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Investing Podcast recorded on May 9, 2019

From the Desk - April Recap 2019

Podcast Transcript

Muni Recap

Welcome to the Breckinridge market recap. I am Sara Chanda, a member of the portfolio management team here, and I am joined today by Eric Haase, my colleague and fellow PM. For those of you not familiar with our format, we choose three topics to discuss that we feel are notable in the muni market and today's agenda includes state revenue bounce back and market implications, extreme ratios, and lastly special revenue bonds. So for those of you who tuned in last month, you may recall our discussion about states reporting lower revenues for the fourth quarter of last year and Eric what do we see now?

Right, so last month, we did talk with the decline in state revenue relative to late 2017 and early 2018. Primarily that was driven by tax reform, so income was actually recognized in December 2017 and early 2018. And the main reason for that is that taxpayers wanted to take advantage of lower rates or avoid elimination of deductions and you know, the biggest portion of that is the elimination of the state and local tax deduction. What we have seen recently is that state revenues have reportedly rebounded in March up to as much as 11% year-over-year. So this really includes a jump in states like California, New Jersey, Illinois and Connecticut amongst other states. But California, which is a really good example, they collected over $18 billion in personal income taxes. That far exceeded Governor Newsome’s estimate by $3 billion. And the other side you also have Illinois, where the sate of Illinois received more than $4.1 billion of individual and corporate tax revenue last month. That is an increase of nearly 40% from April 2018 and it is more than $1.5 billion higher than projected.

Right. So this rebound that we are seeing in revenue collections really means states are more likely to finish in line with the beginning of the year at budget estimates, and maybe even slightly higher. And this trend is certainly supportive of the market and may provide additional tailwind as we head into the summer months. One notable exception would be in the oil states. Tax revenues in places like Alaska, Wyoming or even New Mexico, they have been weak relative to last year, really given the relative decline in oil prices. And actually while we are talking about income tax, historically investors have used tax-exempt money market funds as a source of capital to pay their income tax and year-to-date outflows from tax exempt money market funds through May 1st of this year stands at -$13 billion so really this year was no different but how that really been reflected in the rates market, Eric?

Right, so we have discussed SIFMA and short-term rates and essentially SIFMA is the best representation we have of what cash yields in the muni market. So generally when you see an increase in money market fund redemptions to pay taxes, that coincides with an increase in yield. So taxpayers this year dragged their feet, so they started actually selling these money market securities a little later, so really that was closer to early April as opposed to March which we have seen in the past. So the March 31st SIFMA yield was around 1.5%. It now sits at 2.12% and in between it hit a peak of 2.3% which is actually the high since the crisis. One thing we want to point out is this is a very seasonal event, this is something that happens every year around tax time. We do expect that that rate will drop. We are looking at redemptions and coupon payments that are very high coming up, lighter forward-looking supply, a number of reasons that these occurs would be in demand and variable-rate demand notes which are essentially the notes that comprise this index, the inventory is down significantly now. So it is down below a billion dollars where three weeks ago that was over $11 billion so we do expect to see SIFMA rates drop in short order.

So moving on to our next topic. Municipal credits have been broadly stable and we have seen state tax revenues increase or rebound over the last month or so and the market has been benefiting from record-breaking demand. So one thing we have seen is that this increase in demand has been reflected in extremely low ratio levels.

That's right and actually when we talk about ratios, just for definition’s sake, we are referring to the relationship between AAA rated municipal yields relative to a Treasury yield for the same maturity. And so unlike a corporate or taxable municipal bond which trade with a spread of similar data Treasury bond, municipals really trade as a percentage of that Treasury. Simply put, the lower the percentage, the more expensive or rich the municipal and recently ratios have hit some extreme levels due to really this tepid supply environment we are in and really the insatiable demand for tax-exempt income. And so now the question is where are ratios now and how does it really compare to historical periods? The ten-year ratio currently is sitting between 73 and 74%, really the lowest level that we have seen since 2001 actually per Bloomberg data and historically post crisis this average ratio in the ten-year spot is around mid-80% or so.The question now becomes you know, what do we see as a catalyst for breaking us out of the cycle?

So the supply and demand are really what drives the muni market which we refer to as technicals. On the supply-side we have seen supply at around $100 billion on a year-to-date basis so that is higher by around 3.5% let us call it. On the supply side, one thing that could change is we have talked about an infrastructure plan for you know, a year now. In reality it's been far from a distance and it is not a high probability factor right now but there have been more recent talks between Trump and Democratic leaders to try to determine how to address the need for infrastructure and the potential for a $2 trillion infrastructure plan. So if that does materialize that could impact supply. So on the demand side when you take a look at the fund flows we have mentioned earlier, we have had 17 consecutive weeks of positive influence that equates to about $30 billion in mutual fund flows. Additionally, we have had strength and separately managed account space within inflows there. In the short-term we are expecting a record number of maturities coming due in Q2 for around $65 billion. So there still should be that the initial demand that we are seeing for municipal bonds.

Right. So you have laid out a case for actually what could obviously offset supply side. On the demand side of the equation what could possibly be a catalyst for outflows which would then obviously change that positive momentum we have been seeing. Looking at a J.P. Morgan recent piece they're talking about really a catalyst to stop those inflows would be obviously an increase in Treasury yields. They had looked at various volatile times over the course of the last several years and they found was that what triggers outflows is an average increase in ten-year Treasury yields of roughly 40 basis points or so. They looked back in periods of time when it was November 2010 during Meredith Whitney, the taper tantrum that happened back in 2013 and also obviously the post-election meltdown back in 2016 as certain periods to cite.

And so turning our attention now on the credit front, recently we have seen the validity of special revenue pledges brought into question as a result of the Puerto Rico bankruptcy. And just as a refresher Eric, thinking about just GOs and revenues and different kinds of bonds in the market. Maybe we start there?

Sure. So the predominant types of municipal bonds are general obligation debt and revenue bonds. One sector of the market that we pay attention to is the special revenue sector. And in that sector the revenue stream is really defined, it is guaranteed, so think of a sales tax or a highway toll or a gas tax. Generally, you would have a lock-box structure with a clear flow of funds and really what it boils down to is the structure disallows for the use those funds for other purposes outside of paying down the particular debt associated with those funds. So what we are seeing now is that actual structure is being challenged in the Puerto Rico bankruptcy case and it is being challenged with toll revenues. So Puerto Rico redirected pledged revenue that was supposed to be used by the Puerto Rico Highway and Transportation Authority and they took that and redirected it to the general fund. So you have the municipal bond insurance companies headlined by Assured Guarantee who actually sued the Commonwealth of Puerto Rico in the U.S. District Court of Puerto Rico. Essentially they have a claim that they should continue to receive the dedicated special revenue throughout the bankruptcy proceedings and on March 26th of this year the Federal First Circuit Court of Appeals upheld last year's ruling and the ruling basically states that the payment of special revenues is voluntary during bankruptcy and that the special revenue bondholders are entitled to the present value of the lien but not the timely flow of revenue.

Right. So thinking about the implications in the market and obviously the concern for bondholders would be would this occur more in the future if we set a precedent now with this ruling. We really don't expect to see any uptick in issuers redirecting revenue for a couple reasons. One, the fact that there's a limited number of special revenue issuers facing insolvency like Puerto Rico. Default would result in higher borrowing costs and third really, debt doesn't go away, so whether the special revenue bond holder, they are still entitled to that repayment. And so then the question becomes, “So how we manage that risk in the market?” so thinking about it from the credit side it’s really important to thinking about the preservation of that lock-box structure we’ve referred to before, focusing on the flow of funds, revenue bypassing the general fund account and really separating the special revenue pledge from the GO revenue. The other thing to really consider as well, is rating agencies and what they may start to do with their methodology and possibly tying the special revenue pledges of particular issuers more closely to their general obligation debt through their processes of rating issuers.

Essentially we just want to make sure that we are getting paid for the structural risk associated with the lock-box structure. So we would expect to see spreads between special revenue bonds and the related GO debt compressed as a result of the ruling and the subsequent rating agency migration. We will have to continue to monitor the market to see if pricing does reflect this.

So thanks for listening we hope you found this information helpful and as always please don't hesitate to reach out to us at with any questions or comments. Thanks.

IG Recap

Welcome to the Breckinridge podcast, I am John Bastoni, a securitized products trader here Breckinridge. Today I'm joined by Khurram Gillani, a portfolio manager on the taxable side here, and today we will be discussing performance in April across the investment grade markets. Khurram, we wanted to recap the month of April in this podcast. I was wondering if you can start off with how investment grade corporates performed relative to other spread products last month?

IG corporates outperformed Treasuries and put up 95 basis points of extra returns this month. They also outperformed securitized product and also agg eligible taxable municipal bonds. The corporate index tightened 10 basis points earlier on in the month but remained freely range bound during the latter half of April. Across the curve longer duration IG corporates outperformed shorter duration corporate bonds and across the quality spectrum, BBBs outperformed all As again this month given the risk on sentiment we had in the marketplace. Year-to-date IG corporate excess returns stayed at 371 basis points.

And how about from a total return perspective?

Yeah, so from a total return perspective, the yield to maturity on corporates fell about four basis points during the month to 3.6%. As such, total returns were positive, 54 basis points during April but total returns were a little bit higher, 14 basis points higher to be exact, for longer duration bonds, and about six basis points lower for intermediate corporate bonds. Across the credit curve, the corporate credit curve has shifted downward during the year and April was no exception. For example, 10+ year corporate maturity bonds are 42 basis points tighter year-to-date. Five to seven year corporates are 54 basis points tighter and one to three year corporates are 33 basis points tighter from an option adjusted spread perspective.

And what were some of the main themes that drove the risk on environment in April?

So there was some good economic news. There was a solid Q1 GDP figure which clocked in at 3.2%. That was above consensus estimates. And then we also had stronger than expected corporate EPS growth and this is all happening obviously in the backdrop of a still fairly supportive Fed policy environment. So I would say technicals continue to remain very strong this month and the risk-on sentiment as evidenced by the strong rally we had in domestic equity certainly helped give corporates, especially lower rated corporates, a boost. But of course at the sector level there was some variation in performance. For example, industrials did outperform financials during this past month.

Are there any other subsectors that you could elaborate on that did better or worse than others and what were some of the reasons for the performance drivers there?

Yes, so first, I would say that most sectors posted positive excess returns during the month of April. Relatively speaking, autos and telecom definitely performed the best. For telecoms, names like AT&T and Comcast did very well and that was partly an offshoot of recent deleveraging comments that the companies have made. Autos were helped by Ford's better-than-expected earnings numbers and the company mentioned “they are improving their mix with higher average transaction prices and margins” and overall the strong performance of higher beta sectors and lower rated names also illustrated the general market preference for higher-risk assets in April as I alluded to earlier and showed that high-grade investors are willing to reach for yield down the credit curve. Another sector that did well this month was independent energy. They had a good showing as WTI oil prices continued to climb to a year-to-date high, and then in terms of, you asked about sectors that didn't perform as well, you know, healthcare, pharma, health insurance names, had a tough month due to a combination of news headlines related to drug pricing reform, Medicare for all, policy discussions and I would say, less rosy forward guidance from some of the larger insurance and PBM companies.

That is great. That is a very helpful overview on some of the fundamentals that we have seen in some of the sectors specifically, but I wanted to switch gears and talk little bit about the technical backdrop. It seems very supportive for corporates and in particular, investment grade bonds lately, and I was wondering if you could shed some light on some of the specifics that we are seeing there as it relates to the technical backdrop?

Yeah sure, so demand for IG corporates continues to remain very strong as evidenced by the strong inflows into high-grade mutual funds and ETF's which have totaled over $24 billion just this past April according to data from the EPFR and that is close to $100 billion year-to-date across short-term and intermediate bond funds. Gross supply on the other hand, you know, declined 31% versus April 2018. It is down 9% versus the first four months of 2018 and also net supply is down pretty significantly also. It is down 24% year-to-date due to lower financial issuance versus last year and also by all accounts demand from foreign buyers continues to remain pretty robust. So it is unclear right now what the catalyst will be for all this to come to a slowdown or a halt, but right now corporates are continuing to grind tighter.

So it sounds like supply is just materially down and there is just an insatiable demand for high quality investment grade paper and that's continued to drive some of the price action that we are seeing.

That is right and you know, May historically has been a very active month in the market and we are expecting several large issuance for M&A so we will see how that turns out, if there is any, you know, spread widening in those names or any new issue concessions there.

Great, thank you.

And then let us turn to the securitized sector. It is sort of the same discussion. Let us first start off with performance. How did ABS and MBS perform during the month of April and is there any difference between what happened last month versus what happened year-to-date?

Yeah, I would say, you know, agency MBS has had a very strong start to the year. Most of the performance however was frontloaded in January. Because really we saw all spread sectors enjoy a nice sort of bounce back after a tough end to 2018. Since then, I would probably characterize the performance of agency MBS as really sort of just treading water a little bit.

So John, there are several spread metrics that the market uses to evaluate MBS performance. Can you discuss one of these metrics and how has it behaved so far this year?

There are a variety of spread metrics used in the agency mortgage-backed sector and one of them being the nominal yield spread of the current coupon mortgage-backed security which by definition is the security that is trading closest to a par dollar price, versus the yield of 50% of the five-year Treasury and 50% of the 10-year Treasury. The reason this Treasury blend is used is because MBS duration is unstable and it varies with the level of underlying Treasury rates. MBS duration does tend to stay within this duration range of the two Treasury securities so the market really uses this as a proxy for the general direction of MBS spreads. So when we look at the spread metric we started the year round 91 basis points over this Treasury blend, and for the most part we have been trading in the 80 to 90 basis point range since then. So a pretty stable performance. And a couple of reasons can be attributed to this stable performance, one of them is again, you touched on this, is supply is low in agency mortgages as well, in addition to most of the investment grade sectors right now. And just to put some numbers on it, to start the year through the end of Q1 we have only seen about $34 billion of net supply, and that is down from about $50 to $65 billion at this time last year. Part of this is just, you know it's Q1, the normal seasonal cycle where traditionally we don't see a lot of homebuying in the winter and therefore ultimately MBS creation. In fact, historical averages point to only around 10 to 20% of any full year’s net supply will occur in Q1. All this is very much interest rate dependent and we still expect to finish the year around $250 billion in net supply, but those numbers can be revised up the longer we stay around 250 in the 10-year Treasury. So all-told MBS performance was down one basis point last month but still stands at up 27 basis points year-to-date on an excess return basis.

Great. Thanks for the color, that makes sense. And then we have talked about uniform MBS or UMBS in the past on this podcast before. Starting next month it looks like Fannie and Freddie will be offering this commingled security. Can you give our listeners a little bit of a background refresher on why they are doing this and if there are any new updates?

Yes, so right now, is UMBS launch time. As you mentioned, we have mentioned this a few times on this podcast but just as a quick refresher, Fannie and Freddie will start issuing the new commingled security under this program starting in June. The exchanges of legacy Freddie Mac securities have actually started this month in May and really it is just being done to promote additional fungibility between the two securities, deepen the liquidity pool and ultimately keep mortgage rates low for home buyers. So as I said, this week is the opening of the exchange of legacy Freddie Mac securities into the new UMBS. Remember that we mentioned in the past, investors will have the option not the obligation, to exchange their legacy Freddie Mac securities. So we will be watching very closely at how quickly the market adopts the program and how quickly those legacy Freddie Mac securities are exchanged. This is one of the biggest operational changes in the mortgage-backed market in the last 30 years and it's largely an operational change but from a market perspective we do expect to see an effective doubling of the free float of outstanding MBS securities which will have an impact on supply and demand dynamics and ultimately pressure spreads, and it could have an impact on specified MBS pools which usually have desirable collateral characteristics which in theory the market will have a preference for relative to the larger more generic UMBS type of float.

Why would this effectively double the amount of generic collateral free float out there?

Because you are taking Fannie Mae securities and Freddie Mac securities and then combining them into one.

Got it, that makes sense. Thank you everyone, for tuning into the Breckinridge podcast. We hope you found this informative.


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