In our latest commentary, get our take on year-end volatility and what's ahead for investment grade markets.
Welcome to the Breckinridge market update. I am Eric Haase, a portfolio manager at Breckinridge, and I am accompanied by Matt Buscone, a fellow portfolio manager. Today we wanted to touch on three major topics: give a quick performance update; a summary of fund-flow activity for the year; and a discussion regarding short-term rates and what we are seeing.
So there has been a strong run of returns in the municipal market over the last four months. What do the numbers look like for the Barclay’s 1-10 Blend?
So if you go back to November of 2018, the Barclay’s 1-10 Blend Index returned 0.87%, December of last year returned almost a full percent, January of this year again up another 0.85%, and February’s returns continued that string with another 45 basis points of total return. So, the cumulative return for the period was 3.22% and the biggest driver of returns on the muni side has been lower yields. Ten-year Treasury yield touched 3.23% in early November before falling to 2.55 at the beginning of January of this year and since that initial drop it has remained in a very narrow band of 2.65 to 2.75%. Municipal bonds have shown a similar drop falling from a 2.75% down to a 2.1% over that same time period, really due to incredibly strong demand from municipal bonds. A big driver for the performance on muni bonds has been from fund flows that have come into the muni space and Eric is going to walk us through some of those numbers.
Right. So first again, look back to 2018. Last year was really a tale of two markets, so the majority of the year up until September, we saw positive fund flows. We had over $10 million in flows up until early September and then from September 19th until the end of the year we saw a lot of outflows to the tune of around $12.5 billion. 2019 has been a reversal of that outflow session. So we have had eight consecutive weeks of inflows. The total is about $12.5 billion through the end of February. It’s really the best start we’ve seen since 1992 and since they’ve actually been starting to track the data in 1992, and additionally we have seen kind of record inflows by sector. So high-yield munis have $3 billion in inflows, the intermediate part of the curve is $5 billion of inflows, and the long-term is around $6 billion. So to offset that, we have seen outflows from the actual money market space which has been around $8.5 billion.
And those outflows from money market funds which Eric was just highlighting brings us to our last topic which was the rise of the SIFMA yields that we have seen over the last several weeks. The SIFMA Index is an index that represents the rates on what are called variable rate demand notes in the muni market over municipal bonds that have their coupons reset on either a daily or a weekly basis. These are mainly purchased by money market funds. They own about 60% of the short term debt outstanding and they are a good representation of what cash yields in the muni market. Where are those rates now, Eric?
So this past week the rates were at 1.67% for a weekly muni. The low on the year was about a 1.3% in mid-January, so although it is elevated, we expect that it will get higher as you get closer to April 15th. So generally the money markets are sold and the proceeds are used to fund tax payments. Right now what we are seeing is the selling is manageable. So inventory is manageable from a supply and demand dynamic, and one thing that we are actually seeing is that investors are choosing to buy VRDNs or the short weekly securities rather than buying two- or three-year bonds just due to the fact that the front end of the curve is pretty flat, so it does not make sense to take that extra duration risk. Additionally, what we are expecting to see is that you know, a lot of, typical of muni market, a lot of the rates and performance is driven by supply and demand and rates could be higher by around 50-75 basis points if we see additional selling from these money market funds which will probably happen as we get closer to tax time.
And it is important to note that these variable rates can be very volatile and there is a seasonal effect to a lot of these, they typically get much cheaper as we come into the end of the year. At the end of December rates got very cheap as well. We are seeing that now, but oftentimes these periods where the SIFMA rates are very elevated are usually pretty brief and it usually reverses and we usually see two or three-year bonds with higher yields than the SIFMA floating rate, and it is likely that we will see these SIFMA rates come back down as we get through tax season and the selling does stop. There has been somewhat of a dearth in VRD issuance over the last several years and that market is down to $140 billion outstanding, so it is likely to be somewhat of a brief respite where the SIFMA yields are higher than short-term maturity bonds.
Thanks for listening and we hope you in the field found this helpful and if you have any questions, please do not hesitate to reach out to us at email@example.com.
Welcome to the Breckinridge podcast. I am John Bastoni. Today I am joined by Khurram Gillani who is on our portfolio management team and this month we are going to give you a quick recap of the investment grade markets for the month of February. Khurram, we will start with you with corporate. It seems like we have a few themes we are going to touch on this month. So just really quick, how did corporates do for the month of February. It seems like so far year-to-date we have had really a continuation of just really strong performance in that space.
Yes, that is right, John. So what we saw this month was more or less a continuation of what we saw in January although at a slower pace I would say. The Bloomberg/Barclay’s Corporate Index closed 5 basis points tighter this month. It was 25 basis points tighter in January so not as strong, but still solid performance. This month, the market was supported by strong technicals, progress in U.S.-China trade negotiations, and the backdrop of a more dovish Fed. Total return gains were broad-based across most sectors. The index posted positive 22 basis points of total return and positive 59 basis points of excess returns, bringing year-to-date excess returns to 243 basis points. From a total return perspective, cumulative returns in January and February are over 2.5% which basically offsets the negative 2.5% of total returns that we saw in all of 2018. Given the risk on sentiment in the market, BBBs did outperform As this month and long corporates outperformed short and intermediate corporates from an excess return perspective.
Touching on supply really quick, it looks like gross supply for the month was $115 billion. How does that compare to some of the earlier Street estimates heading into this year?
Yes, the Street in the beginning of the month was calling for between $80 and $90 billion of debt issuance for the month of February, so the $115 billion number is pretty impressive, and it almost exactly equals what we had in February in 2018. New issue concessions, you know, on average were negative during the month and order books from both deals were 3-4 times oversubscribed. March is typically a big month for issuance so initial estimates for March are calling for anywhere between $100-$120 billion of debt issuance.
The spread performance in the month I think really is impressive when you consider the additional $25 billion or so in supply we are projected to get. So specifically, who was bringing some of these deals to the market?
Yeah, well it is interesting, several of the deals were actually related to M&A. One of the biggest deals of the month was Altria. They issued $11.5 billion of debt across several tranches to fund their acquisition of the e-cigarette maker Juul. According to data from Bloomberg, it was five times oversubscribed and spreads tightened in the secondary market. Also, Eli Lilly, a large pharmaceutical company, and Boston Scientific, issued a combined $9 billion of debt to fund recent acquisitions, and also AT&T issued $5 billion to redeem and repay certain existing debt. The market is still expecting some sizable debt related to M&A this year. We have Bristol Myers which recently acquired Celgene. Admittedly, that is facing some trouble given the opposition from stakeholders but if approved, Bristol Myers could issue $30 or $35 billion sometime this year. We also have IBM which recently acquired Red Hat. They could issue $15-$20 billion of debt sometime this year. T-Mobile and Sprint merger, we are looking at another $25-$30 billion just from that. And also, recently Danaher acquired GE’s healthcare assets for $20 billion. That is going to be debt funded also.
So it seems like we have also seen several companies tendering bonds recently, names such as Medtronic, Verizon, and Anheuser Busch. Can you elaborate on what exactly it means to tender a bond issue?
So, that is right. Some companies have issued tender offers to bond holders recently. You mentioned a few already. So, in IG corporates there are really only two ways to retire existing debt a company has already issued. One is to do what is called a make-whole call, another is to retire debt through a tender offering which is basically a company is offering bond-holders the option of buying back certain bonds at a predetermined price.
Thank you for that. Can you give our listeners just a more concrete example with some numbers perhaps?
Yes, sure. So recently Medtronic, a large medical device company, recently announced a tender offer for several of their bonds. So, one of them was a 6.5% bond maturing in March of 2039. These bonds were issued with a make-whole spread of +45. That transits to a dollar price of about $143. Currently the bonds are trading at a dollar price of $130. So based on that example, you can already tell that doing a make-whole call would be very expensive for Medtronic. So, what they did instead was they went to bond holders and said, “Would you like to do a tender offer at a price of $133 per 1000 bonds?” And that’s the option that’s currently out there for bond holders. As a portfolio manager and trader, when you're evaluating tender offers, there are several issues to consider when you're trying to accept or reject a company’s tender offer. Some of those issues include liquidity, you want to think about what liquidity will be like for bonds that are not tendered. You obviously want to look at the tender offer spread versus where they are currently trading in the market. You also want to look at the tender offer spread versus the make-whole spread also for the bonds, among other factors.
That is great, thank you for that.
Okay, great. So turning to the securitized market, so spread product had a pretty strong month again in February. We discussed back in January which was also a strong month. Can you talk a little bit about performance in the securitized market?
Yeah, I’d say the risk-on theme has really been persistent across spread product asset classes. Securitized products were certainly part of that in the month of February. We had a very strong start to the year in terms of returns as we discussed last month, January was one of the better months we’ve seen in quite some time, and while February was not quite as strong, we did see modestly positive excess returns. So far, year-to-date we are at +39 and +38 basis points respectively for ABS and MBS.
Okay, that is great, thanks for that. So perhaps you know, one of the biggest news stories we have talked about, and we have talked about it on this podcast recently, is a uniform MBS where Fannie and Freddie will start to comingle MBS issuance into a single security starting in June of this year. There has been further developments announced by regulators this month, can you elaborate on that a little bit?
Yeah, so Fannie and Freddie’s regulator, the Federal Housing Finance Agency recently announced new rules that will help align prepayment speeds between the two issuing entities. Historically, the market has had the ability to trade the Fannie/Freddie swap to police prepayment speed differences however, with the single security under UMBS, that will not be an option going forward.
Can you give our listeners a little bit more detail on prepayment speed and why that is so important for MBS and some of the changes that have been proposed for that?
Yeah, a lot of attention recently has been focused on the increasing weighted average coupons or the WACs of MBS pools. And there are a few reasons why the WACs have been increasing but, in a nutshell,, a higher WAC will mean higher prepayment speeds, all else equal. Consider, for example, a 4% MBS pass-through security where the underlying mortgages have a WAC of about 4.5%, and that is pretty close to the current mortgage rate offered in the market, versus another similar 4% pass-through MBS with a WAC of 5%. The latter borrowers are going to have significantly more economic incentive to refinance their mortgages. The announcement last week from the Federal Housing Finance Agency capped the weighted average coupon spreads over the mortgage-backed security coupon rate on the bond across the two entities at 112 basis points from 250 basis points where it was previously, and that should help enforce prepayment speed parity between the two mortgage-backed security issuers. There were a couple of other announcements as part of this release that relate to steps that will be taken if the prepayment speeds do differ by a predetermined amount, but in general, this is a very positive development as it relates to the successful launch of UMBS. At the time of this recording of this podcast, the securities industry group was set to vote on the final part of the program which would be the TBA delivery guidelines, and while we do not expect any surprises on this, the June launch is expected to go on as scheduled so far for these securities.
So John, can you summarize what you just detailed to our listeners?
Yeah, in summary this is, you know, we really do not expect this to affect spreads or returns. This is really just an operational thing that is going on in the background. Ultimately the goal of the UMBS program is to create better prepayment divergence between the two issuers, to promote liquidity in the already very liquid agency mortgage-backed security market, and to ultimately have better mortgage rates for U.S. borrowers.
And we do not expect this will have a major impact on spreads and total returns, right?
No, it’s really a prepayment story and really just to tie it all back, we got the long-awaited prepayment report on the afternoon of March 6th, which was the first prepayment report that fully reflects the impact of the increasing WACs that we have been talking about, but also captures the full effect of the drop in interest rates that the market has seen since the end of 2008. Just to summarize this prepayment report, it came in largely as expected with prepayment speeds up around 10% month over month, and we expect significantly more attention to be placed on managing prepayment speeds going forward because we are coming out of a very benign prepayment environment over the past couple of years.
Great. Thank you, John, and thanks to our listeners for tuning in to the Breckinridge podcast.
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