Market Update

Why Higher Treasury Rates Are Challenging the Muni Market

We have written many times this year on the support the municipal market has received from the provision in last year’s tax bill that eliminated advanced refunding transactions. Through September, tax-free municipal issuance is down approximately 14% versus the first nine months of 2017. Lower supply is one of the reasons why municipals have produced flat returns through September, while most other investment grade sectors have sold-off with the rise in interest rates.

Of course, this positive technical environment has not just been due to a supply reduction, but also because of steady demand. For much of the year, flows into municipal bond funds has been solid, with net flows (inflows minus redemptions) hovering in slightly positive territory.

This dynamic has changed over the last four weeks. For the first time since late 2016, the muni market has now experienced four straight weeks of net outflows. According to Lipper, flows for the week ended 10/17 were ($636mm), which brought the four-week average to ($495mm).

Unsurprisingly, this has coincided with a rise in Treasury yields. Historically, when US Treasury rates experience a sharp move higher, municipal flows turn negative. Because the municipal market has such a large retail investor base, we tend to see reaction based selling. In other words, when bond prices are selling-off, retail is quick to reduce exposure.

10.22.18 bullet 1.png

So far in this redemption cycle, the market has held-in fairly well. We typically assess market health not just on overall performance versus other investment grade sectors, but also on how lower-rated credits are performing relative to higher-rated credits, the subscription levels of new issuance and our anecdotal trading observations. In all three areas, we haven’t seen anything that would cause significant concern. We will be paying close attention in the coming weeks however, not just how the market is trading, but how fund flows are evolving.

Source: JP Morgan, Lipper

Jackson Hole – Summer Home to Our Central Bankers

8.27.18 image 1.jpg

The Jackson Hole Federal Reserve Economic Symposium, held last weekend in Wyoming, is the only time of year when U.S. Central Bankers get to loosen their ties, breathe a little fresh air and wax philosophically about monetary policy. But let’s not get too excited—it’s no Burning Man!
We care about Jackson Hole as we hunt for short-term clues as to the speed of rate hikes and the destination for fed funds rate over the next few years. We all wonder if the Fed will pause raising rates for emerging market mayhem, if higher inflation or lower unemployment will push higher the fed funds target rate, or whether the committee is more likely to just gradually, modestly and carefully raise rates and shrink its balance sheet as the economy continues to improve?
Jay Powell, chair of the committee, clearly indicated there is no clarity. The world is uncertain, and the Fed’s crystal ball remains cloudy as it constantly tries to navigate between “moving too fast and needlessly shortening the expansion, versus moving too slowly and risking a destabilizing overheating.”  Mr. Powell reiterated the Fed’s talking points, that “if the strong growth in income and jobs continues, further gradual increases in the target range for the fed funds rate will likely be appropriate.”  Though he was quick to note that this is the consensus view, there are differing opinions on the committee. The markets interpreted his comments as mildly dovish, and stocks rose as the dollar fell.
Despite the good short-term news, Mr. Powell also commented on a number of longer-term structural challenges facing the U.S. economy that generally can’t be fixed by raising or lowering the fed funds rate. Real wages (particularly for medium- and low-income workers) have grown quite slowly in recent decades, economic mobility in the United States has declined and is now lower than in most other advanced economies, the U.S. federal budget deficit is unsustainable and there is continuing low productivity. More interesting side bar conversations included challenges to the economy stemming from monopoly power and corporate consolidation, the potential for technology to reshape how retailers set prices and the trade-offs between stability and competition in the banking sector. We shall see if these trial balloons get any traction!
Ultimately, it was no Burning Man in Jackson Hole, with no disruptive technologies announced or new visions for the future proposed. But when it comes to central banking, maybe cautious, conservative and calm is the best course.
Enjoy the last days of your summer.

Sources: The Federal Reserve, the Wall Street Journal, Bloomberg, the Financial Times

Muni Supply Hits a January Freeze

As the east coast digs out of the recent winter blast, the muni new issuance market is likely to be frozen for a while longer. Not because there are fundamental issues in the market, but because so much was issued in December, that there simply isn’t much left to do as we start 2018. We wrote about the tax-reform induced supply wave a few weeks ago here:
Thus far, the numbers are playing out as expected. December was a record month for muni issuance, with over $64 billion sold, surpassing the prior record in 1985 of ~$55 billion. Looking ahead, there was a meager $1 billion sold last week, and 30-day visible supply, which gives a rough indication of deals in the pipeline, stands at approximately $7.5B. We think this means municipals are poised for a nice run relative to other investment grade sectors as there simply aren’t enough bonds to go around. Returns last week highlighted this as the ICE/BAML Municipal index was flat, while the ICE/BAML Government/Corporate Index fell slightly. And while 1-week does not make a year, it could be a precursor of things to come. This trend is most impactful to our Blend Strategy, where we have the option of owning both taxable and tax-free bonds. As the muni market underperformed in December because of the heavy supply, we added exposure to the sector, and now look to benefit from the deep freeze. For more information on the Blend Strategy, see our recent blog post here:

Stay warm out there. 

Source: ICE BAML, Janney Montgomery Scott, SIFMA

2017 Review and Outlook

2017 Review and Outlook

At this time last year investors worried about the end of the bond rally that has been a force in fixed income investing for about as long as many of us can remember – where were you in 1981 when the bond bull market began with interest rates over 15%?  

Interest Rates Have Been Falling Since 1981

1.2.18 bullet 1 image 1.jpg

But as we all know, changes in interest rates are only one part of the bond return equation, with yield (i.e. income generation) being the other component. This is especially true in the intermediate and short end of the curve, where income determines the majority of a bond’s return. When one holds high quality intermediate bonds to maturity, as we often do, then income really determines returns. In looking at 2017, we see this illustrated quite well. Returns were positive in the year considering the 2-year treasury rose 72 bps, the 5-year 30 bps and the 10-year was flat.

2017 Returns                                                  BofAML Intermediate Returns (1-10 Yr)
Treasuries                                                               1.08%
Municipals                                                              2.83%
Corporates                                                             3.31%

In addition to demonstrating the power of income, this data highlights the impact (or lack thereof) that rate hikes by the Federal Reserve can have on bond returns. The three rate hikes in 2017 caused short-term rates to rise. However, bonds with short-term maturities exhibit limited price sensitivity to changes in rates, and when longer-term rates don’t move much, like we saw last year, bond returns are positive. Alas, these trends combined to produce an environment for bond investors that we have described as “the sweet spot.”

So, will we stay in the sweet spot this year? Let’s look at a few of the factors we expect will have an impact on fixed income markets in 2018.

Fundamentals: The economy is growing nicely in the United States and around the world. The recovery from the great recession has been frustratingly slow and sub-par compared with other recoveries, a real tortoise vs. hare recovery, yet this recovery has the potential to continue for a while longer in the absence of a major central bank policy mistake or a black swan.  

Consistent economic growth is a tailwind for corporate bonds and for municipal tax receipts. More people are working, companies’ earnings are very strong, the stock market is hitting new highs and property prices are rising. Adding to strong fundamentals are benefits we may receive from changes in the tax code. We do see much of the benefit going to corporations, which will likely result in higher dividends, stock buy-backs and capital expenditures. Yet there are some consumption benefits to lower personal tax rates. The combination of corporate and personal tax cuts could help extend this economic cycle by pulling demand forward. 

Technicals: Supply and demand should favor municipals in 2018. The supply of municipal bonds will likely be lower in 2018 as new legislation takes away the tax shield from some forms of municipal issuance. At the same time, the demand for municipals could grow in 2018 in high tax states where personal exemptions are newly limited. More buyers and fewer bonds could push up prices.

Corporates should continue to be supported, as domestic buyers are still looking for any return in a yield starved environment, and foreign buyers are still investing in U.S. markets as European and Japanese interest rates remain close to zero or even negative.

Valuations: We are not going to say valuations are attractive. After close to ten years of historically low interest rates we should not be surprised that just about all asset classes are rich: treasuries, corporates, municipals, stocks and even Seattle real estate, our hometown. 

But these asset valuations got rich due to a combination of low interest rates and a growing economy, and until these factors change the path of least resistance is for the rich to stay rich. 

Outlook 2018: The big question in our mind is when will inflation pick up enough for central banks to raise rates at a faster pace and tip this recovery into a recession. As economists often note, economic expansions don’t die of old age – they are murdered by the Fed!  At some point the Fed will get behind the inflation curve and be forced to more aggressively raise rates.

Still, we are not worried about inflation and aggressive Fed interest rate hikes at this time. Inflation remains stubbornly low in the U.S., with wages held in check by the powerful twin forces of globalization and automation. In addition to these factors, high government, corporate and personal debt levels tend to moderate growth and, therefore, inflation. We have a ways to go before the Fed acts decisively. As for Europe and Japan, we do not see pressure to raise rates in 2018 or even in 2019. Europe is still in recovery mode and Japan’s battle with disinflation is at best fighting to a draw. 

The final part of this forecast is the possibility of black swans, or the unknown-unknowns, as Secretary of Defense Donald Rumsfeld so famously quipped in 2002. Black swans are even more difficult to forecast than interest rates, but we do know they regularly occur, especially when the world is rapidly changing. In anticipating these unknowns, we feel we are structurally insulated from their worst impacts by duration neutrality; by holding high quality assets; by diversifying asset classes, industries and issuers; and through the benefits of separate account management.

We trust 2018 will be another decent year, whatever comes our way. Happy New Year! 

Source: Bloomberg, BofAML

MuniLand: Pension Obligation Bonds or Pension Obligation Bombs?

Last week the City of Houston came to market with a $1.0 billion voter-approved pension obligation bond or POB. As a refresher, POBs are issued in the taxable market by local and state governments for the purpose of paying unfunded pension liabilities. Key to the success of POBs is the ability to arbitrage the cost of debt versus the returns for the pension assets and reasonably managing future pension costs. If the issuer cannot earn enough relative to the cost of the debt, as well as manage the pension plans in a manner that reduces the pension liability, then the outcome will likely be credit underperformance and potential rating downgrades.

Enter the City of Houston and its notable pension reforms and POB bonds. Houston pension reforms are notable because of the implementation of “cost corridors” on pension benefits for current and retired fire, police and municipal employees. In Houston’s case, market risk was transferred from the City of Houston to the retirees and employees. There was also a reduction of the assumed rate of return on pension assets to 7.0% from 8.0% or 8.5%, the implementation of a fixed 30 year amortization period and, finally, the City’s request of its voters (through a ballot referendum) for a $1.0 billion bond to stabilize the pension plans. The level of compromise between voter, employee, retiree and the city can only be described as impressive.

Two key provisions of Houston’s pension reforms are guided by the “cost corridor” concept, which means if pension assets grow slower than pension liabilities, current employees and retirees could receive benefit reductions because the city’s cost would be fixed. This represents a transfer of market risk to the pension plans from the city. These reforms could be used as a national model for pension reform because they ask all stakeholders to give and take.

Even with all of the compromises and the potential stabilization of the City of Houston’s finances, S&P Global Ratings warns in its December 6, 2017 report titled “Pension Obligation Bonds’ Credit Impact On U.S. Local Government Issuers,” POBs are a negative credit factor if issued in an environment of fiscal distress or as a mechanism of short-term budget relief. Generally, local governments do not need to issue POBs if their pension systems are well funded, return assumptions are conservative and if the city or county is fully funding its annual required contribution. Clearly, if a local government is issuing a POB something has gone wrong. Houston’s problems started with poor funding and the miscalculation of its pension liability. The result was a quick deterioration in funding ratios and significant fiscal stress.

S&P is correct that POBs alone do not fix pension issues. There are many cases where aggressive return assumptions or poor timing lead to unfortunate outcomes. S&P cites the New Orleans, LA 2000 POB and Stockton, CA 2008 POB as examples of POB risk. Nevertheless, we do not view Houston in the same light as New Orleans or Stockton because of the major and far-reaching pension reforms the city enacted, its diverse and thriving economy (anchored but not dependent oil and natural gas activity) and its significant taxing authority. These credit factors help defuse potential Houston pension obligation bombs.

Source: S&P Global Rating