Podcast recorded March 12, 2019
Our investment team discusses muni market performance, short term rates, tender offers in the IG corporate market and an update to UMBS.
Hello, and welcome to the Breckinridge podcast. I am Matt Buscone, a portfolio manager here at Breckinridge and this month I am joined by fellow portfolio manager Eric Haase. This month, we are going to discuss the legal challenge to some of the state of Illinois’ general obligation debt, take a closer look at the composition of and impact of the strong mutual fund inflows this year, and lastly, we will review how the dramatic fall in yields has impacted municipal bond performance for the month and year-to-date.
Let us start with the Illinois lawsuit, can you give us some background on the lawsuit, Matt?
So, on July 1st, the Illinois Policy Institute which is a think tank, and Warlander Asset Management, a hedge fund, filed a petition challenging the constitutionality of two series of Illinois general obligation bonds and issuance from 2003 and from 2017.
So why did they focus in on those two series?
So the lawsuit is challenging whether the use of proceeds in both of those issues was being used for a specific purpose. The 2003 series was issued to help fund the pension system while the 2017 issuance was used to pay a backlog of unpaid bills. In their eyes or in the eyes of the lawsuit, those did not qualify as specific purposes which you generally view for municipal bond proceeds. What is interesting about this is that the suit was filed by an outside party and not the state or some type of oversight board or watchdog group which is different from what is happening in Puerto Rico's case.
So what was the ultimate outcome of this lawsuit?
So, not surprisingly, it was rejected. Most observers had expected this outcome and the judge did note that the specific purposes were defined in the authorizing acts. Really what it seems like is the lawsuit did not like that it was used for pensions and unpaid bills, is really what they were getting after. And so after widening out in the weeks following the lawsuit, spreads began to tighten again in August and continued to improve after the ruling.
So ultimately, no major impact?
Yes and no. No impacts on the spreads after the round trip, so from a total return perspective you are probably right back to where you started with Illinois. But it has increased the scrutiny around Illinois and everyone is now more aware of the state’s structural deficit and underfunded pensions. And just a few years ago the thought of someone challenging the legality of a state GO deal would have been unthinkable, so certainly new norms in the muni market.
And with that comment, thinking about the greater volatility that we have seen in spreads, particularly in the state of Illinois, due to the increased headline risk for a lawsuit, investors are still finding tax exempt municipals pretty attractive out there. So we have seen 35 straight weeks of positive fund flows and that has been about $64 billion of flows in the mutual funds, so on a more granular level, what do those flows look like?
So if you take a look at the breakdown, and this is, you know, we are highlighting mutual fund flows, not from separately managed portfolios and they break them into three different categories, long-term funds, intermediate, and high yield. Long-term funds this year have seen about $40 billion worth of inflows, intermediate funds $20 billion, and high-yield $14 billion worth of inflows. And as yields have continued to drop and the quest for returns has continued, the demand for mutual funds with longer durations is increased as evidenced by those flows. And over the year, about 62% of the total fund flows are going into this space, and for calendar years with positive total return flows since 2011, on average this number has been closer to 42%, so certainly a marked increase this year. And at first glance, you would say the flows would have had an outsized impact on long-term funds given that magnitude, but the size of the funds in that universe is much larger, currently estimated around $475 billion.
And that high yield fund flow number you mentioned earlier, that's pretty large.
It really is. I mean you look at it and you say well, it is only $14 billion versus the other, but the universe’s high yield fund is much smaller, just $121 billion and the depth of the investable names in that space is also much smaller than what's available in either the intermediate or long-term market. So the flows have had a more noticeable impact on spreads and performance in that space. The $14 billion in high-yield fund flows is around double the average annual flow amount seen in those years that have had positive flows since 2011.
So that increase is much more impactful based on the size of the overall market but it should be noted that the data only represents mutual fund flows and a larger portion of the investment grade municipal market is accessed through separately managed accounts.
So the last point we were going to talk about this month was with regard to returns. Interest rates fell sharply in August, fueling another strong month of returns for municipal bonds and we thought we would walk you through some of the breakdown of those returns.
Right. So we another positive and strong month of performance. So if you look at the broad municipal index it is up around 1.6% on the month and that is the 10th straight month of positive returns and when you look back even further, out of the last 16 months, 14 have been positive excluding September and October of last year post Fed hike. If you look at the markets overall, so the Treasury markets, yields ended lower over the month by around 20 to 55 basis points. That depends on the maturity of the bond you are looking at. Just as a reference point, the five-year was lower by 44 basis points and the 10-year by 52 basis points. In typical fashion, munis did lag a little bit. They did end lower, but only by between 8 and 40 basis points, depending on your maturity, and it is a similar kind of position on the curve, the 5-year was lower by around 16 basis points and the 10-year was lower by 27 basis points. So in the world of decreasing yields what worked on the performance side? Naturally, longer duration outperformed. If you are looking at total returns from the muni universe, it ranged from around 14 basis points to 2.5%. The 5-year part of the curve was up 57 basis points for the month and year-to-date that brings it up to around 5.25%. And on the other side you look at the quality side of it, lower credit quality continued to outperform higher credit quality. So if you think about it this way, over the course of the month, you picked up around 50 basis points in total return to be in BBB rated assets versus AAA, and if you extrapolate that out on the year, BBBs are up 9.73% and AAA’s are only up 6.91% which is a staggering difference.
Yeah, pretty marked outperformance from low quality this year. We have talked a lot about the demand-side obviously this month, a couple quick notes on supply. August really did see a burst of supply after lower levels coming in June and July. We had about $38 billion worth of issuance in the month of August. That now brought the year-to-date total about 5% higher than what we saw through this point of 2018 and munis did lag the Treasury rally throughout the end of August so munis got cheaper on a relative basis across the curve. We had also talked about how we added Treasuries at several points during the year due to those exceptionally low ratios. The ratios increased the most in about five years over a couple-week period, up anywhere from 10 to 14 ratios depending on where you are looking at the curve. So certainly that elevated supply and some of that underperformance help cheapen munis up versus Treasures at the end of August.
And one thing that we have talked about in the past is crossing over into taxable securities based on that ratio, the yield ratio. So naturally if municipals have gotten cheaper, it is a little less attractive right now to buy Treasuries or taxable municipal bonds in portfolios.
That's right. Thanks for listening and we hope you found that interesting and helpful. Please feel free to reach out to us at CR@Breckinridge.com with any questions or comments.
Welcome to the Breckinridge podcast. I’m John Bastoni, a securitized products trader here at Breckinridge. Today we will be recapping the month of August. I am joined by Khurram Gillani, a portfolio manager on our multi-sector team. He is going to kick it off with the investment grade corporate sector. Khurram, what was sort of the tone in the corporate market, and how did that translate into overall performance for the month?
Yes, so the corporate environment was fairly challenged in August. The credit index widened 11 basis points in August. The corporate index widened 12 basis points in the same month and both indices underperformed Treasuries. And all corporate sectors were wider during the month, but financials, led by the REIT sector, did outperform. BBBs lagged as they tend to do in a risk off a month like we had in August, and they widened 15 basis points, and the corporate credit curve steepened during the month.
And what were some of the fundamental drivers of the underperformance. It sounds like it was a tough month across the board for spread products but specific to corporates what were some of the fundamentals that we saw?
You know, the main driver of the underperformance was the ongoing and escalating concerns about the U.S./China tariff war, as well as market concerns about a potential looming recession. President Trump signaled that he could put in place a 10% tariff on the remaining $300 billion worth of goods currently not subject to a tariff, and then China a few weeks later towards the end of the month indicated that they will increase tariffs on $75 billion worth of U.S. imports which led to a follow-up presidential tweet that he would retaliate by raising tariffs by an additional 5%. Other factors also weighed on spreads including weak growth out of Europe including its largest economy, Germany, which seems to be on the verge of, if they are not already in, a recession. And of course, the significant drop that we saw in rates, the 10-year was down 50 basis points in August. At that level it is difficult to outperform Treasuries. When rates rally at that level, historically corporate spreads have widened.
Right. So it sounds like month to date excess returns were negative across the corporate landscape. The total returns, I am assuming, were positive depsite the spread widening due to the lower rates across the curve?
That’s correct, John. So total returns for IG corporates were positive. They actually outperformed domestic equities and increased the year-to-date total return figure to about 14%. August was actually the best month for IG corporates in over 10 years from a total returns perspective. However, month-to-date excess returns for IG corporates were negative. It is noteworthy to point out that month-to-date total returns for corporates with maturities of 10+ years were most positive whereas month-to-date excess returns for 10+ year corporates were actually the most negative. So that might seem a little unusual. The reason for that is because the 10+ year corporates, that was the best-performing maturity bucket during the month. However, the moves in IG spreads led to lower excess returns. The reason for that is the Treasury curve flattened during the period, so the lower rates actually helped total returns for the longest duration corporates, however the credit curve widened or steepened and as a result that hurt excess returns for the longest duration corporates.
Given the negative sentiment, I would imagine the market had a hard time absorbing supply for the month. Do you have any numbers around the net supply figures for the month of August?
So the gross supply figure for corporates during the month was actually up pretty significantly versus August 2018. The main reason for that is there are a few debt-funded M&A deals in the market, the largest being Occidental Petroleum’s $13 billion debt-funded issuance for their acquisition of Anadarko Petroleum. However if you look at the last four year average of Augusts, issuance was likely down a little bit, and kind of looking forward to September, September has historically been a very large month of issuance averaging over $100 billion over the last few years so we expect issuance to ramp up after the seasonally slower month.
So lower rates must be attractive from an issuer perspective, but I am wondering if they detract from the investor perspective as far as locking in these lower rates?
So, so far, you know, we are not seeing lower rates to detract investors from going into corporates or fixed-income in general. On the demand side you know, if you look at the street figures, there were net sellers of corporates in August which indicates a fairly strong demand and also the fact that if you look at fund flows into high-grade bond funds which are now up over $200 billion year-to-date, and they were up about $20 billion during the month of August, that shows pretty robust demand for high-grade corporate bonds.
Well, thank you Khurram, for that nice recap of the IG credit markets for the month of August.
So let us turn it over to the securitized market. As we alluded to in the beginning, August was a challenging month for securitized products as well. Starting with the positives, can you talk about that on the ABS side?
Yeah, ABS was the star for the month, had a strong month exhibiting sort of this defensive flight to quality characteristics that we've seen in the space pretty much all year. The sector returned 15 basis points from an excess return perspective and again in what has been otherwise a pretty volatile year for spread products. Notably, net supply in the credit card segment is down almost 50% year-over-year which has helped bolster performance as well.
And on the MBS side, it was the worst month since the 2015. Can you talk a little bit about that, and what happened there.
Yes, the worst month since 2015. The third worst month since the crisis where more agency mortgages returned -63 basis points again from an excess return perspective. Really the main drivers in the space has been heightened prepayment fears due to low rates, leading to borrowers having a significant economic refinancing incentive. And those all continue to weigh on the sector. Also the market is seeing an uptick in negative convexity hedging which is something that we have mentioned in the past in this podcast, but to remind our listeners when interest rates fall, mortgages lose duration. And there is a segment of the investor base that will actively try to replace or hedge this loss duration so they will buy Treasuries or they will receive the fixed rate in interest rate swap. From a market price action perspective this has the effect of driving rates even lower when they are already headed lower and it becomes almost like a self-fulfilling prophecy type of thing.
So MBS spreads have obviously repriced to reflect a deteriorating prepayment fundamental environment. Obviously rates have fallen pretty significantly here in the month of August. It looks like MBS spreads are a little cheaper. What are some things investors should look at in determining if MBS is right for them?
So as you mentioned, MBS spreads are now pricing to a deteriorating prepayment landscape and we have seen spreads widen to the cheapest level they have seen in several years. So we think there is an opportunity to be had in the sector and we remind our listeners that agency MBS has no credit risk and that the question is not if you will get your money back, but it is when.
So there are a couple of things that I wanted to mention when you look at mortgage spreads generically. The convention in the sector is to quote current coupon yield spreads to a 50-50 blend of the yield of the 5 and 10 year U.S. Treasury. The current coupon mortgage yield is calculated by interpolating the two MBS securities that have dollar prices on either side of par, or 100 cents on the dollar. So with rates where they are now, the current coupon is using the 2% and 2.5% coupons. Recall that MBS coupons earn 50 basis point increments so 2, 2.5, 3, 3.5, and so forth. The challenge in the market right now is that the 2% coupon, and to a lesser extent 2.5% coupons, do not have a lot of bonds outstanding which impairs liquidity and makes it difficult to get reliable pricing points on those two coupons. If you think about sort of, the path of interest rates over the past few years, 2.5’s have not been produced in quite some time.
So in the end, the current coupon spread bounces around with the level of underlying interest rates and right now we show a spread of around hundred basis points over that 5- and 10-year Treasury blend. This Treasury blend is used because mortgage duration, as we mentioned previously, moves around with rates but typically falls somewhere in the range of the 5- and 10-year Treasury range. This hundred basis point spread is the widest we have seen in several years but does not quite tell the whole story of what is going on in the mortgage coupon stack. Higher coupons, such as 4’s or 4.5s inherently have more refinancing risk behind them as borrowers in those MBS pools carry, obviously, higher mortgage rates. The higher coupons have widened substantially more than this current coupon metric so for sophisticated investors that can manage prepayment risks accordingly, we think there is an opportunity.
Thank you, John. I hope you in the field found this recap informative. Please join us next month for our Q3 recap and outlook for Q4.
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Podcast recorded March 12, 2019
Our investment team discusses muni market performance, short term rates, tender offers in the IG corporate market and an update to UMBS.
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