Podcast recorded August 9, 2016
This week’s podcast discusses the disadvantages of laddered strategies, one of the most common strategies for fixed income investors.
Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today we will be discussing market events for the month of April. For the municipal side, I am joined by Matt Buscone, co-head of portfolio management here at Breckinridge and a member of our Investment Committee. So Matt, at the end of our March podcast, we talked about how uncertainty around healthcare and tax reform would be the key themes as the second quarter began. So should we start with updates on those areas today?
Yeah, we should and I think it makes sense to start with healthcare since the house recently passed legislation to repeal and replace the Affordable Care Act. The vote was very close and it does seem likely the Senate is going to rewrite its own bill and we have not seen a score yet from the CBO. So unfortunately, like we have talked a lot about these policy decisions over the last several months there is still a high degree of uncertainty around it. So it is still somewhat hard to see what the impact will be until we get the Senate’s final version and time frame but it does create some negatives again in the muni space, particularly for lower rate and healthcare credits and potentially some uncertainty for state budgets in its current form right now. So there is still a long way to go on that but as we have been back and forth on this several times it seemed more likely about a month ago. Then the bill was defeated the first time around and now it is back on the burner so continuing to see multiple evolutions of the healthcare reform.
I see. So still some uncertainties there, and what about the tax side? Have we seen some progress on tax reform?
The president did release an outline of his tax proposal with the main goals of being lowering business tax rates and broadening the tax base. The plan decreases the number of brackets and lowers marginal rates across the board. The Affordable Care Act surcharge will go away and rates on other forms of investment income will be taxed at lower rates as well. The plan also removes the deductibility of state and local taxes from your federal return and the elimination of the alternative minimum tax. And on the corporate side a tax rate of 15% was proposed.
Are any of those changes a negative for the muni market?
So the muni exemption was not specifically targeted, nor was there a cap placed on the amount of income you could earn from munis. We have seen that with the last several budgets under President Obama so that is a positive, but lower marginal rates and lower taxes on other forms of investment income are a negative for munis as it makes them slightly less compelling. But it does seem less likely that we will see transformative tax reform which would have been more negative for munis. The removal of state and local deductibility is likely to produce more in-state demand and high tax states like California and New York and unfortunately, while it sounds a little bit like a punt we talked about on the healthcare side, we really do need more detail on tax reform before we can make changes, and that timeframe for tax reform is dependent first on what we see from the healthcare side. So if healthcare makes progress over the next couple months, potentially you see tax reform come later in the summer.
I see. Well, switching gears now from the policy side back to the market side, can you give us an update on the economy and the Fed?
So in April the economy was met with a weaker batch of economic data that included some softer readings on retail sales, lower readings on inflation, and sub 1% GDP growth for the first quarter of 2017. Now we have seen this in several years past where the Q1 growth has been weak and it has rebounded for the rest of the year. So both the Fed and the market seems to be anticipating a similar rebound this year with growth expected to be north of 2.5% for the second quarter this year. But this in combination with lower job gains earlier in the month casts some doubt on the strength of the economy and you also had some geopolitical concerns over the month with elevated negative rhetoric around North Korea and the bombing in Syria that made headlines, so that contributed to a bit of risk aversion during the month as well.
Okay and what is the Fed expecting for the rest of the year at this point?
So the odds of a Fed rate hike for June now stand at over 90% although there is starting to be a little divergence again between Fed expectations and what the market is pricing in via the futures market. The Fed projection showed two more hikes this year, while the futures market is projecting just one, and as I mentioned a little bit earlier the Fed indicated in their most recent statement that the weakness in economic growth in Q1 is likely to be transitory and the weak GDP print is unlikely to alter their path of rate hikes. There is also starting to be more discussions about beginning to reduce their balance sheet by curtailing the reinvestment of its Treasury and MBS portfolios that are maturing, and some Fed officials have been out and saying they expect the balance sheet to return down to the $2 trillion range from its current range of north of $4 trillion.
And how did that impact Treasury yields?
So Treasury yields remained range bound for most of the month but they did hit a year-to-date low of 2.16% on the 10 year following that brief flight to quality trade that was mainly sparked by those geopolitical concerns. That marked about a 45 basis point drop from the high of 2.62 that we saw back in mid-March. Over the month, the best performance was in that 5 to 10-year range with yields following 10 basis points, while 2 and 30-year maturities fell by only 5.
Okay, did muni bonds exhibit similar changes?
So muni yields did fall the largest decline was again, in that 4 to 10-year range. Those were also lower by about 10 basis points, 20-30 year yields were lower by about 3 to 5 basis points, a pretty similar performance to what you saw on the Treasury side, but yield volatility reached a 90 day low during April, and you can really characterize the muni market in April as sort of slow and steady over the month.
And returns for muni bonds were positive every month of the first three months of the year. Did that continue in April?
It did. So not only for the first four months of this year, but if you go back to December, we had positive returns as well. So now we are talking about five straight months of positive returns. The Barclay's 1-10 Blend index returned 64 basis points over the course of the month. Short maturity bonds, those in the 0 to 3-year range, had the lowest returns up anywhere between 16 and 30 basis points compared with the 10-year spot that was up almost a full percentage point at 96 basis points. And unlike some of the other months this year where BBB rated bonds have outpaced higher quality, this month, the A rated sector performed the best, outpacing other categories by 7 to 16 basis points depending on where you were.
What was the big driver of returns during the month?
You know, I would really point to the supply side. Municipal supply fell for the third consecutive month just over $28 billion worth of issuance for the month of April. That is down 20% from what we saw in April 2016 and for the year now, new issue supply is off 12%. And again, this month we saw new money deals outpacing refunding volume as they increased 33%. You contrast that to a 50% drop in refunding volume over the course of the month. So that is typically what had been driving issuance over the last year, had been the elevated pace of refunding issuance, that continues to decline. Demand was strong earlier in this month as weekly funds reported over $1 billion worth of inflows in the first two weeks compared with the trailing five-year average of outflows of $52 million during that timeframe. April has historically been a weak month for muni demand as oftentimes investors redeem from their muni mutual funds to pay for taxes. That was not the case this year, so you take a combination of low new issue supply and some positive support from mutual funds combined to make a very strong technical backdrop for munis during April.
Okay, so given the good run we have seen in performance partly driven by those technicals, what does the relative value look like in munis right now?
So ratios to government bonds are down substantially from the highs that we reached post-election. Some of that is due to less concerns about tax reform that targets munis specifically, some of that has been somewhat of a stable rate environment that has encouraged people to get back into munis. But if you look at 10 year ratios that had reached, call it 106% in early December, those were down at 94% at the end of the month. And if you look at the front end of the muni curve, say 2 to 3 year maturities, those ratios have seen the most amount of compression. Both of those spots were close to 108% in early December and they are now down back to the 76% area. The 30-year spot, the long end of the muni curve, has shown the least movement. That has come down from a high of 108 to 102%. So certainly the strong rally in good returns of the last several months has removed some of that more attractive relative value that we saw in tax-exempt munis post-election and in early December 2016.
And what about slope? What does the slope of the curve look like?
So one of the real strong performers so far this year has been the five-year maturity and so if you look at the slope of the 1 to 5-year part of our curve, the amount of basis points that you pick up from extending from 1 year out to 5, that is down to just 55 basis points right now. That had peaked at close to 90 basis points earlier in the quarter, I think late January. The pick-up from 5 to 10 years is a little bit more compelling if you extend to a 10-year bond now from a 5-year bond, you are picking up 73 basis points. The peak of that slope was 85 basis points earlier in the year, so a little bit better relative value out of the 10-year spot but like we talked about the in ratio side, curve not quite as steep, there has been some flattening so not quite as attractive to extend now as it was earlier in the year.
Okay, then let us switch gears again and move over and look at credit. Can you give us some thoughts on the credit environment?
So credit fundamentals for high-grade issuers remain largely intact. They have been driven by improving home prices and employment growth that remains positive in most parts of the country. On the pension side, strong equity returns have helped pensions during the first quarter. I think I read they were up 4-5% during Q1 so that certainly helps. So by and large the credit environment continues to be stable. There are, however, still several high-profile states that are struggling.
What about Illinois?
So you would certainly put them in the basket of one that continues to struggle. Illinois is at a credit tipping point. It is coming up on three years without a budget after which it may be more of a challenge to maintain its credit fundamentals in the market's confidence. If the state fails to enact a budget soon, it is likely that at least one of the major rating agencies will downgrade Illinois to below investment grade and that will be unique, particularly in this era post bond insurance other than we have such a large state potentially in junk territory. In Illinois, the backlog of unpaid bills continues to grow. That is accruing at a high rate of interest as well, and that stress is continuing to be pushed down to some of their local credits as well. And you have also started to read more about the State of Connecticut. They are popping up more and more in the headlines. They have had some repeated revenue shortfalls from income tax collections and that has opened up a pretty sizable gap in their budget. So more and more states starting to see more and more struggles on the budgetary side.
Okay, so definitely two states to watch there, and then what about Puerto Rico? There were some negative developments there recently, is that right?
There were. The island did file for Title III relief in U.S. District Court that was created under the PROMESA Statute last year. On May 1st, the automatic stay under PROMESA had ended, and in the past two days Puerto Rico has been inundated with lawsuits demanding payments from the island. Title III would place another stay on those suits by establishing a court supervised process akin to Chapter 9 and the recent price action implies that investors are starting to favor the GO bonds over the sales tax bonds. Those prices have fallen more sharply over the last several weeks. We have still got a very long way to go for Puerto Rico but now it is likely that you are going to see a bankruptcy-like proceeding where a judge may determine what the haircuts may be for the GOs or the sales tax bonds, or who gets favored. So again, still a long way to go, but Puerto Rico continues to be teetering.
Okay, and it sounds like there are some important lessons that could potentially come out of that for the muni market.
Yeah, I think you are really talking about, you know, what is going to be the preferred security structure. Does a general obligation bond remain, sort of that most secure and safe structure? Or does the sales tax bond which has a lien on those proceeds get preference over the GOs? And that is certainly what the different investors that have filed lawsuits are claiming in their suits, saying who owns this revenue stream and I think what it will boil down to is when you get to a credit that is this distressed does all the revenue go into the same pot and does everybody get treated equally? Or does one class of creditors get treated differently because of the security lien they own?
Well given all these issues, what do we see having the biggest impact on the muni market over the next few months?
So, certainly any changes to tax reform that impacts munis more directly will need to be watched. If that plan changes and it is more negative to munis, we would certainly see a readjustment of the relative value on the muni side, but we are also in a time period now where the amount of maturing bonds is very high. Between May 1 to September 1, I think there is over $120 billion worth of maturities coming into the muni market. That potentially creates a huge amount of demand in an environment where supply is still very tight, so that may be setting us up for a strong technical backdrop in munis over the summer.
All right, great, well thanks so much, Matt.
Now let us move over to the corporate side. I am joined by Khurram Gillani, a member of our portfolio management team. So Khurram, on the corporate side, how did performance look for the quarter?
The Bloomberg Barclay's Corporate Index returned 107 basis points or 23 basis points of excess return during the month. Long corporates returned 163 basis points or 23 basis points of excess returns and intermediate corporates also had positive returns but lagged slightly. Intermediates had 83 basis points of total return and 22 basis points of excess return. So overall, it was a pretty good month for IG corporates.
What about spreads? Can you give us some color there?
Spreads remain range-bound. They actually tightened 2 basis points in April. They are about 7 basis points tighter year-to-date. Most Bloomberg Barclay’s sectors were better on the month especially home construction, refining, midstream paper and life insurance, airlines, autos and supermarkets were about 1 to 2 basis points wider on the month.
And can we look at some other asset classes in comparison, was this more of a risk-on month? What do you think?
I would say so. So equities and high yield were up 1% while the VIX hit new cycle lows. Crossover bonds displayed the best performance, generating 69 basis points of excess returns, then BBB outperformed single-A AA and AAA and generated 29 basis points of excess return during the month. Single A bonds lagged a little generating positive 17 basis points of excess returns per Barclay's.
And what about sectors? Can you give us some thoughts on which sectors performed better and worse?
So industrials outperformed financials which outperformed utilities. In terms of tenor, long industrials generated the most total and excess returns, 168 basis points and 28 basis points, respectively. As I alluded to earlier, energy refining, midstream and old fuel services all showed positive total and excess returns despite the continued volatility in oil prices. On the other hand, airlines, autos and supermarkets displayed negative excess returns on the month. Oil peaked at about $53 a barrel in April and ended the month 7.5% percent from its peak in April. There is continuing concern that the pace of higher U.S. crude output is not going to be enough to offset efforts by OPEC to limit output. Also, autos were noticeably wider on weaker than expected auto sales report and negative news on used car prices, and diminished Q1 earnings expectations.
Let us switch gears and talk about technicals. Can you give us some thoughts on supply and demand?
So the first quarter produced record supply at over $400 billion. In April the final supply number was $84.5 billion, down from $129 billion in March 2017. This is still a solid figure, but the lowest April since April 2012. A slowdown in M&A funding, companies frontloading new issuance, and earnings blackout period contributed to the lower level. However, 2017 year-to-date is running 5% ahead of last year's record pace. On the demand side, demand continues to be very robust. Fund flows remain supportive as investment grade funds extended their streak of inflows. High-grade corporates and high-grade agg funds reported over $10 billion of inflows in April per Lipper, bringing the year-to-date number to $76.4 billion. Net form purchases of U.S. credit continues to remain strong, especially from Europe and Japan. Also most deals were oversubscribed and new issue concessions were minimal averaging 4 basis points in April. Some of the bigger issuers of the month included $5.25 billion of JP Morgan 5 and 10-year, $4.5 billion of 5 and 30-year Citi, $3 billion of 10 and 30 Loews, and $4 billion of 2s and 10s of American Express. And Pepsi $3.4 billion 2s, 5s and 30s.
And I know we are deep into earnings season. Can you give us some thoughts on how earnings are coming out?
So, so far first-quarter earnings have started off very solid. However, high gross leverage, a high-level of share purchases and an uptick in M&A deal discussion are all symptoms of late credit cycle behavior and are challenging fundamentals. On the other hand, in the bank sector high levels of liquidity and capital are a credit positive. We are continuing to monitor a Congressional bill that could make material alterations to Dodd-Frank which could be a headwind for bondholders. We are continuing to monitor C&I loans which have decelerated over the last six months, indicating some low-down in lending activity. New Fed data shows C&I lending down to 0.4% on an annualized rate and consumer loans are flat. However, Q1 2017 earnings expectations are very high and the street is expecting to be the best quarter since the fourth quarter of 2011.
And let us switch gears again and talk a little about tax reform, one of the main issues for investors right now. Can you give us some thoughts there?
Yes. So the Trump administration and some Republicans have proposed cutting corporate tax rates, eliminating the tax deductibility of interest, accelerating the tax deductibility of CapEx and implementing a one-time tax holiday to repatriate overseas corporate earnings and cash. Reducing the corporate tax rate would obviously be positive for after-tax corporate earnings. If this legislation were passed, it could slow down debt issuance over time with less needed to issue debt in the U.S. to fund shareholder rewards such as dividends and share buybacks. The outcome of a tax holiday would also be a credit positive. This would likely benefit large U.S. multinationals with sizable overseas cash holdings, especially in the healthcare and technology sector. Depending on how the liquidity was utilized, we could see some debt reduction from that cash that is brought back overseas. We could also of course see higher CapEx, more share buybacks and special dividends as well. So we are continuing to monitor the potential tax reform very closely.
I see. So a lot of things to think about in the corporate market with respect to tax reform.
That is right, yes.
Well thank you so much. We hope that you in the field have found this informative and we look forward to you joining us on our next podcast.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
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Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
Podcast recorded August 9, 2016
This week’s podcast discusses the disadvantages of laddered strategies, one of the most common strategies for fixed income investors.
Podcast recorded June 14, 2016
In this podcast we discuss the different types of bond yield measures.
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