Podcast recorded September 11, 2015
This podcast discusses the recent volatility in the markets.
Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today we will be doing a recap of market events in the month of August. I am joined by two of our portfolio managers, Eric Haase and Khurram Gillani and we will be going through some of the major market events of the month. So, Eric, interest rates were essentially unchanged over the month of July, did this trend continue into August?
The U.S. Treasury markets started the month very sluggish and became much more active as time went on. Ultimately, the curve bull flattened. The 5-, 10- and 30-year U.S. Treasuries ended the month at yields of 1.70%, 2.12% and 2.73%, respectively. So, the longer end of the curve dropped the most in yield, but the 10 to 30 maturities ending the month approximately 17 basis points lower, while the 5-year only dropped by around 13 basis points. At a 2.12% yield, the 10-year closed at the 2017 year-to-date low. Since the end of March, the 10-year has been trading in the 2.12% to 2.4% range. So, it will be interesting to see if we bounce off the lows or break down in yields.
Okay, so given what happened with the curve, what is going on in the geopolitical or macro-space and how might that be affecting yields?
So, the major geopolitical story for the month was the continued conflict with North Korea. Threats of action from both North Korea and the U.S. and the allies, culminated in North Korea launching a missile over Japan on August 29th. Yields have moved in reaction to threats with yields decreasing in times of concern and a flight to quality and increasing as the situation cools down.
Got it. Well North Korea has clearly been a driver of yields, but what other events occurred over the month?
There were a lot of geopolitical events this month. There was additionally a terrorist attack in Barcelona, Spain, racial tensions in Charlottesville, Virginia, delays in the completion of the administration's agenda items and the arrival of Hurricane Harvey at the end of the month on the southern shores of the United States. These have all resulted in a flight to quality.
Okay and what are the major political hurdles that exist in the U.S. right now?
So, Congress has a busy agenda over the remaining months of 2017. At the forefront is the need to approve approximately $8 billion in funding for disaster relief after Hurricane Harvey ripped through the south. In addition to that, they must pass a budget, and raise the debt ceiling by September 30th. Initially, the White House had been adamant that the new spending bill would have to include funding for a border wall. However, it now seems that they may pass a continuing resolution which would keep the government funded at current levels for three months and require Congress to address this issue again in December. Additionally, tax reform is still being discussed with the hope that something is done on the corporate side by year end.
Okay, well moving on to economic data, how did the macro data for the month of August look?
So economic data continues to be a mixed bag. Inflation data is underwhelming yet again with both PPI down 0.1% and CPI staying steady at 1.7%. The readings were the same for both headline and core but on the positive side, the second reading of Q2 GDP came in at +3% and that is up from an initial reading of 2.6%. The revised number is the highest reading in two years and is driven by stronger household spending and a bigger gain in business investment.
Okay, well the Fed did not have a meeting in August, but they did release the minutes from the July meeting, as well as host the annual Jackson Hole conference. Were there any takeaways?
Overall, the minutes from the July meeting were more dovish than anticipated. Members discussed concerns regarding below target inflation, and the potential for it to last longer than they had anticipated. Additionally, they continued to hint towards a balance sheet announcement in September. The Jackson Hole conference was largely anti-climactic with Yellen discussing the reforms and regulations that have made the financial system more resilient rather than monetary policy.
Okay and how has all of this impacted the expectations for Fed rate increases going forward?
So currently, the market is applying a near zero chance of a rate hike in September, and only a 36% chance of a rate hike in December. Any increase in pace of rate increase would cause additional volatility in the market.
Okay, and switching gears now to talk about munis, did muni bond yields move lower over the course of the month?
Like U.S. Treasuries, municipal bond yields ended lower for the month of August. The largest drop in yields took place 20 years and in, where yields dropped anywhere from 7 to 11 basis points. The 2-, 5- and 10-year maturities ended the month at 85, 112, and 186 basis points. The 2- and 5-year maturities closed the month at the year’s lows, while the 10-year was near the low which was a 183. The 30-year muni ended the month at 2.70 which is four basis points lower than July 31st.
Okay, so we see that munis fell along with Treasuries, while for the month of July, munis outperformed Treasuries resulting in lower ratios. What about ratios for the month of August?
So, demand continues to be very strong at the short end of the curve with ratios in the 2- and 5-year maturities closing lower over the month. The 2-year ratio dropped from 70% to 64%, which is near the year-to-date low. The 5-year ratio remained in the low to mid 60s for most of the month and ended at 66%. The 10-year and 30-year ratios increased over the month ending at 88% and 99%, respectively.
So last month Matt Buscone mentioned that Breckinridge was looking at crossover opportunities in the taxable municipal bond space, as well as the relative value in the U.S. Treasury market. Any updates there?
Sure, so the previously mentioned ratios reflect the relative unattractiveness of municipals in the front end of the curve. So, we continue to analyze the after tax yield advantage of purchasing taxable municipals and U.S. Treasuries in tax efficient strategies. So, although the after tax yield on taxable municipals can still make sense at the lower tax bracket accounts, it remains difficult to source compelling opportunities in the market. Where we have permission, we have been purchasing U.S. Treasuries that mature in the 3- to 5-year range. This is a yield pick-up for low and mid bracket accounts and a relative value trade for those in the high bracket as we believe that U.S. Treasuries should outperform municipals as ratios normalize back to more traditional levels. Furthermore, U.S. Treasuries have lower transaction costs than taxable municipals.
I see. Well overall, how is municipal performance and were there any trends?
Municipals had another positive month as longer duration and lower credit quality assets performed the best. So, beginning in December 2016 the Bloomberg Barclay's Municipal Bond index has turned in a positive return in every month except for June. The index returned 76 basis points for the month of August and is up 5.2% on the year. Bonds maturing 12 years and longer were the best performers earning 95-100 basis points, while bonds maturing in 1 to 2 years, only earned 23 basis points and the 4- to 6-year part of the curve return 65 basis points.
Okay well you mentioned credit. How did lower credit quality add to performance?
So, in August the AA rated portion of the index was up 0.63% while the A and BBB portions were up 0.94 and 1.43, respectively. There continues to be a lot of demand for yield in the market.
So, August is historically a quiet month in the market due to less participants. Has the positive technical, the supply and demand dynamic remained in place that we have seen this year?
It continues to feel like Groundhog Day. Another month has passed with limited supply and steady demand. So, the total municipal supply for the month of August was $30.5 billion which is around 28% lower than the August issuance of 2016. Year-to-date issuance now stands at $256 billion, which is 15% lower than what we saw in 2016. Meanwhile Lipper’s reported around $10 billion of fund inflows year-to-date through August and with the combined low issuance has continued to result in strength for the municipal market.
Okay, well in the past you have mentioned the summer redemption period. Is it safe to say that we are most of the way through that period where redemptions are heavy?
Yes we are through most of redemptions for 2017. In August, we had $40 billion in redemptions which capped off the June to August total of $130 billion. The historical average for those three months has been $98 billion. September is expected to be lower at around $18 billion.
Well, what does the municipal credit backdrop look like these days?
In general, not too much has changed in August. We continue to see stress on the states due to pension issues. However, income and sales tax revenue are stable. Local issuers are benefiting from stable real estate prices, which result in more reliable affluent property taxes. Overall an improved economic environment continues to help credit fundamentals. It should be noted that based on the outperformance of lower quality issues the market in general has a level of comfort with current credit fundamentals.
Okay, well could you discuss any idiosyncratic or one-off credit stories?
Sure, so the major credit headlines have revolved around Illinois and Puerto Rico. But as we have mentioned in the past, we continue to monitor the second-tier of credit issues which may not be front and center yet. An example of this is Connecticut where tax collections dropped by $400 million unexpectedly in April and the state was not able to agree on a fiscal year 2018 budget at the end of June. As a result, the state has been operating on an emergency budget since July 1st and is now projected to have a deficit of approximately $94 million for fiscal year 2018. On a positive note, the state of Illinois finally released state aid to schools during the last week of the month. This includes $450 million in funding to Chicago public schools which brought the Chicago Board of Education bonds to the highest price in two years. Taxable bonds maturing in 2042 were trading at 75 at the end of June and are currently priced at 98.4.
Okay, well all things to watch. Another big credit story, how do you anticipate that credits will hold up in the wake of Hurricane Harvey?
There are still a lot of outstanding unknowns after Harvey swept through Texas, but we anticipate that the impact will be more short-term than long-term. The local issuers in Texas tend to have sufficient liquidity for short term emergencies. And with additional funding from Texas, which is a well-capitalized state and the federal government, we expect that the vast majority of debt will continue to be paid on time.
Okay, well any expectations for the rest of 2017?
Well, municipals have had a great run so far in 2017 and rates are currently at the year's lows. It would not be surprising to see a pull-back if demand wanes from lower redemptions and supply picks up off these low levels. On the other hand, continued geopolitical stress could hold rates lower into the end of the year.
Got it, thanks Eric.
So now let us move over to the corporate side, so Khurram, how did performance look for the month? Can you give us a rundown on spreads?
Sure, the Bloomberg Barclay's Corporate index widened 8 basis points during the month to end the month at plus 110 OAS. Last time spreads tightened during a full month was actually in March of this year. The widening was due to a rise in geopolitical risks, continued steady supply and slowdown trading volumes related to the summer season. For the year, IG corporate spreads are about 12 basis points tighter and 8 basis points wider than year-to-date tights. On a duration-adjusted basis, they are obviously a few basis points tighter than the 110 OAS I mentioned earlier, given the fact that the duration of the index has increased over the last several years. The index returned 78 basis points in terms of total returns, but had -62 basis points of excess returns as a credit curve steepened during the month. By comparison, high-yield corporates had negative total returns of 4 basis points and -67 basis points of excess return. Unlike the last several months, shorter tenor corporates outperformed intermediate corporate and long corporates and down in quality names, namely BBBs, underperformed A names. Year-to-date, corporates have performed pretty well. The IG corporate index has return 5.4% and 1.5% in terms of excess returns per Barclay's.
Okay, so sounds like there was a break in some the trends we have seen this year. Well, let us break it down a little more and talk about sectors. Did anyone of them outperform or underperform?
Yeah, so within corporates, industrials underperformed and financials outperformed. REITs, especially retail and office REITs, help contribute to the outperformance in financials. The REITs and home construction sector were the only sectors with positive excess returns in the corporate index this month. Cable, satellite, independent energy, pharmaceuticals fared the worst during the month. Despite the markedly lower Treasury rates, the banking sector, especially short and intermediate senior bonds held up well relative to most other sectors. To highlight a couple of additional things, metals and mining benefited from improved commodity prices, particularly copper. The cable and satellite sector was weak mainly due to the large bond-backed merger of AT&T and Time Warner Cable along with the ongoing event risk surrounding Charter Communications. Property and casualty insurance softened due to concerns around Hurricane Harvey and potential payouts that could happen there. And as I mentioned earlier, higher beta sectors fared the worst during the month.
So, you mentioned earlier the credit curve steepened, which tenor steepened the most?
So 1- to 3-year corporates steepened 3 basis points, 3- to 5-year corporates steepened 5 basis points, 5- to 10-year corporates steepened 8 basis points and 10+ year corporates steepened the most at 11 basis points. So, this month was interesting because longer duration bonds performed better than shorter dated bonds on a total return basis. However, the trend was opposite in terms of excess returns as shorter dated bonds saw better returns, while longer dated bonds had negative excess returns. So while 10-plus year corporates had the highest total return during the month, 128 basis points, they actually have the most negative excess returns at 154 basis points.
Okay, so that tells us how well Treasuries performed at the long end.
Okay, so in your view, what else was behind that?
So mainly, I think, it is due to the heavier supply at the longer end of the curve. The new issue market was robust this month. There were several large deals to fund M&A that helped tip the concentration of August issuance relatively speaking toward the longer end. In addition, there was concern over the FOMC hiking rates, which had some investors seeking shorter duration bonds rather than going longer.
I see. Well what were some specific noteworthy new deals this month?
So this is a big month for issuance. It was actually the second largest August ever, after last year's record issuance. Per Barclay's we had $103 billion of corporate bonds price this month, down 13% from August 2016's record pace. Also, debt issued to fund M&A as I mentioned earlier spiked during the month highlighted by AT&T, Amazon, British-American Tobacco, and Thermo Fisher Scientific. So, for example Amazon, which is rated Baa1/AA-, priced a nonregistered $16 billion 7-part benchmark deal to fund its acquisition of Whole Foods. It was the fourth largest deal year-to-date and was said to be three times oversubscribed. Average new issue concession was in the low single digits, but it was a little higher for the longer maturity bonds. Final pricing ranged from Treasury +40 in 3 years, to T+90 in 10 years, to T+145 all the way out to 40 years. AT&T also issued $22.5 billion across 7 tranches this month to fund the acquisition of Time Warner Cable. This was the third largest deal of all time behind Verizon’s $49 billion deal in 2013 and InBev’s $46 billion offering in 2016. AT&T is now the largest issuer in the U.S. corporate index representing about 2% of the overall index. So the 6-, 7-, 10-year priced 2-7 basis points tighter than existing secondaries while the 20-year, 33-year, and 41-year priced 10-15 basis points wider.
Okay, so sounds like with those oversubscriptions, those deals were very well-received and I know in some of our conversations we have discussed that those concessions were weighted towards the long end which goes to what we were talking about earlier, with underperformance in the longer end of the curve. And now that we have talked about supply, let us talk about demand. You mentioned that fund flows have been solid this year. Exactly how good?
The month of August saw about $9.5 to $10 billion of inflows into high-grade bond funds bringing year-to-date total to $171.2 billion. In all of 2016, we had $131 billion of inflows into high-grade bond funds. So, 2017 is looking to be a strong year in terms of demand as measured by fund flows.
All right, well now let us look broader at the IG market. What are some of the risks facing the IG market looking forward?
So, we think that the credit landscape remains fairly weak, while second-quarter earnings were strong and revenue growth was robust, gross leverage is historically high and coverage has weakened. Fundamentals remain fairly weak and in Q2, gross leverage excluding financials, commodities, and utilities increased to nearly match the all-time high, which occurred in the first quarter of 2002. There are some positive tailwinds including the weaker USD, slow and steady U.S. growth, and repatriation that could bring more cash into IG corporate balance sheets. We also continue to be fairly constructive on U.S. banks, which continue to have solid capital and liquidity. The biggest banks reported solid Q2 earnings. Energy continues to drive part of the improvement in earnings growth for IG corporates. Energy revenue was up 15.2% in Q2, albeit from a lower base in 2016. The sector continues to benefit from easier comparables and cost controls. We warn that muted global growth could spawn increased concerns over leverage. Also, significant reversal in energy prices, continued reversal of the U.S. dollar weakness and geopolitical headwinds that we have recently seen, could prompt spread widening. For that reason, we continue to espouse diligent credit research and we remain high quality.
All right, thanks Khurram. We hope that you in the field have found this informative and we look forward to you joining us in our next podcast. Thank you.
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.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
Podcast recorded September 11, 2015
This podcast discusses the recent volatility in the markets.
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