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Investing Podcast recorded on February 10, 2020

From the Desk - January Recap 2020

Podcast Transcript

Muni Recap

Hi, welcome to this month’s muni market recap. I am Sara Chanda, a portfolio manager on the tax-efficient team and I am joined today by my colleague and fellow PM, Eric Haase. Thank you for joining us today. As we open up 2020, we continue to see strength in total returns, so we will provide an overview in January. Next, we will review the current holders of municipal debt supported by data found in the most recent Fed flow funds report, and we will finish up with a discussion on a legal ruling that affects the special revenue sector of the market. So, let us get started. So, Eric, we had a solid year of performance in 2019, how has the market opened up in 2020?

It has opened up the same way it ended, so we have had continued positive performance through the month of January. So overall, the market continues to grind tighter. So yield ended lower by between 20 and 30 basis points depending on your location on the curve and really, the 10-year and 30-year ended the month at historical lows. So the 10-year ended at a 1.15% and the 30-year at a 1.80%. So your total return on your portfolio would range anywhere from flattish to nearly 2.5%. As a proxy for the overall broad market we look at the Bloomberg Barclays Municipal Bond Index, and that returned around 1.8% in total return for the month. And really it is the same trend we have been seeing. So the longer duration assets have outperformed shorter as rates have come down, so you look at the five-year versus the 10-year part of the curve, the 10-year part of the curve earned just under 2% and that was around 70 basis points more in total return than the 5-year. And when you look at quality, lower quality continues to outperform as well. So the BBB portion of the curve earned around 2.3% which is 60 basis points more in total return over AAA's for the month. And on the state side, the lower quality states, Illinois, New Jersey, they continue to outperform the broad index. The Illinois portion of index was up nearly 2.5% as spreads continue to grind tighter for Illinois state general obligation debt, and New Jersey was up slightly over 2%.

What about the supply and demand dynamics from last year? Have those carried through to 2020?

They have. Mutual fund flows continue to be strong. In January we had around $11.5 billion in inflows compared to last January, last January we saw around $9.7 billion so a pickup there. And on the supply side, the story remains the same as well. Supply is up for the month of January, 18% year-over-year. We had around $30 billion in total issuance, but the taxable municipal portion of the issuance remains elevated, so in January it was around 22% of issuance of this year and last year it was around 12%. So now we have clearly seen a substantial demand over the past year, and we have seen that show through by way of increased mutual fund flows. In the most recent Fed flow of funds data for the third quarter of 2019, we got a little bit of a better idea of the overall composition the market, right?

That is right, Eric. So thinking about just the market in general, the trend we continue to see, unlike other debt markets like corporate debt and Treasury market, the muni market is actually still slightly shrinking. So we lost just about $4 billion or so in the overall market, so we ended the market size at just about $3.8 trillion. That has been fairly steady over the last couple of years. And ownership, again, a similar trend that we are seeing is still dominated by individuals relative to corporate entities. So individuals, in general they make up about 70% of the market and how they're broken down, about 46% of that is really just direct participation folks just own munis outright. About 20% is really the mutual funds and then 5% or so is really allocated to the money market funds and closed end funds. So direct participation in general was lower by just about $6 billion or so from the second quarter of last year to the third quarter. Looking at the corporate ownership side, that also decreased slightly about a half a percent or so in Q3.

But of that corporate ownership portion, the P&C and life insurance companies were up a little over half a percent on a quarter over quarter basis. Really the banks were lower by around 1.4% and again, that is kind of the theme we have been seeing with lower tax rates over time, the banks have continued to sell and reduce their ownership of municipals. And when you look at the property and casualty insurers, really the increase is related to the additional issuance of taxable munis that we have seen on the market. They view them as, you know, they have wider spreads, it is a diversifier and generally they have longer duration which meets with their needs. We do think that as taxable municipal issuance continues to increase, we anticipate continued support from corporate and foreign buyers. But overall, we do think that the muni market is still dominated by individuals and kind of the retail buying base and we expect them to remain the largest municipal bond holders. So moving on to more of a credit-related topic. There has been recent news regarding a court ruling related to special revenue bond payments in Puerto Rico. So what is the update there?

Right, so if we look back to March of 2019, the first Court of Appeals maintained a 2018 ruling which stated that Puerto Rico is not required to pay special revenue debt service on highway revenue bonds during bankruptcy. So this ruling was appealed by the monoline insurers and in January the U.S. Supreme Court declined to take the case so the ruling now stands. Just to give a quick definition of the difference between a revenue bond and a special revenue bond for folks in the field, a special revenue bond has a specific revenue stream used to fund a specific project. So the example we will cite here is actually one that Citi had actually just put in a particular report, they use the example of a transit authority capital plan backed by farebox revenues only, and that would be versus a revenue bond which may have multiple sources of revenue.

And then, so why does this really matter?

Well, it runs counter to how most market participants understand how special revenue bonds are handled in bankruptcy, because a special revenue bond has a lien on revenue post bankruptcy proceedings versus a non-special revenue bond which does not. So this ruling could actually impact the broader market if others look to challenge that special revenue pledge. Looking at actions that we have seen so far in the market or implications, rating agencies have actually taken some action on this. In a recent Merrill report, they were citing Moody's, they had stated that this ruling is a credit negative development for several categories of the municipal debt market but overall should have a modest impact to the market going forward. That said, Moody's did adjust some credits lower, and Fitch has come out to say they are probably going to adjust some credits that may be affected as well so that is something we will continue to monitor.

Great. Well, thanks for listening. We hope you found the information helpful. As always, please do not hesitate to reach out to us at CR@breckinridge.com with any questions or comments.

IG Recap

Welcome to the Breckinridge podcast my name is John Bastoni, I am a securitized products trader here. Today I'm joined by Khurram Gillani, a portfolio manager on our multi-sector team. We are going to start like we always do, talking about IG corporates. So Khurram, welcome, how did corporates perform last month?

Great. Thanks John, it’s good to be here today. Yes, corporates generated positive 2.34% of total returns during the month of January, which actually outperformed high-yield credit as well as U.S. equities during the month. This was primarily due to the fact that yields on corporates fell over 25 basis points to 2.58% during the month. As for corporate spreads, however, those ultimately widened 8 basis points during the month after reaching multi-year heights at the start of the year, and hence, outperformed Treasuries by 80 basis points. The sell-off in corporates mostly occurred in the last week of the month on coronavirus concerns and was the biggest selloff since mid-August of 2019.

That sounds like quite the reversal from December.

Yeah, it was. As a result, longer duration corporates underperformed, short and intermediate corporates, while BBB's underperformed A’s but only by about 14 basis points on an excess return basis. December was quite the opposite. As you recall, in terms of sentiment, we saw BBB’s and longer maturity corporates outperform Treasuries. All corporates widened during the month by an average of 5 to 15 basis points. The higher beta lower quality sectors, in particular energy, as well as metals and minings were the worst performers due to fear of weakened demand for oil and materials from China.

It seems like a continuing theme that we talk about on this podcast quite a bit is issuance and obviously, fund flows. How did those shake out last month?

Yeah, so according to data from Bloomberg Barclays, gross issuance was a little over $170 billion during the month which beat expectations. It was actually the second-largest January total on record. Notably, over half of this total figure was used for redemptions, which includes refinancing upcoming maturities, as well as for calls and tenders. IG fund flows were very strong during the month. They totaled over $24 billion per data from UPFR. The last week of the month alone, saw $6 billion in total fund inflows, which was the largest week in terms of inflows in high-grade bond funds over the last five years according to J.P. Morgan. Despite the lower yields and longer duration of the index, investors continue to put cash to work in high-grade corporates.

Well, thank you for that Khurram. We would be remiss if we did not talk about the coronavirus and its impact on the markets last month. Specifically, how does that impact corporate bonds do you think?

Yes, so in general we do believe that it may present risk to some corporate bonds especially in the short term and especially for those multinational corporations with significant presence in China. It really depends on how long it will take to contain and develop an effective treatment for the coronavirus. We are continuously monitoring it and evaluating how companies are responding to its impact. Our head of corporate research, Nick Elfner, actually recently wrote a piece about this topic, which is available on the Breckinridge website. But in summary we do believe that all corporate sectors could be impacted if the outbreak drags on longer than the SARS epidemic 15 years ago, and if it significantly impacts global economic growth. The industries that we feel would be most at risk include restaurants, brick-and-mortar retailers, luxury goods, department stores, autos, airlines, lodging and leisure. Some of these industries tend not to be large sectors within the investment-grade bond indices so that should mitigate the impact from a bond-holder perspective. Also, as many know, China is the world's largest oil importer bringing in a total of 10 million barrels per day. Oil prices have declined due to reduced air travel to and within China and with much of the country's transportation ground to a halt. This could also have an impact on the energy sector due to the weaker demand in China. Lastly, some sectors such as the healthcare sector, could benefit if some names within the space develop a vaccine or an antidote for the coronavirus. This could be a large market opportunity for large pharma companies.

That's great, Khurram, thank you very much for that recap.

Great, so turning over to the securitized market during the month, can you give us a quick recap of the performance during the month?

Yeah, sure, so specific to agency mortgages, we continue to observe a very directional trading pattern to underlying interest rates. So, in other words, agency mortgages tend to outperform when interest rates are rising and underperform when interest rates fall, particularly sharply like they did last month. A couple of factors also come into play here. The first is when rates move a lot in either direction, that means interest rate volatility is going up, mortgages are inherently short volatility as the homeowners own that ability to prepay at any time with no penalty. And secondly lower rates project ultimately lower forward mortgage rates which will then project faster prepayments down the road, which is also going to be detrimental to MBS performance. So January's price action was eerily reminiscent of most of what we saw last summer when the 10-year Treasury came close to the all-time lows and the yield curve, as measured by the yield difference between the 2-year and 10-¬year Treasury note, inverted.

Right. So MBS had negative excess returns during the month as rates rallied.

That is right, it was -53 basis points for the month.

And so why do prepayments hurt mortgage-backed securities?

Well if you think about this way, prepayments ultimately drive duration, or the sensitivity to changing interest rates. When MBS prepay faster than expected, duration will shorten. Typically, prepayments pick up in a falling rate environment as more and more homeowners refinance their mortgages. Into falling rates, an investor naturally wants to keep as much duration or exposure to interest rates as possible which is exactly the opposite of what actually happens when you hold an MBS security. The opposite is also true. In a rising rate environment, mortgage-backed security duration, MBS durations, extend as less and less homeowners prepay their mortgages. In a rising rate environment, an investor generically wants to reduce exposure to interest rates. So this is just another way to simply describe negative convexity.

Great, that makes sense. So given that prepayments are such an important aspect in evaluating and understanding MBS positions, how do we measure our model prepayments?

Well, every month, the agencies, so Fannie, Freddie and Ginnie Mae, report their prepayment speeds on all their mortgage-backed securities. MBS investors like ourselves will use a prepayment model to project future prepayment speeds, and ultimately what that translates into from a yield and spread and duration or sensitivity to interest rate perspective. We will also look at things like the Mortgage Bankers Association Refinancing Index which can act like a leading indicator for future prepayments. Really all of our analysis of MBS boils down to prepayment management and in situations like we mentioned earlier, we are trying to identify bonds that are going to keep duration into falling rates and naturally will shed duration into high rates. So prepayment and therefore convexity management is one of the hallmarks of separate account managed by Breckinridge.

Well, thank you John, for that great color on the securitized market in the month of January. Thank you, everyone, for joining us this month. We hope you found this informative and we hope you join us next month.

 

 

 

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