MuniLand Higher Education Sector Outlook

SNW has a stable to slightly negative outlook on the municipal not-for-profit higher education sector. The NFP higher education sector represents about 3% of our municipal benchmark. It is not a major performance driver, but it does contain some of the highest quality names in the municipal market, which makes it an important sector to watch. The high relative credit quality is driven by the presence of large state institutions like the University of Texas and University of California. In addition, very wealthy institutions like Harvard and Stanford also have a material impact on the sector’s credit fundamentals. Because of the dominance of these big names we give the sector a stable to slightly negative credit outlook. The slightly negative outlook is because of secular population trends and cyclical affordability headwinds that may influence the performance and credit quality of the sector over the next 12 to 18 months. 

The Department of Education’s National Center for Education Statistics forecasts that the growth rate for high school graduation rates between now and 2025/26 will be about 5.5%. Positive growth is generally a sector positive, but its pace is expected to be significantly slower than the 1992 to 2005 period, which reflected the bulge in “Echo Boomers” graduating high school. What is more, the growth is not evenly distributed. The South and West regions are expected to grow in the high single digits, while the Midwest is projected to be flat (literally and figuratively) and the Northeast will likely see declines. Attracting students was relatively easy in the past, but now colleges and universities face a stiffer and more competitive market environment. Management must be more strategic in regions with less favorable secular demographic trends.

Declining tuition affordability and slow real income growth will pressure institutions with high tuitions. Affordability is a serious concern for private not-for-profit colleges. We can measure affordability concerns by looking at net tuition revenue, which is tuition revenue that subtracts student financial aid. This is a critical credit driver because low or negative net tuition growth is a potential credit negative if expenses cannot be controlled or alternative revenue sources cannot be developed. One way private universities can offset uncompetitive tuition cost is to increase endowment transfer so as to support revenue growth. However, endowments will likely see lower investment returns in the future due to lower expected returns and rich valuation for many asset classes. Nonetheless, higher education institutions with sufficient net tuition revenue growth that demonstrate pricing power typically have solid credit fundamentals and large moats protecting their market position. Also, relatively affordable institutions will likely continue to see solid student demand.

It is at the confluence of declining high school population trends, solid market position and affordability that we see value in the sector. Flagship public institutions can provide value where states are experiencing fiscal stress; secular demographic trends are limiting the total number of high school graduates, yet affordable tuition creates demand. Where these trends meet we continue find pockets of value in an increasingly rich municipal market. 

Source: National Center for Education Statistics, SNW AM Research
 

First Read on What the Tax Plan Means for Munis

The House released their much anticipated tax plan last week, which in general, is supportive of municipal valuations. From a corporate tax standpoint, the highlights of the plan include a reduction in the corporate tax rate to 20%, adjustments to the taxation of foreign earnings and changes in the way capital expenditures are expensed. The tax rate on pass through business income would also be reduced. From a personal tax standpoint, the top individual rate remains at 39.6%, though there is some reshuffling in the brackets. There were also changes to the deductions for state and local taxes and an elimination of the AMT.

Republicans have been searching for additional revenue generators to help finance their proposed tax cuts, but taxing municipal bond interest was not one of them. Some changes to municipal taxation were included, however. The plan includes eliminating the tax exemption for advanced refunding bonds, which are essentially bonds municipalities issue to refinance existing debt. It also eliminates the tax-exempt status for bonds issued to finance private activities (think public private partnerships for transportation and housing projects) as well as bonds issued by non-profit healthcare and higher education providers. The tax-exempt status of bonds already issued by these entities will be grandfathered in. 

On net this is a good outcome for municipal bond valuations as the tax-exemption for the vast majority of municipal issuers is maintained and individual tax rates are unchanged for high earners. Supply may also fall because of the changes to the treatment of advanced refundings. As we have written about in the past, the true wildcard for the muni market is the reduction in the corporate tax rate. Banks and insurance companies are large buyers of municipal bonds and have taken up a larger and larger share of municipal holdings in recent years. A decline in corporate tax rates may make municipals less attractive for these entities. 

All of this should be taken with a grain of salt as this initial proposal is far from complete. The bill now goes to committee, where significant changes could be made. As a first step, however, the strong performance that municipals have put in throughout 2017 appears safe to continue. 

Source: Morgan Stanley, Tax Foundation

The Federal Reserve, Mr. Powell and the Sound of Crickets

Jay Powell was named last week by President Trump as his nominee to be the next Fed Chairman once Janet Yellen finishes her term in February. The market’s reaction is exactly what we hoped for – quiet and peaceful like the sound of crickets on a summer evening!

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So why the sound of crickets?  First, Jay is likely to continue along the Fed’s current path of slowly and cautiously raising interest rates and reducing the size of the Federal Reserve’s balance sheet. And like Ms. Yellen, he is anticipated to act only as the economic data allows. Second, he is expected to work with the Fed’s new regulation tsar Randal Quarles (the Fed’s first vice-chair for financial supervision) to improve Dodd-Frank and Volcker Rule regulation. It is widely agreed we should keep the important safeguards that were put in place after the financial crisis, yet we should also modify some small bits that only add to costs or reduce profits without enhancing soundness or stability. 

We can also be comfortable with Mr. Powell’s nomination as he is a well know commodity. Jay has been on the Federal Reserve board since 2012 and has proven himself to be a centrist. He has worked in the Treasury under George H W Bush in the 1990s, has business experience as an executive in the Carlyle Group (the well know D.C. based investment firm) and even has the recommendation of Janet Yellen who noted his “seriousness of purpose” and said she was confident in her successor’s “deep commitment to carrying out the vital public mission of the Federal Reserve. I am committed to working with him to ensure a smooth transition”.

A good resume, extensive experience and a strong recommendation are a good start. Still, Mr. Powell will face some challenges that no other Chairman has faced. Under Mr. Powell’s watch the Federal Reserve will need to thread the needle by raising rates at just the right speed to avoid choking off our slow economic expansion, and will need to shrink the Fed’s balance sheet which is a lot like trying to turn an aircraft carrier in a small harbor – doable but very tricky (see our note here). 

We think Mr. Powell is up to the task and he can help prolong accommodative monetary policy and the slow and steady economic recovery. And we like the sound of crickets!

Source: The Financial Times, Bloomberg, The New York Times

ECB Tapers and the Doves Fly!

The doves fly again! Last week the European Central Bank (ECB) reported it will taper the amount of bonds it buys from 60 billion euros monthly to 30 billion euros, starting in January of 2018. Although this is a material reduction in monetary accommodation (30 billion is real money), the markets viewed the announcement as dovish, with the euro falling and European stock markets rallying.

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So how is this dovish?  Mario Draghi made it clear that while the 30 billion euro target will run until September of 2018, the program will not end quickly and can be extended and even increased if there is a need. The ECB also made it clear that interest rates will remain “at the present levels for an extended period of time, and well past the horizon of net
asset purchases.” As we have mentioned before, the ECB rates are below low. In fact, the ECB charges banks 40 basis points yearly to deposit money. This negative deposit rate is a real incentive to lend and to stimulate the economy, so goes the ECB’s argument. All this accommodation is part of the ECB’s plan to drive the inflation rate to just below 2.0%. Pushing inflation to the target level has proven difficult, and has required a dovish stance for longer than most anticipated. 

Dovish central bank policy is generally positive for fixed income assets like corporate and municipal bonds, and also positive for economic growth. And as we look around the world, most bankers are dovish. The U.S. is still accommodative, as evidenced by the low Fed funds rate and the Fed’s large balance sheet. However, the U.S. is further along in its economic recovery, so it makes sense the Federal Reserve is less accommodative than the ECB. Japan shows no sign of reducing its highly accommodative stance, as it continues to struggling with low inflation and growth. The doves will be flying in Japan for some time.

From our perspective, the doves around the world will fly for a while longer, as central bankers are in no hurry to take away accommodation. In fact, we believe central bankers would be quick to offer further stimulus in the event of an economic hiccup. However, if we do see a sharp rise in inflation, the hawks would have a stronger position, though this is not our core forecast at the present time. So with doves still in the skies, decent economic growth and low inflation, these remain as good times for fixed income investors. 

Source: The Financial Times, Bloomberg, CreditSights, BCA Research, the ECB
 

Municipal Supply Picks Up with Large Illinois Bond Issue

The State of Illinois has issued $6 billion in general obligation debt over the last two weeks, the largest portion of which came last week when the state issued $4.5 billion in $500 million serial maturities from 2020 to 2028. The 10-year non-callable bonds priced at approximately +175 basis points (1.75%) over the AAA muni scale and traded down slightly after they were issued, which was consistent with other municipals on that day. The deal was not heavily oversubscribed, as has been the case with most municipal deals with higher yields this year, and the shortest maturities were left unsold. The spread level for the 10-year tenor on the new issue represented a concession of about 15 basis points versus where bonds had been trading in the secondary market prior to the deal. Spreads were much lower on some of the short maturity debt, especially the 1- and 2-year bonds that were issued two weeks ago, which priced at +70 over the AAA municipal scale. These shorter bonds have struggled to find homes with investors.

Overall, Illinois bonds have been among the top performers YTD, as spreads came crashing back in after the state finally passed a budget and staved off downgrades to below investment grade (see chart below). This performance has come with a very high degree of volatility, and is subject to reversing very quickly should the state fail to make sound fiscal decisions moving forward.

All of the ratings agencies confirmed their investment grade ratings prior to this deal, although Fitch has maintained a negative outlook for the credit (though its rating is currently one notch higher than the other two agency ratings). Moody’s also has a negative outlook, and an additional downgrade would take the state below investment grade. All three major rating services believe that Illinois’ problems are related to management (and associated budgetary and fiscal policy dysfunction), and they do not believe that the state’s current rating is driven by underlying economic fundamentals. A Fitch report, seeking to put the rating in a global context, notes that the fundamentals for the state are stronger than other comparably rated European sovereigns. In addition, Fitch points out that comparisons to Puerto Rico are at this time unfounded as the state maintains a robust economy, unlike the commonwealth in the years leading up to its bankruptcy.
 

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Investors have spent most of this year on a hunt for yield, as evidenced by the performance of corporate bonds and lower rated municipal bonds relative to other investment grade bond market segments. While Illinois still offers a large yield premium over other BBB category municipal issuers, that premium is much smaller than it was a year ago. Furthermore, the managerial concerns have not materially improved and the state’s pension liability continues to grow, causing the fundamental picture to deteriorate at the margin. A downgrade to below investment grade remains possible and would likely drive spreads wider. This could cause a great deal of selling pressure if investors with investment grade mandates were forced to sell, and is among the reasons that we avoid this name in our portfolios.

Source: Bloomberg, Fitch