a long-term time horizon.
With strong performance and more stable flows into municipal bond mutual funds, the tone of the muni market has improved this year. Through mid-April, high-yield muni bonds have outpaced most other fixed income sectors, and high-grade muni returns have also been respectable. Such performance tends to be self-reinforcing, as attractive returns draw greater investor interest and drive prices higher.1
Despite this relatively healthy start to 2014, we remain cautious. New muni bond issuance has been low, with issuance in the first quarter the second lowest in 10years, but there is a risk that it could increase. Fund flows have been mixed but, on balance, modestly positive. As tax season winds down, flows may be bolstered by a newfound appreciation for the tax benefits of muni bonds. Nevertheless, if the recent Treasury rally reverses on improving macroeconomic data, flows could again be pressured by duration-wary investors.
Lets examine these and other factors to arrive at a balanced assessment of the muni market.
SUPPLY AND DEMAND DYNAMICS STILL FRAGILE
The dynamics of supply and demand challenged the muni sector last year. The second-lowest calendar year ofsupply since 2002, 2013 also saw exceptionally weak demand onsharply rising interest rates and uncertainty regarding changes in the US Federal Reserves asset purchase program before the tapering began in December. Two characteristics of munis caused these concerns to weigh especially heavily on the sector:
- Relatively high sensitivity to interest rate changes, given their comparatively long-term structure
- Greater source of demand from a predominantly retail investor base because of their tax-exempt status
Interest rate sensitivity can result in negative returns when rates rise, and retail investors are less inclined than institutional buyers to hold on to allocations when performance headwinds threaten. This can create a negative feedback loop, begetting more poor performance as fund redemptions cause forced selling, which drives prices down further.
After municipal bonds experienced their worst year of performance since 2008, the tide of fund outflows was expected to continue in 2014, since interest rates seemed likely to rise and market worries about outcomes in Puerto Rico and Detroit seemed unlikely to relent. Our best hope at the beginning of this year was that fund flows would turn positive when rates had risen enough to make muni yields attractive to investors. And we hoped that proceeds from muni calls and redemptions would go back into the asset class, also helping to stabilize flows.
The market often surprises, however, and demand this year has outpaced limited supply as falling Treasury yields have supported performance. While investors have enjoyed the positive impact on muni returns, we think this dynamic is fragile and may be fleeting. To see why, lets consider supply and demand in turn:
Supply. New bond issuance has remained at a subdued rate so far this year, reflecting austerity at the state and local level as well as reduced refunding activity because of higher rates.2 One of the muni markets self-regulating mechanisms is an inverse relationship between rates and refunding: Rising rates tend to curb new supply as well as dampen demand. Bond calls and redemptions have exceeded new issuance, resulting in net negative new supply.
We think this may persist, with 2014 becoming the fourth consecutive year in which outstanding issuance of muni bonds has declined (see Exhibit 1). The shrinkage could be modest, as outstanding municipal issuance is expected to fall about $20 billion year over year.
Demand. Flows have turned net positive in aggregate, though they have been inconsistent across muni bond categories: Long-term funds are still struggling, while shorter- duration and high-yield funds have gathered assets because ofthe preference evident in direct retail and managed account buying for shorter-duration securities with maturities of 10 years or less. Moreover, flows are hardly robust and show no signs of meaningful acceleration.
Will the positive technicals of modest supply and somewhat stronger demand last? While seasonal tax selling typically dampens demand as some municipal bond holders liquidate positions to pay taxes in March and April, that traditional behavior may be less prevalent this year because higher tax rates and reduced deductions make the tax-exempt income of muni bonds even more desirable. Yet we still worry about yield sticker shock in what is a highly retail-oriented segment of the market. With strong performance on the back of a Treasury market rally, yields are lower and potentially less appealing to investors.
RISING RATES KEY THREAT TO DEMAND
Our greatest concern about the durability of demand has been the expectation that US Treasury yields could resume their upward path if the weather-impaired macroeconomic reports prove transitory. In our view, the first quarters surprisingly weak data have not derailed but merely deferred the thesis of above-trend US economic growth in 2014. We feel that underlying private demand has been solid, and its strength will be revealed as the fiscal drag rolls off, so the Fed will proceed with tapering as planned. Rising rates will likely mean negative price returns for all bonds and especially those with longer durations which could ultimately hurt investor demand for munis.
One potential offset would be a flight-to-quality bid for Treasuries driven by geopolitical concerns. Tensions in Ukraine and elsewhere could counteract the upward pressure on rates, especially if any of these situations see an escalation of conflict.
FUNDAMENTALS GOOD BUT NOT GREAT
We have maintained our conviction that credit quality remains sound for the majority of municipal bond issuers. Fundamentals in the sector have improved significantly from Great Recession lows. Debt defaults are often regarded as a sign of poor fundamentals, and last year defaults represented just 0.08% of muni bonds outstanding even less than the 0.11% default rate in 2012.3 In addition, there were just seven Chapter 9 municipal bankruptcy filings in 2013, compared with 11 in each of the two preceding years.
A number of metrics point toward the benefits of the US economys nearly five-year-old expansion. State tax revenues are based primarily on corporate, income and sales taxes that respond quickly to an economic recovery, and these revenues have grown for 16 consecutive quarters (see Exhibit 2).
Local revenues have also grown, though the improvement has been slower than at the state level. Nearly two-thirds of local revenues are derived from property tax receipts. These have risen in response to rebounding home prices, but tend to lag because of delays in reassessing property values.
Nevertheless, we feel that muni bond fundamentals are best characterized as neutral. In certain sectors, such as health care and higher education, fundamentals have been showing signs of deterioration. Hospital revenue bonds, for example, have a risk/reward profile that is now asymmetrically skewed to the downside because of uncertainty surrounding the rollout of the Affordable Care Act and related reimbursement issues. Typically volatile tobacco bonds, on the other hand, are exhibiting relatively stable fundamentals.
From our perspective, an outlook that is somewhat mixed for the sector overall warrants careful selection on the basis of each issuers underlying fundamentals. In general, given some developments in Chapter 9 filings, we are inclined to find greater safety in the visible cash flows of revenue bonds especially essential service revenue bonds than in the full faith and credit pledge of general obligation bonds, or GOs.
PUERTO RICO RISKS DEFERRED
For some time, the risk that the Commonwealth of Puerto Ricos massive debt burden and unsustainable fiscal dynamic could force a restructuring of its debt has spread a cloud of uncertainty over the municipal bond market. Though hardly a bellwether for the sector, Puerto Rico represents almost 2% of the municipal bond market, with approximately $70 billion in debt outstanding. So potentially negative outcomes could be expected to have broad systemic implications. And Puerto Rican debt has been widely held across muni funds because of the unique triple tax exemption granted to the bond issues of US territories.
Those concerns were allayed, at least for a time, after Puerto Rico came to market in mid-March with a $3.5 billion GO deal the largest ever in the high-yield segment.4
With this successful issue likely to meet the commonwealths cash flow needs through June 2015, the immediate prospect of default receded and Puerto Rico got some breathing room to service existing debt. Longer-run outcomes are still unclear, however. The territory continues to face pressing fiscal problems and its ailing economy has been mostly contracting since 2006 (see Exhibit 3). Unemployment is high, impacting revenues, and pension obligations remain onerous. The debt burden has been serviced with deficit financing, though one bright spot is that revenue collections in some months have exceeded budgeted estimates.
PROGRESS IN DETROITS BANKRUPTCY PROCEEDINGS
Investors have been closely watching the largest municipal bankruptcy in US history for potentially precedent-setting court rulings. The concern has been that judgments made in this case could have far-reaching implications for how investors think about the safety of owning local GOs, which in turn could impact the future cost of funding for cities and towns.
In particular, the case was expected to test the strength of the citys unlimited tax general obligation bonds, or ULTGOs, which have a separate and distinct property tax levy and are secured by a pledge of the full faith and credit of Detroit meaning that the city is required to collect property taxes sufficient to pay the bonds when due. It was not clear whether the bankruptcy court would find that the ULTGOs had a senior secured statutory lien on specific property taxes or constituted special revenue bonds as defined by Chapter9, or would treat the ULTGOs as unsecured liabilities.
Detroits emergency manager has been seeking out-of-court settlements with creditors both pensioners and bondholders. Settlements would have the effect of avoiding protracted litigation that could delay confirmation of the plan of adjustment. In a recently negotiated settlement that affects the ULTGOs, three bond insurers agreed to a 26% haircut, a modest write-down when compared with Detroits plan of adjustment, which contained an 85% write-down. As of this writing, the settlement is still subject to the bankruptcy judges approval. Although hardly ideal from a bondholders perspective, the settlement averts less favorable scenarios and will not serve as negative judicial precedent.
PERSISTENT ISSUE OF UNFUNDED PENSION LIABILITIES
Pension funding remains a major long-term issue facing the municipal bond market. According to the Feds most recent Flow of Funds report, total state and local pension liabilities stayed at an unsustainably high $5.0 trillion, or just over 29% of GDP. Unfunded shortfalls are estimated to be as large as $2 trillion to $3 trillion, mostly because of overly generous benefits, failure to meet annual required contributions and disappointing investment returns. Better market performance should help, but pension reform will be necessary in the long term. Such reform is never easy and always contentious, as it typically requires some combination of reduced benefits and increased employee contributions, which public employees unions oppose.
For example, the pension system of Illinois has been massively underfunded, with a $100 billion shortfall and a funding ratio of only around 40%. In late 2013, the legislature finally enacted reforms that should place the states pension system on a path toward stabilization over time. Ifsuccessfully implemented, the reforms could ultimately reduce funding costs for the state, since there tends to be a relatively strong negative correlation between pension funding ratios and muni credit spreads. However, the plan involves unpopular changes, such as lower COLA increases and a higher retirement age, and the unions have vowed to challenge it legally.5
LEGISLATIVE AND REGULATORY CHANGES NOT IMMINENT
The muni market weathered the Volcker rules threat to secondary market liquidity, with the final version less restrictive than earlier proposals. However, Basel III guidelines for banks mandated liquidity coverage ratio, or LCR, would exclude muni bonds from the definition of high-quality liquid assets, or HQLA, that can be used as collateral to offset liabilities. Ifthese guidelines are enacted as currently formulated, banks would be less inclined to hold municipal bonds. This poses arisk to demand especially since banks hold a significant 11% share of outstanding muni issuance.
Tax reform that could change municipal bonds exempt status is probably not a near-term threat but remains a perennial risk. Recent congressional proposals and the administrations budgets for the past three fiscal years have kept alive the legislative risks to the sector. These tend to overstate the cost of the exemption to the federal government and understate the favorable impact of lowering the cost of capital for municipalities.
The good news is that impressive strides toward reducing the federal deficit have removed much of the impetus for addressing tax expenditures, or potential tax revenues foregone because ofexemptions.
VALUATION ATTRACTIVE FOR THE LONG RUN
With their recent outperformance, municipal bonds are looking rich relative to Treasuries, especially at the shorter end ofthe yield curve. Relative value is not uniform across the tax-exempt curve: Yield ratios have fallen to below 90% at the 10-year segment on strong demand, while the 30-year segment remains at about 100%. These valuations suggest that if Treasury yields rise as we expect, higher-quality munis may underperform Treasuries.
Even with the prospect of further declines in muni bond prices, the reinvestment of coupon income at increasingly higher yields may generate reasonably attractive total returns over time. Indeed, over a sufficiently long horizon defined here as within the time to maturity of the average municipal bond annualized returns with reinvestment at higher yields could potentially exceed the returns that would have been realized if muni yields had stayed lower.
In addition, we think that high-yield munis look attractive relative to taxable corporates, especially on a tax-equivalent basis. Depending on the tax bracket applied, tax-equivalent yields on BBB-rated revenue bonds yielding 5.25% now range from nearly 7.3% to almost 9.3%. Obtaining that level of yield in taxable debt would require investing in securities rated single B or below well into junk bond territory.
We continue to see better value in essential service revenue bonds than in many other market segments, including GOs, and we find select opportunities in areas such as charter schools and continuing care retirement centers. In our view, the ongoing economic expansion will help to keep default risk well contained, so we also see the value of moving modestly down the quality spectrum rather than concentrating on the highest-quality issuance.
- Municipal bond funds garnered nearly $3.5 billion in net inflows year to date through 9 April 2014. This compares to net outflows of $58.4 billion in calendar year 2013. Source: Investment Company Institute.
- Year to date through 9 April 2014, tax-exempt issuance totaled $63.1 billion, more than a 19% decline versus the same period last year. Source: Bank of America Merrill Lynch.
- Source: Bank of America Merrill Lynch.
- To put the pricing in context, this far exceeds the yields that cross-over buyers can currently obtain from BB-rated taxable corporates.
- Similar developments are happening elsewhere. Scott Pattison, executive director of the National Association of State Budget Officers, recently noted that since 2009 44 states have enacted significant revisions to at least one retirement plan, 28 have increased employee contributions, 28 have raised the eligibility service requirement and the retirement age and 18 have cut back on increases to post-retirement benefits.
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