April 2014 Municipal Market Credit Review- “A Muni Market Buffet”
The municipal market continues to be a challenge for long-term relative value investors. Year-to-date municipal bonds are one of the top performing asset classes due mainly to their scarcity. A large drop in issuance is supporting historically rich market levels that are getting close to where they were last summer. In fact, there has been more excitement in the research and news world of munis over the last 30 days than in the market. Unfortunately, that’s like saying the halftime show at the Super Bowl is better than the actual game. This month, we discuss the following:
- The lack of value in the municipal market and what to do as we wait for it to return.
- The “buffet” of municipal news and research on topics that we have been following, and how they may affect you.
April 2014 Municipal Market Review:
The 2014 nightmare continues for municipal underwriters and traders as bond issuance and yields remain quite low and market activity slow. We feel the main reason for the muni outperformance in 2014 is due to the drastic drop in supply, coupled with taxpayers seeing their 2013 tax bill. Year-to-date, issuance is 69% of 2013’s. If you want to look back even further, 2014’s issuance is 40% lower than the past five year’s average. This lack of supply is causing the market participants to become complacent and trying hard to identify value. This is leaving those who chose to invest to either buy bonds with maturities of five years and less, or reaching for additional income by buying high yield bonds. More specifically:
|Asset Class||% Returns YTD|
|Barclays Muni High Yield Index||6.8%|
|Barclay’s Muni Bonds Index||4.5%|
|S&P 500 Stock Index||1.8%|
- Through the 1st four quarters of 2014, municipal bonds are a top performing asset class. Results are in in the chart to the right.
- Muni investors in search for additional yield have bought high yield bonds (bonds rated below BBB-). Year-to-date, the Barclay’s High Yield index has outperformed the national muni market by 230 bps.
- Those muni investors looking to stay defensive have invested in the short-end of the market. This has caused the curve to be steep, which is reflected in the muni to swap ratios:
- 5-year muni yields look rich versus swap rates at 69% versus a long-term average of 73%.
- Longer muni yields (25-year) look cheap on a relative value versus swap rates at 100% versus a long-term average of 90%. Yet, the actual level of 3.44% (AAA 25-year rate), is historically rich for a 25-year bond.
So what is a relative value investor to do, especially with the prospects of more cash being available in the coming months?
Investment Strategy Review:
We are starting to think this “rich” market may continue through the summer, unless the economy or Fed changes the market’s perception of interest rates. Muni demand will only get stronger as we approach the summer months, and if issuance remains slow, yields will probably stay at current levels or drift lower. We advise staying defensive for the short-term and are encouraging investors to invest cash in short-call high coupon bonds for the upcoming months. This short-term strategy will allow an investor to earn income, and still have some price protection while waiting for the market to correct. When yields finally increase, the initial correction should be in longer term munis. At this point, it will be time to sell shorter term bonds and invest out the curve quickly, as we fear the next wave of selling will be the “rich” short-end as the entire muni curve begins to flatten.
The month of April brought us a lot of interesting news from the municipal research world. This month’s credit report is going to be a “buffet” of muni news that we think should be of interest to investors.
Detroit Bankruptcy plan has been amended and we were not surprised to see that the unlimited, voter backed General Obligation debt is finally getting some respect. The new plan is as follows for municipal bond investors:
- The unlimited general obligation bonds, (voter approved and have a statutory lien on tax revenues) will now receive 74% of principal versus the initial 15%. It appears the insurers will pick up the remaining 26% and most likely keep all investors from losing any principal.
- The limited General Obligation bonds will still receive only 15% of their principal. This is a harsh lesson for investors to learn that there are differences in General Obligation bonds.
- The CTF’s used to finance the pension obligation bonds appear to be receiving nothing.
- Detroit Water & Sewer will still be unaffected by the Chapter 9 proceeding. The big question remains whether they are refunded early as part of a system break up, or stay outstanding to their earliest call date. Either way, it appears the bond holders will most likely receive 100% of principal.
What does this mean for MainLine West customers? It means that a full faith and credit pledge made by a municipality, approved by voters, with a source of funds dedicated to repay the bonds is protected under Chapter 9 proceedings. It does, however, also support our belief that an investor should not have to pay up for a General Obligation bond (receive a lower yield), versus an essential service bond.
Merrill Lynch/Bank of America’s municipal team did a study on the municipal market’s liquidity by analyzing the bid/ask spread for different size trades. The information was reported in their Municipals Weekly document published 4/4/14. The highlights of the study are as follows:
- The difference between a bid/ask spread for a par amount of $25,000 and that with a par amount greater than $100,000 is .94% (155 bps vs. 77 bps). This can greatly impact the yield earned when buying or selling the bond.
- $1 million and greater par amount enjoys the greatest efficiencies with the spread at roughly 17 bps.
What does this mean to MainLine West customers? This supports our belief that investors should purchase bonds in increments of $100,000 or greater when they have a portfolio $1 million in par or greater. The larger the trading size, the more efficient the execution and therefore the higher the income to the investor.
The Fiscal Health of State Pension Plans was published at the end of March by the Pew Charitable Trust Institute and showed that funding levels by states worsened in 2012 as compared to 2011. The highlights of the study are as follows:
- The state average unfunded pension gap widened by 2%, from 74% funded to 72%.
- States making improvements over the year were as follows:
Washington (95% funded), and Oregon (91% funded).
- States with weaker funding levels were as follows:
Connecticut (49% funded), North Dakota (63% funded), and Mississippi (58% funded).
What does this mean to MainLine West customers? This continues a bad trend of states not funding their pension plans as they should be. We do anticipate, when the next study is released in March of 2015, that we will see this trend has reversed, with increased funding having begun in 2013.
Puerto Rico’s (PR) credit outlook continues to be classified as “developing”. PR 2014 fiscal budget shows it they will not need to access the capital markets again until fiscal year 2015. This is good short-term news as it removes any possible liquidity and solvency problems in the near term. Other recent news reports that PR has hired restructuring experts, causing many investors to wonder what they may be up to. Long-term, the demographics remain negative for the Commonwealth. Economic growth has yet to return, and debt levels are unsupportable by the current resident base. There needs to be economic growth, and a halt to its declining population trend.
What does this mean to MainLine West customers? We recommend only investors with strong stomachs and expertise in purchasing distressed bonds be invested in Puerto Rican debt.
With many of the signs pointing to a “rich” market continuing through the summer, we advise staying defensive for the short-term and encourage investors to invest cash in short-call high coupon bonds for the upcoming months. This short-term strategy will allow an investor to earn income, and still have some price protection while waiting for the market to correct.