Podcast recorded May 9, 2019
This month our investment team discusses state revenue bounce backs, extreme ratios, corporate market performance and more.
Welcome to the Breckinridge podcast. This is Sara Chanda, I am a portfolio manager here at Breckinridge and I am joined today by Matt Buscone, co-head of portfolio management. Matt and I work together on the tax-exempt desk and in similar fashion to last month, we will be discussing several key themes in the muni market we feel are relevant for folks in the field. And those themes that we chose today are Cal spreads and how much they have tightened recently, crossover trading, and for purposes of this discussion, what we mean by that is purchasing or crossing over into a taxable security in lieu of a tax-exempt bond. And the third item on our agenda today is yield curve movements and the diversions we have seen between Treasury and muni markets. And so talking about spreads, maybe before we get started, Matt, with the specifics of the Cal market, let's define spread for folks in the field.
Sure, so convention in the muni market is typically to refer to the price of a bond as being over or under what we refer to as the Municipal Market Data AAA scale, so MMD will set a daily scale and say a bond with a maturity of 5 years is yielding, say, 2% right now and so we will express the value of that bond as trading over or under the scales, so over would be higher, under would be lower.
Right, and in most cases I would say we purchase bonds that are off-scale, but in fact, in California, we have consistently been seeing things trade at yield levels that are lower than the AAA scale and we refer to that on the desk as trading through scale. And much of that demand comes from the tax reform we saw recently and a cap on state and local tax deductions which makes investors in high-tax states like California want to generate as much tax-exempt income as possible which, in turn, has ratcheted up that demand in state bonds like Cal. And while we are seeing that same dynamic in other states like New York, it really has not had such quite a move or as dramatic of a move. We actually looked back at some data and some trades that we had conducted earlier this year, back in the beginning of 2018, and if we look at AA rated Cal community college district and its 5-year part of the curve, that was trading 1 basis point through-scale or just 1 basis point lower than the AAA. And then if we compare that to a recent trade we had done on the desk, AA rated, high quality Cal school district, it came 30 basis points lower than the AAA scale. And so Matt, why is that important to mention to folks?
So two reasons, really. State of California, obviously with its size, is typically one of the largest issuers we see in the muni market every year, and due to the high level of state taxes in California, there is a tremendous amount of demand for in-state exempt California paper, so simply a supply and demand story and as Cal goes, oftentimes that drives the muni market, so very strong demand for a state that is pretty expensive and one of the largest issuers in the muni market. So what we struggle with sometimes or what we try to do is make sure we are finding good value for these, and if California is very expensive, oftentimes there are some other things that we can do, right, Sara?
That's right, so currently what we have been doing, because again, it has been a challenge on the desk, we are evaluating other opportunities out of state, both tax-exempt and in the taxable market, so crossing into other tax-exempt munis and Treasuries where appropriate. And for accounts that permit us to do so, we are actually buying some taxable muni bonds as well, but in all of those cases, we are always looking to focus on capturing the highest after-tax yield depending on the client's tax rate, and actually, that gets us to really our next topic which is really crossing over and so Matt, let's just define for people what we mean by crossing over.
So the majority of the portfolios that we build in our tax-efficient strategy are going to be mainly populated with tax-exempt municipal bonds. When we talk about crossing over, we are going to use our ability to purchase a taxable security in lieu of a tax-exempt bond in periods where we think tax-exempt bonds might be trading more expensively than we deem they should be at a given time and maybe it is a temporary phenomenon. So simply put, and as you mentioned before, there are times when buying a taxable bond and paying the tax still gives you a higher after-tax yield than if you had simply bought a tax-exempt security. So then Sara, the challenge for us is how to assess that relative value between the taxable and the tax-exempt securities, right?
That's right, so what we tend to do, we will talk about the yield ratio between those two similarly dated bonds and again, taking a muni yield over a U.S. Treasury yield and so typically, what we see is that munis will under-yield that Treasury, really due to that tax exemption of muni income and the ratio, depending on where you are on the yield curve, will typically run between 70% and 100%. As those ratios dip lower, tax-exempt bonds become less attractive on a relative basis which is what we have seen, especially on the short end of our yield curve of late. That is what actually happened over the last couple of months and so Matt, why do you think some of those things tend to occur? Why do we have those shift in ratios?
So I think one of the biggest drivers this year has been simply a supply/demand imbalance between the two. Demand has been outpacing supply for the majority of the year. New issue supply on the muni market is running about 15% behind what we have seen so far in 2017 and we have also seen pretty steady support for mutual fund flows. Flows through the end of August have totaled about $11 billion so far, so a substantial amount of demand on one side but there are also a couple of other things that could come into play, right, Sara?
That's right, so changes in credit worthiness of muni bonds and so while right now we are in a pretty stable environment, it is the late stages of the credit cycle. So while we are seeing lower default rates and stronger balance sheets, we have seen an uptick in longer-term liabilities and deferred maintenance from some issuers and so if we do hit a recession, that could impact and the credit quality of those issuers could certainly decline affecting ratios and the other real thing is also the rising risk to just the tax exemption in general. We actually saw that play out at the end of 2016. So while always a risk, the fear of this occurring has diminished post tax reform and that is really evident in ratios being more stable. So again, that shift in relative value can create opportunities to cross over into taxable securities and pick up more after-tax income despite that muni exemption. And so how do we take advantage of that dynamic, Matt?
Sure, so what we will do is assess the after-tax impact at the portfolio level and it is important to note here that we want to take the client's tax bracket into account. So say we are looking at a bond with, say, a 3.25% taxable yield for an investor in the 25% bracket, that comes out to, say, roughly a 2.45% on an after-tax basis. If that is a higher yield than we can get in a tax-exempt muni, then again we would take that opportunity to cross over into the taxable bond to capture that higher after-tax yield. So we are obviously focusing on the after-tax yield pickup here, Sara, but it cannot all be that easy so there are some risks associated with employing that crossover strategy.
Yeah, so I think one of the bigger risks would be the directional bet on ratios. If you are too soon, you do run the risk of munis continuing to outperform and that price performance on the muni may outstrip what you would be able to gain on a taxable security.
And the last topic we were going to discuss today was a comparison of the two yield curves, the Treasury and the municipal curve. And so common convention again is to talk about the slope of the yield curves by focusing on two different points along the curve, one of a shorter maturity, say a 2-year bond, and one slightly longer of a 10-year bond and typically, investors want to be compensated with higher yields as they are buying longer maturity bonds, so if you are going to lock up your money for 10 years, you want to get paid more than you would if you were just buying a bond for two years. But what we have seen lately is some pretty different performance of both the Treasury and the muni curve where the Treasury curve slope has been very flat, i.e., there is not as much difference between the 2 and the 10 year while the slope of the muni curve has been much steeper. And there has been a lot written about this lately, Sara.
That's right and so actually, just looking at some points of data just to give people some context, if you look at the Treasury curve, that spread between the 2-year and the 10-year really has collapsed dramatically over the course of the year, so now we are talking about roughly 20, 23 basis points or so. How that compares to the beginning of the year, we started the year at 54 basis points, that is again on the Treasury side. Now compare that to the municipal market, we actually started the year fairly flat on the muni 2-10 curve, it was just over 40 basis points and then we finished up at the end of August actually at 74 basis points, so you can imagine a fairly dramatic difference there between the two curves. And I guess, Matt, one thing to mention to folks is why we are seeing these diversions.
So I think the biggest difference on the muni side is really a different buyer base in the tax-exempt muni market than there is in the Treasury market, and even within the muni market, that buyer base is often split where you have got retail investors and separately managed account advisors that are typically buying from 10 years and shorter and banks and insurance companies that typically buy longer maturities in our market, say 10 to 30 years. They have been less inclined to participate in the muni market due to the tax law changes that made tax-exempt muni bonds less attractive for them on an after-tax basis, so while retail and separate account managers have shown a tremendous amount of demand for short maturity bonds, there has been a lack of demand for that longer maturity paper so hence, the yield curve has had to stay steeper to try to entice buyers onto those longer maturities.
Right and I think what is important to underscore that it just really serves as a reminder that while buying shorter maturity bonds may be perceived as a defensive move, again you may be focusing on a more expensive segment of the market, exposing buyers if ratios do revert back to normalized levels.
We hope you found this information informative and for anyone in the field who has any feedback for us, we would love to hear from you at CR@breckinridge.com. Thanks for joining us.
Good day, this is Laura Lake from Breckinridge Capital Advisors and I'm joined by Khurram Gillani and John Bastoni and we are going to talk through the monthly market recap from August.
Since the Great Recession, August has been a difficult month for corporate bond performance. They have underperformed Treasuries six out of the last ten years and Khurram, anything different this year?
No, so excess returns for corporates were negative in August which means that they did not outperform equivalent duration Treasuries. Corporate spreads, which is the difference between a yield on a corporate bond and a U.S. Treasury bond widened by 5 basis points during the month, however, total returns, which is a combination of price and income returns, were positive during the month for corporates.
And while it was the summer and things are typically quiet, we still had a lot of headlines in August.
It was interesting because in the U.S., equity markets such as the S&P 500 performed pretty well, so one might expect, as this, you know, sometimes happens, is that corporate spreads tend to compress as a result. However, that did not happen in August. There were a few main drivers or a few main reasons for that. First, while equity markets here in the U.S. had a strong showing, global equity markets lagged. There was significant volatility in emerging markets, especially Turkey, South Africa, and Brazil due to concerns over their debt and growing concerns over their future economic prospect, and then number two, while issuance in August was down 30%, which is supportive of credit spreads generally, the market is expecting a very large September new issue calendar, so the expectation of higher issuance in September prevented spreads from compressing in August.
And I thought it was interesting that performance across the corporate curve was rather mixed. The corporate curve steepened, we had a short to intermediate corporates outperform longer maturity corporates, and it's interesting to see where fund flows were going. That drove a lot of the relative performance where we saw a lot of funds coming into shorter dated corporate mutual funds.
Yes, so short corporates continue to be, generally speaking, harder to source and valuations have definitely become a little bit less attractive compared to intermediate and longer duration bonds. Demand for shorter dated corporate bonds continues to remain strong as evidenced by fund flows, so in August, about 80% of the positive inflows into investment grade funds was into short duration funds.
And M&A was another big driver in August, not something we typically see in the summer.
That's right. So in August, United Technologies, which is the aerospace and defense company, priced $11 billion, a seven-part deal, for their acquisition of a company called Rockwell Collins. They paid as high as 10-15 basis points of new issue concession in the front end of the curve and on the long end of the curve, it was a little bit less subdued of only about 5 basis points of new issue concession. However, they did trade tighter in the secondary market. And just to add, we were talking about M&A and we're on the topic, the market is expecting over $400 billion of debt to be issued for the specific purpose of funding M&A in 2018. So far, year-to-date, it has already surpassed the 2017 figure but we’re expected to remain below the record for debt issuance for M&A set back in 2015.
Those are big numbers to throw around, especially in late stages of the cycle. So M&A was a hot topic in August but outside of that, AT&T had a big issuance this last month.
That's right, so interestingly, AT&T was in the market. They issued $3.75 billion of 5-year floating-rate note which had very strong demand globally and according to data from Bloomberg, it was the largest floating-rate note since 2007, so floating-rate note is a variable-rate security where the coupon changes periodically because it is tied to benchmark rates such as LIBOR. Floating-rate notes are popular when you think that yields are expected to rise, so they are very defensive in a rising rate environment.
And I think the other headline we had in August, lots of headlines, was Ford downgraded to BBB- by Moody's. This is a big move.
Yes, that was one of the more prominent credit stories for the month. So Ford was downgraded to just above high-yield, Baa3 negative by Moody's. It is still a notch higher at S&P, but it does have a negative outlook there as well. So in short, the downgrade is due to slowdown in sales that the company is experiencing, higher leverage, and specifically uncertainty surrounding a large multiyear restructuring program that the company is initiating. So the Ford 2021 bonds were as much is 50 basis points wider on the news, but then they retraced a little less than half of that widening but if you look at their 10-year bonds, they fared a lot better. They were ultimately only 15 basis points wider during the month.
So wrapping up our corporate recap for August, we will transition over to the securitized market and talk with John Bastoni about mortgages.
So last month, we introduced the concept of UMBS, or uniform mortgage-backed securities, to our listeners and in the past month, there’s been some important headlines, specifically as it relates to tax consequences for UMBS.
That's right. Over the past month, the Internal Revenue Service provided guidance that the exchanges of the legacy Freddie Mac securities into the new uniform MBS will not be considered a taxable event. It was important because if the IRS had rolled the other way, it could have been a deterrent to investors exchanging securities and also been a more significant obstacle more broadly to the successful completion of this program.
We also got an announcement that Tradeweb, which is an electronic trading platform for both agency mortgages and other asset classes as well, that Tradeweb has partnered with Freddie Mac and developed software to facilitate electronic exchanges which hopefully will make this process more efficient.
Yeah, I mean, at this point, it still seems like summer will be the go-live date for this initiative. There were a couple of open items. The first one includes how will the Bloomberg/Barclay's indices evolve to treat the exchange securities, and the second major thing is if the Federal Reserve will exchange their holdings of Freddie Mac securities or not. In the most recent Federal Open Market Committee Minutes, Fed officials commented that they were developing the capabilities to exchange the securities, so perhaps this is a clue that they will move forward.
Much of the debt market is priced off of a floating-rate benchmark and historically that's been LIBOR, but going forward, there are going to be changes to the LIBOR market. What can you tell us about that?
So the London Interbank Offered Rate, which is also known as LIBOR, is the benchmark borrowing reference rate for the vast majority of floating-rate mortgages, student loans, auto loans, and other consumer loans. It is also the referenced floating-rate for trillions of dollars of interest rate derivative contracts. LIBOR, however, is on track to be phased out by the end of 2021, and it will most likely be replaced by the Secured Overnight Funding Rate, which is also known as SOFR.
So SOFR and LIBOR sound pretty different. This could have ripple effects across the debt markets, not just in the U.S. but potentially more broadly. How are these different?
There are a couple of major differences between the two rates. Namely, SOFR is based on actual transactions of collateralized or secured borrowing, whereas LIBOR represents a "guesstimate" of where a panel rate setting bank could borrow in the unsecured market. The lack of actual transactional data in LIBOR has created ambiguity over the years and has opened the door to manipulation. There have been several high-profile criminal cases related to this. This is probably the main reason that LIBOR is going away.
So I think about investors and how this change impacts their portfolios. We talked about corporates earlier, corporates price off of the Treasury curve. How does this change impact mortgage investors?
Well, within securitized products, the convention is the price bonds off the swap curve which is essentially just the LIBOR curve extrapolated out into the future. When that underlying benchmark curve changes, it will affect pricing conventions and relative value analysis, not only in securitized products, but also more broadly across asset classes. We have seen some early positive developments on this front in that Fannie Mae, World Bank, and MetLife have all issued SOFR-based floating-rate notes in the past month and these deals have been met with strong investor demand.
Great, thanks, John. Thank you for that great recap of what happened in August and thank you to all our listeners for joining us on today's podcast.
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Podcast recorded May 9, 2019
This month our investment team discusses state revenue bounce backs, extreme ratios, corporate market performance and more.
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