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Municipal Perspective published on January 10, 2020

From the Desk - December Recap 2019

Podcast Transcript

Welcome to the Breckinridge municipal market recap. I'm Sara Chanda, portfolio manager here, and I'm joined today by Matt Buscone, a fellow PM on our tax-efficient team. Thank you for joining us today. Municipals closed out 2019 with solid returns so we’ll begin with a recap of performance followed by discussion about the January effect, that’s something we typically encounter in the market this month, and close out with a conversation on high-yield supply. So just to get started, similar to other fixed income sectors, municipals staged quite a rally over the course of 2019, so Matt, let’s take a look at returns and what drove performance.

Sure, so while returns slowed a little bit from the strong pace earlier in the year, municipals posted positive returns for both the quarter and the year. And as a proxy for the broad market, we look at the Bloomberg Barclays Municipal Bond Index. That index returned 31 basis points for December, 74 basis points for the fourth quarter and a whopping 7.5% for the full year. For the intermediate index, which lines up a little bit more closely with what we do here at Breckinridge, the Bloomberg Barclays 1 to 10-year Blend, which has a duration of about four years, finished off with 30 basis points for the month of December, 86 for the fourth quarter, and 5.6% for the full year of 2019. What were the main drivers of the returns last year, Sara?

So with the drop in rates that we saw throughout 2019, and investors really reaching for a lot of yield, a longer duration and lower quality had really been the key drivers for the majority of the year and it really helped contribute to overall muni performance. So looking at the long index, which is really bonds 22 years and longer, that was up just over 10% over the year and compare that to segments of the market we tend to be in, more the 5-year and 10-year spots, 5-year was up just about 5.5% compared to the 10-year was just over 7% or so. Looking across the quality spectrum of the market, BBBs outpaced all the other rating categories coming in at 9.2% for the year and looking across just the A-rated categories, AAAs returned about 6.7%, AAs at 7.1%, followed by As at 8.1%.

So, we’ve discussed in several other of our prior podcasts the technical picture was very strong for tax-exempt municipals last year, specifically with regard to manageable new issue supply and robust demand which provided a tailwind for the market throughout the year. As we move into a new year, we tend to face something we call the “January effect” in our market. What is that, Sara?

So thinking about many firms coming into the beginning of the year, they’ve been operating with a limited staff during the holiday so no surprise when they tend to come in with a little bit more of a frenzy once people are back in their seats. And so typically the January effect is that period of time with limited issuance and exceptional demand from investors as they are trying to put to work some of their coupon payments and maturities that tend to hit in January. So this dynamic really starts to produce an environment where buyers will reach for bonds which tends to push prices higher. And looking across performance between 2008 and 2016, all of those years actually posted solid performance. The exception to that was 2011. This is actually coming from MMA, is our data source there, however in recent years if we look across how January did, the effect has been more muted or in the case of 2018, really nonexistent. That particular year we actually saw kind of a bump up in Treasury rates and less appetite from the banks and insurance companies post tax reform, so that particular January actually posted negative returns across most of the yield curve. So after seeing a little bit less in the way of a January effect in most recent years, do we anticipate a continuation of solid performance this month, Matt?

So I’d say a couple of different things. We do think that municipal credit spreads are going to continue to remain tight due to the strong national economy and ratios are likely to remain low if demand continues on the pace that we've seen within the still muted new issue calendar. That said, we do expect the supply and demand factors that were so strong in 2019 to moderate somewhat in 2020, although it might take a couple more months for that to come through. Net supply is something that we talk about a lot in our side of the market and that’s simply the difference between new issues that are coming to a market and minusing issues that are maturing in coupons coming back into the market. In 2019, that net supply figure was a -$50 billion, very strong number that supported demand for muni bonds last year. This year, that looks to be only -$20 billion so not quite as strong as support as we had last year. Another thing to think about is that we did have a record-breaking $94 billion worth of inflows into municipal bond mutual funds last year. That's going be pretty hard to replicate. And the last piece that we would look at is something that’s called total cash flows from maturities and calls coming back into the market, and for this year it's going to be about $70 billion or 20% lower this year than it was last year. So the three of those things adding up are making it somewhat a less compelling technical story for the muni market.

Right, so I’d say the bottom line here is that while investors in high tax states really are still feeling that pinch from the cap on the state and local tax deductions, we’ve talked a lot about that in past podcasts, that’s really helping fuel the muni demand that we've been talking about as they continue to look for more tax-exempt income wherever they can find it. We are seeing some factors that may be less supportive than what we had seen in prior years.

And a quick side note is, as Sara and I were putting together the notes for the podcast over the last couple of days, it does seem like the January effect is in full force right now. In fact, numbers released last night show inflows into mutual funds posting a record $2.9 billion in, that's the highest weekly total they’ve seen since that data was taken, so for right now, it feels like we are experiencing a January effect. So new issue supply in the muni market rose to $420 billion in 2019 driven by a gain in both taxable and tax-exempt issuance. There was also an increase in the high-yield sector of the muni market. What do those supply figures look like?

So if we look across last year, actually sales of high-yield munis rose about 31% to just under $17 billion, that’s according to Bank of America and Merrill Lynch, that's really marking the most issuance we had seen in that segment of the market in eight years. And just to qualify what those sectors tend to be in, it’s senior living facilities, charter schools, and nursing homes. So you could ask the question, how come we’ve seen such an increase in this segment of the market? Continued growth in the economy has supported the credit quality of many of these projects and while demand has been strong for these types of names due to record inflows into the high-yield space, $19 billion or so last year. So looking at the amount of below investment rate or unrated debt in the market, it’s actually risen five of the past six years so the amount of debt outstanding since 2013 is about double or so. But what's interesting to point out is that despite that growth, high-yield munis are still a fairly small fraction of our overall market, standing at just about 10% or so, roughly $320 billion outstanding compared to $3.8 trillion in the muni market. So one other thought to think about is any warning signs that we've seen, Matt.

Yeah, and I’d say yes, so last year, there were 150 borrowers that have run into trouble and either had to skip a debt service payment or breach other terms of their covenants, that's a 20% increase over what we saw in 2018 and the most or the highest level of distressed borrowers since 201. So somewhat of a warning sign and a little bit of a concern if those deals are going bust so quickly after issuance. And while Breckinridge doesn’t invest in high-yield securities, it is important for us to keep track of both the inflows into those funds and what credit spreads are doing as that does have an impact on the investment grade space as well.

So thanks for listening and we hope you found this information helpful. As always, please don't hesitate to get in touch with us with any questions or comments. Thank you.




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