By Peter Coffin
A discussion of three investment objectives in the context of high-grade bond investors.
Welcome to the Breckinridge podcast. I'm Sara Chanda, a portfolio manager here and today I'm joined by Matt Buscone, co-head of portfolio management. We want to wish everyone a Happy New Year and we're excited to kick off our 2019 podcast series. Today we will provide performance review for 2018 and discuss the following three themes: prospects for an infrastructure bill, oil and real estate prices and tariffs, and lastly municipal demand heading into 2019. So before we get into our themes today, Matt will give us a quick recap on muni performance for 2018.
Thanks, Sara. So, in 2018 volatility certainly spiked across a number of asset classes after a relatively quiet 2017. The investment grade muni market, however, was one of the best performing asset classes globally. For the fifth consecutive year, municipals posted positive returns with the Bloomberg Barclays Municipal Bond Index returning 1.28% and the high-yield municipal bond index returning 4.76%. When you compare this with the S&P 500, which was down about 4.4% for the year, a -2% return for U.S. high-yield bonds, the Barclays Aggregate Index was flat and the Treasury Index was up less than 1%, so a pretty positive year for muni returns when compared to other asset classes. If you look at returns across the yield curve for munis, the shorter range was the best performer with inside of four years having an average return of +1.75%. If you look at it on a sector basis, the best-performing revenue sectors were housing, leaseback bond, and resource recovery bonds, and as I mentioned just at the outset, lower quality outperformed by a pretty strong amount with BBB rated bonds up nearly 2% compared with just 1% on AAA rated bonds. So again, a very solid year for taxes and municipal bond returns.
We talked a lot last year about the low level of new issue supply and its impact on the municipal market. Sara's going to walk us through a couple of things that may drive supply higher this year.
As we recall, infrastructure spending was part of President Trump's election platform alongside healthcare and tax reform, so we've been discussing the prospects of a bill for more than two years now. With Congress now split with the Democrats taking over the House, there is a higher probability of infrastructure legislation being pushed through, so the question now becomes what is the impact for the muni market? So if passed, we suspect overall supply might increase relative to expectations, but in the absence of a Federal plan, we may see state and local governments pick up some of the slack if combined with a moderation in fiscal restraint. In fact, we did see issuers start to support more projects, that was really evident in the composition of new money versus refunding deals this past year. While the market had benefited from several years of $400 billion in gross supply, 2018 was actually down about 24%, just under $340 billion. That was really due to the Tax Cut and Jobs Act restricting refunding supply. So as a result of that, if we look at new money issuance, it jumped to 70% relative to the 45% it had been in 2017, and that in combination with refunding deals dropping, so 2018 refunding deals only totaled 18%, that was down from 34% again from 2017. So state credit quality is generally solid. If we look at state revenues, they're up about 7% for Q3 2018 and credits are really benefiting from a boost to disposable income and sales tax revenues which really rose about 3% again in Q3 and that was really again thanks to the Tax Cut and Jobs Act. So we do suspect and expect new money issuance along with the overall level of rates to drive issuance for this year. And if we look at some street estimates that we've seen, gross supply for 2019 is in the range of about $360 to $390 billion or so.
So we mentioned earlier how lower quality credit performed in 2018 on the back of a strong economy, but there are some areas of concern for the economy as we enter 2019 that Matt can cover.
So the price of oil is really a double-edged sword. If you look at states like Louisiana, Oklahoma, New Mexico and Texas that are very heavily tied to oil prices given their energy-dependent economies, if the price of oil stays lower, that could lead to a prolonged period of lower revenues for those states, much like we saw at the beginning of 2016, it started to impact some of those specific state economies. However, lower oil prices can benefit other local governments that are spending money on gas for motor vehicle fleets or perhaps some of the inputs for some of their improvement projects like they're looking to do, so lower oil prices there can be somewhat of a boon to some of those economies. So the price of oil is generally regional depending on how dependent their local economy is on the price of oil. On the real estate front, we've seen higher mortgage rates start to have an impact both on slowing home sales and on the overall prices of real estate. If you recall, the local general obligation bonds are typically driven by property tax receipts. If we tend to see a prolonged period or continued decline in home valuations, that will likely start to flow through to local government bonds via lower property tax receipts although that's typically a longer runway but again, something to keep an eye out for. And the last one is tariffs. As President Trump has continued to negotiate with China over perhaps increasing tariffs, we have seen some export-dependent states, Washington and California come to mind, that are very heavily dependent on exports. Again, that may start to slow some growth in some of those states as well. And while we here at Breckinridge and many others aren't predicting any sort of recession in 2019, we are likely to see somewhat of a moderation in growth in GDP, perhaps in into the 2 or 2.5% range this year.
The last topic that Sara is going to touch on is what the potential demand sources for munis may be in the coming year.
Right. So we talk a lot about market technicals. We did talk about supply a little bit and demand. Both of those play a big role in the muni market, whether it's underperformance or outperformance at times. And again, turning to demand, a lot of times people are asked how do you measure demand in the muni market, and the municipal market, by trade, is just a retail-dominated market and many retail investors own bonds through mutual funds. So one proxy for demand is the mutual fund flows data that are published on a weekly basis, Lipper is actually one source of that data and for 2018, they reported total outflows for municipal mutual funds to the tune about $1.3 billion and that's really on the back of several years of inflows, so the question then becomes what do we anticipate for 2019? Well, the Tax Cut and Jobs Act lowered taxes not only for individuals but also for corporations, so as a result of that, banks and insurance companies who have traditionally been big buyers of municipals have pared back their holdings over the last year or so as munis are no longer as compelling. Actually, as we saw in 2018, we do expect less support from these institutions into the new year, which could impact overall demand especially in the long run which could cause the curve to steepen. So, while that's the case, and the Q3 Fed flow of funds data does substantiate that point, other entities like P&Cs, life insurance, and foreign investors have actually increased their exposure to munis during that same time period. And additionally, tax-exempt money market mutual funds actually reported inflows well over $1 billion for the last week of December, pushing year-to-date inflows to more than $15 billion for the year, again reflecting more of a risk-off sentiment and current aversion to duration from retail investors. So while the muni market closed 2018 with outflows having returns that outpace most other fixed-income sectors in a period of elevated volatility does auger for stronger potential demand this year.
Thank you for listening and we hope you found this information informative. Please don't hesitate to reach out to us at CR@breckinridge.com with any questions or comments.
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By Peter Coffin
A discussion of three investment objectives in the context of high-grade bond investors.
While fixed-income investors experienced many surprises in March, the Fed’s hike came in line with expectations.
Podcast recorded February 23, 2016
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