Podcast recorded December 6, 2016
In this podcast we discuss the recent increase in interest rates and subsequent bond market volatility and what it means for bond investors.
Hello this is Natalie Wright, product manager at Breckinridge and welcome to the Breckinridge podcast. Today I am joined by Adam Stern, Breckinridge's Director of Municipal Credit Research and we are going to discuss the election and its impact on the municipal bond markets. Adam, nice to have you back.
Thanks for having me.
So it has been one week since the elections. What does Trump’s rise and the Republican victory overall mean for the muni market, especially municipal credit?
You know, the election, I think the important thing for folks to keep in mind, it creates some new risks and possibly some opportunities for investors. The election, it may impact credit in a number of different ways and I’m actually glad you mentioned the Republican victory more generally, because you know, this is really, it's not all about the President-elect. The material difference here for the muni market is really that the Republicans had a sweep so the same party controls the House, the Senate and the executive branch and that means that the policy spigot which has really been closed off, you know, for the last six years is about to be reopened in some way, shape or form.
I see. Well what exactly are some of those risks and opportunities that you are thinking about here? Trump's trade or immigration rhetoric or other items like the Affordable Care Act, there has been a lot of policy issues brought up. The tax exemption, infrastructure, what are we thinking about?
So you know, I think, mostly the ACA, the Affordable Care Act, the tax exemption, infrastructure... those are sort of three big areas... but I do think it is important just to address trade and the immigration piece as well. I mean, those were his big campaign themes you know, and before getting into any of that, I think it is really important just to reiterate that right now everything is really up for grabs. We really do not know what the new president wants as much as we think we do. The only thing predictable about Trump so far has really been his unpredictability. He seems to be fairly non-ideological and may sort of go with what he thinks the best answer is and may change his view. He does not have a voting record. He does not have a consistent policy record to speak of. So we really start there before anything else just with uncertainty.
I see, so uncertainty is the main thing and there is so much that is unclear. As we look forward and think about some scenarios, which policies do we think could potentially be the most impactful?
Good, get me back on track there. So why don't I deal with trade and immigration first. So trade - Trump’s policy bent is pretty well-known and I think you have to accept as a base case that at least something will be done on trade policy, you know it's a little unclear, like a lot Trump's policies, specifically what he wants to do and of course the Republican party until this election has been a pretty pro-trade party. But, our expectation is that there will be something to do in terms of policy, which is not a positive for trade, though perhaps not as strong as he indicated on the campaign trail. So to the extent the trade flow slows, you want to watch transportation holdings. You have to expect some reduction in maybe airport and port cargo activity possibly. Looking at trucking - motor fuels taxes might be something also to pay attention to bond investors, coverage numbers for airports, ports, motor fuels, tax pack credits and toll roads. You know those are sectors to look at but right now we are not anticipating huge changes.
Okay, I get that, but how big are exports as a percent of GDP?
Yes, to put some more meat on that I guess... U.S. goods exports are about 12% of GDP, but it is lower than that state to state. So if you look at the auto states, in particular, Michigan, Kentucky, South Carolina, it is higher than 12%, Washington state is actually upwards of 18%, that is mostly Boeing, so you know, if something big was to get done, you might see some impacts on the economies in those states, but again not really something we are anticipating any huge change there
Okay, and I know that immigration reform was one of the primary themes of the campaign. What can you say there?
So immigration, I think you can make a case of there would be a modest impact on the higher education sector. So you know U.S. colleges and universities just passed in the last year, so the million student mark in terms of foreign students to the U.S. A lot of those students come so that they can get an H1B visa at some point and work, even if it is a legal status but not a citizenship status, in fields, technology fields, where we have a shortage of workers. There is probably some credit negative there for the higher education sector. Trump has said he wants to reduce incentives to hire H1B visa workers so that is something watch as well.
What about the affordable care act? I know that is something on the docket.
Yeah definitely, I actually think the Affordable Care Act is among the policy prescriptions that we may see come out of Congress, the most likely. House Republicans have voted around 50 times to repeal the ACA. Senate President Mitch McConnell has publicly stated that ACA repeal will be at the top of his agenda and House Speaker Paul Ryan's "A Better Way" plan outlines how to do it. Last year they already got a bill to repeal the ACA to president's desk. He, of course vetoed it, but importantly, that went through the reconciliation process which can be complicated so they sort of have some off-the-shelf language they can use. You know, repeal of the ACA is going to be a credit negative for hospitals and probably states as well as maybe even some local governments.
So they have had in a way a trial, so to speak, of the repeal and as we look forward, I know that nonprofit hospitals have been a big focus in markets. What would repeal mean exactly?
Yeah good question. So for hospitals, outright repeal is going to mean a reversal of the Medicaid expansion quite possibly, and elimination of subsidies offered on the exchanges that were set up under the Affordable Care Act. It might also mean the end of a lot of pay-for-value schemes. So to give you a sense of the scale here reversing the Medicaid expansion would push about 15 million insured people off of current coverage relative to what we had before the ACA and ending the exchange subsidies would push another 5 million on net off the rolls. Fewer insured patients, whether through Medicaid or through the exchanges, means higher bad debt expense for hospitals. I think having said that, to be fair, both Speaker Ryan's plan and Trump's latest statements strongly suggest that any sort of repeal or replace effort is going to be crafted to keep everyone who has gotten insurance the last few years still on the rolls. So we are unlikely to see a huge wholesale drop in coverage. But maybe the coverage will not be quite as generous. The Republicans’ plan involves subsidizing private insurance through a refundable tax credit and then things would be phased in, in terms of the replacement, although that legislation is not quite as clear. The other thing to think about is Medicaid. So the proposals that they have put forth in the house "A Better Way" plan, includes transforming Medicaid into a block grant program or what is called a per capita grant program. Both of these changes would be enormous to Medicaid. So they would be the first major changes since the inception of the program in 1965 and while the immediate impact on states and hospitals are not going to be enormous. It is likely over time we would see slimmer margins. So under either of these scenarios a block grant or per capita grant structure, the scheduled growth rate in federal funding is going to be lower than the annual healthcare cost growth. So this is going to reduce federal liabilities over time and offload more risk on to the states and hospitals to manage more efficiently. Whether that happens or not, I think that is a little up in the air, but it is important to realize here that some states from a credit perspective, and even counties pick up some of the tab for Medicaid services. So if states do not change what they do, certain states could be impacted over time, especially states that offer more generous Medicaid plans over and above federal minimum requirements. The one thing I will say is that while there has been some concern about these pay-for-value models of care where the hospital takes on the risk, for example, they insure a bunch of patients and they get paid whatever it is $100,000 per patient and as long as they keep the person healthy they get to reap the rewards of that and if they end up spending more money than $100,000, they lose some money. These pay for value models. It looks like those are to be here to stay. The house Republican plan is largely in favor of the concept and certainly hospitals across the country have spent a lot of money on the IT infrastructure to manage population health and pay for value models and private insurers are moving in that direction anyway. So that will tend to trim margins going forward, but repeal of the ACA may not have as big of an impact in affecting that area of the law.
Okay, so that's healthcare. Could we switch gears and talk about infrastructure, I know that Trump has espoused infrastructure spending as sort of a fillip for the economy. Any thoughts there?
Yeah definitely, good question. You know, behind ACA reform may be infrastructure policies, the second most likely item to be tackled on the president's agenda in terms of its relevance to munis. I think from a political standpoint, both parties have expressed significant interest in an infrastructure deal and they have shown the ability to get something done just in the past couple of years, so they found a way to get a multiyear authorization of the highway trust fund done last year and now they have got a president who is on board where maybe some other Republican presidents would not be. Trump's plan specifically is new for muni folks. So it looks like it includes somewhere between $500 billion in $1 trillion in new funding. He has also mentioned tripling investment in the clean water revolving loan program and of course he is a builder so it is not unreasonable to assume that among some of his bluster, he really does want to spend money on infrastructure, but the details of the plan involve a lot of private seed money and has a private equity feel and likely would have to involve some public-private partnerships and it is just unclear exactly how it is going to work. You know the market's challenge with infrastructure right now is that most plans lack a specific funding source, not really new financing mechanisms. But I think there is a lot of discussion around this area and we will see how it transpires.
Okay, so a lot of uncertainty there as well. We have not talked about the tax exemption yet and I know that is on the minds of many investors. What do we see there?
Yes. So obviously for investors, the most important thing to be thinking about is really the tax exemption. Curtailment or elimination of the of the exemptions is, in my view, slightly less likely than some sort of infrastructure bill or even ACA repeal, but some change to the exemption is more probable than not, at least in our view here. You know first, tax reform and stimulative tax cuts are a major priority of this Congress and the president. So if you look at Speaker Ryan's plan and the House Republicans, they have a plan at the ready. It can be passed through budget reconciliation so they do not really need 60 votes if they do not want to find them. Recall a budget reconciliation has, for better or worse, really become an almost normal way to get legislation out of Congress. It was used during the 2003 Bush tax cuts and to pass the Affordable Care Act. Second, Speaker Ryan's plan and the president elect's plan, they are about the same in terms of tax brackets so three sort of brackets, a 33% bracket, a 25% bracket and a 12% bracket. They are both more or less silent on the tax exemption. They would also cut taxes on investment income. So even if they do not intend to touch the exemption directly, lower rates would diminish the value of the exemption for investors. Third, to get the margin rates down, obviously, it would help to curtail or eliminate the exemption itself. So according to tax foundation, the exemption is the eighth largest exemption in the federal tax code and costs the treasury about $34 billion a year and you know, my best guess is something may get lost in here. It is probably most likely it is something relatively minor, like disallowing the exemption for truly private activities like a sports stadium or for some economic development projects, but it could be something more like ending the exemption for nonprofit hospitals or private colleges.
Well what should we think about as bondholders? What does this mean for current holdings?
Yeah, that is an important question. So current holdings I think as a base case if something gets done are unlikely to be impacted. You know there was a risk a few years ago when we had fiscal cliff negotiations, that bonds that were currently outstanding might become...the interest on those... might become taxed. But I think it is important recall those negotiations were largely about raising revenue and to a lesser extent relieving income inequality, but the tax reform we are talking about here is an across-the-board cut for everyone and streamlining and making more efficient the current tax code, so there is no reason to really go after bonds currently at standing given what the goals are. One caveat to all of this by the way, is that under both the House Republican plans and the president's tax plan, we are talking about large increases in the federal deficit. The Tax Policy Center, which is a place where I think the scorecards they use are pretty good, notes that Trump's would decrease federal revenues by $6-7 trillion depending on whether you want to use dynamic scoring or not. And the question on all this stuff is, you know, how affordable is it? So even if they did do some base broadening or rate cutting maybe the brackets are different than what they have been talking about and you know, when the rubber meets the road, it is always hard to put through a tax plan. Ideologies tend to fall by the wayside pretty quickly.
I can see that with all the impact that it would have on the deficit. Well, we touched on a lot of things thus far. Are there any other things we are thinking about post-election that might impact credit?
I think there is some, you know, maybe under the hood risks we're thinking about in terms of federal appointments and you know I think it is also we are thinking about taking stock of what is going on at the state level too. So recall that the Republicans now control the legislative and executive branches in 24 states. That includes 32 legislatures, up from 14 in 2008. So on the margin, the sort of control is probably meaningful for things like trying to pass the right to work laws, instituting 401A programs for new employees as opposed to pensions, possibly maybe having more charter schools. All of these sort of policy issues do have long-term credit implications.
So those are some possible marginal impacts from the election that seem like longer-term items, and I recall you wrote over the summer a piece on populism globally and how that impacted U.S. muni markets. Is there anything populism related we should be thinking about? What about willingness to pay in what is a very populist election result?
I think it is important just to reiterate this point. We have been talking about willingness risk being elevated for quite some time and over the summer did put out a piece on populism in the muni market. I think this election really hits this point home, that the public and elected leaders seem willing to throw caution to the wind more often than they have in the past and when we enter the next recession, it is just common sense on some level to just be a little bit more vigilant of the risk that you know some folks may decide to blow up covenants or threaten creditors in unexpected ways. Now I want be clear, you know, that being said, high-grade munis, bread-and-butter essential service revenue bonds and GO bonds, those are unlikely to be impacted by this sort of behavior and that is what we do here at Breckinridge. But it just does provide a little more evidence that this willingness risk is elevated.
Thanks so much, Adam. Please see Adam's piece on populism, "Thoughts on Modern Populism in the Muni Market," which is currently available on our website.
Thanks so much for joining us on the podcast today, we hope that you found it informative and we look forward to you joining us next time.
DISCLAIMER:The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state and local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.
Podcast recorded December 6, 2016
In this podcast we discuss the recent increase in interest rates and subsequent bond market volatility and what it means for bond investors.
Podcast recorded April 17, 2015
A review of the first quarter in the muni market
By Adam Stern
The President’s continued emphasis on infrastructure investment is not entirely shared by Congress, which has prioritized replacing the Affordable Care Act (ACA) and revamping the federal tax code.