By Laura Lake
What do bond investors need to know about their options for duration as rates rise?
Hello, this is Eric Haase, a portfolio manager at Breckinridge. I’d like to welcome you to July’s municipal market recap. Today I will be joined by Sara Chanda a fellow portfolio manager, and we will be providing a quick market summary, discussing some of the extremes we are seeing in the market, as well as shedding some light on an increase in forward delivery new issues. So, Sara, why don’t you start us off with a brief market update from July.
Thanks, Eric. So, looking across the market, we saw a positive total return that really continued in July, a theme that we’ve been talking about for several months now. The broad index, if you look at that, was up about 81bps, really driven by the fact that yields continue to drop. The 5-year part of the curve was lower around 17bps or so. Ten years was lower by about 13bps, and really what helped drive performance was a longer duration. Total return for bonds with maturities longer than 4 years, was about 80bps, whereas bonds inside 4 years earned about 60bps or less in total return. And credit in fact this month was actually a nonfactor, from AAA to BBB that was about 80bps in return, and it really should be noted that Illinois underperformed the index over the month, only up about 53bps on the month and that’s really resulting from the fact that Illinois paper in the 10-year spot widened back out to about +164 over the AAA scale.
So the story we’ve been telling in regards to supply and demand on a year-to-date basis remains intact. On the demand side, we’ve continued to see positive inflows in the mutual fund space, so we’re at 30 straight weeks, and that’s about $53 billion of inflows on the year-to-date basis. On the supply side, when you look at July there was about $25 billion of total issuance. So on an absolute basis, that’s lower by around 10% year-over-year relative to 2018. But as a percentage of issuance, July was only lower by around -2% on the year. So that being said, year-to-date supply is $196 billion which is about 1.5% higher than last year. Think about relative value in our space, we’re comparing the yield you'd earn on a municipal bond to the same maturity U.S. Treasury. And primarily for bonds inside of 5 years, or with maturities inside of 5 years, we’ve seen a lot of richening in the market, so the 2-year spot on the curve went from around 72% to 56% yield, and the 5-year went from around the mid-70s to 60%. When you got further out the curve, the relationship was not as strong, and the ratios only dropped by around 6 and 3 ratios for the 10 and 30-year maturities. So this is a good segue to our next topic, so we’re going to talk about some extremes that we’re seeing in the market.
That’s right, so the fact that you just brought up ratios, that is actually a good starting point, thinking about ratios and how they richened over the course of the month. So munis outperformed Treasuries across the curve, especially in shorter maturities. That really did pressure ratios over the month and nearly a 15-ratio move in that two to three year space. And while the two-year closed near 60%, it really doesn’t accurately reflect what we’ve been seeing in the market, especially in high-tax states like California and New York, which really have been commanding a higher premium, due to extraordinary demand, really forcing ratios into the mid-50%. Additionally, yields continue to plummet, so if you look at yields over the course of the month, they really close at the year-to-date lows. Month-to-date at the front end of the curve, we saw almost a 20bps drop in yields, down about 5-10bps in that 10-30-year spot. Year-to-date, if we look at yields, they are lower by about 70-80bps across the curve, and just to point out, in the 10 to 30-year range, we close out the month within 25-30bps of historic lows and we achieved those back in July of 2016. Then another extreme we’ve seen is really spreads collapsing. So MMA just put out a piece, they are talking about long-term credit spreads, they have really maintained that tightening trend really playing out since 2016. And if we actually look at spreads, the AAA to the BBB, for the year across the curve, we have really seen that significant tightening, by about 15-20bps or so, so if you are looking at a 10-year spot, it went from 85bps, that is AAAs, BBBs, down to 65 or so.
So as we talk about yields decreasing and spreads collapsing, it continues to prove the fact that demand rages in the municipal bond market. So we mentioned the positive fund flows earlier, and although this is only a partial year, this would be the second largest year of inflows when comparing it to full calendar years. The largest of which was 2009 at $79 billion. So significant demand for munis continues on as we move on a day-to-day basis.
And for our last topic, it really relates to issuers in a post-tax reform world and ways we are still looking to lock in lower rates and they are really doing that with forward delivery new issue bonds, and that is really the result of the Tax Cut and Jobs Act. As we mentioned in the past with this elimination of advance refunding deals, which is about 20% of annual issuance, or has been for the last 5+ years or so. And just for folks in the field, an advanced refunding was a mechanism an issuer used to refinance high-cost debt by calling out bonds more than 90 days prior to their optional call date, and proceeds from that new bond sale were actually placed in an escrow account and used to pay off that older high cost debt.
Right, so the major difference with the forward delivery is that there is no use of an escrow account. So instead, when a deal is issued with forward delivery, there is about a 3-12 month gap between sale date and delivery date, and when you think about that compared to a traditional municipal bond deal, those deals generally have three to five weeks, so a significantly longer time period. And now you ask, “Well why do issuers do that?” Well, it allows them to lock in current market rates and any savings that they are getting from taking out that higher cost debt, and investors on the other side generally get paid more for this. So you will get some additional yield as a buyer and that is due to lower liquidity and some uncertainty regarding interest rate environment. And in today’s environment with a flatter yield curve, especially in the front end, both parties, the buyer and seller, have a little more comfort in regards to changes in interest rate moves.
Right, and just to point out, this really is not the market standard, it is still a small portion of issuance that we see. In 2019, it is expected to be about $1.75 billion or so, but it is still a mechanism and a way for issuers to work around the impacts of tax reform.
We hope you found this information interesting and helpful. Please reach out to us at CR@Breckinridge.com with any questions or comments. Thank you.
Welcome to the Breckinridge podcast. I’m John Bastoni, the securitized products trader here at Breckinridge Capital. Today I am joined by Khurram Gillani, one of the portfolio managers on the multisector team and we are going to start off by talking about corporates. July was a pretty strong month across the board in spread products, but starting with corporates specifically, how did the sector perform and given the strong rate rally we had in Treasuries, I’m assuming they outperformed Treasuries?
That’s right. So, the big story this month was the continued strong performance in investment grade corporates, cash spreads tightened 7bps to end the month at an OAS level of 108, which is at the year-to-date tights and corporates did outperform Treasuries. Corporates posted 63bps of positive excess return during the month of July bringing the year-to-date total to 4.6% in terms of excess return but almost 10.5% on a total return basis given the strong rally we have had in rates so far this year. This actually makes it the strongest year-to-date performance for corporates since the financial crisis in 2009-2010. The rally was also very broad-based, BBBs and longer duration corporates were the primary beneficiaries, but all sectors and all maturity ranges had positive excess returns.
So did yields change much given the drop in Treasury rates?
No, not really. The yields that were on the corporate index stayed steady at around 3.816%, and that’s divided into 2.77% for intermediate corporates and 3.9% for longer dated corporates, and the spread differential between BBBs and As is about 56bps with BBBs yielding about 3.5% and As yielding about 2.9%.
It seems like Q2 was pretty strong for corporate earnings. Can you give us any insight into some specific stories there?
Yeah, so I think this is one of the reasons, and we will talk about more, for the strong performance in corporates. So over 90% of the companies in the S&P 500 have reported their Q2 earnings. Roughly three-fourths of them have beat their consensus earnings per share of targets but only half of them have beat their top line of revenue growth targets. Revenue growth is a better, I would say purer, metric for bondholders because it's less prone to adjustments and manipulation compared to earnings-per-share, however guidance for Q3 and beyond is not looking very encouraging at the moment, so if that guidance and consensus estimates are directionally correct, we may see a little bit more credit or sector-specific spread volatility in the coming months.
And are the market technicals continuing to be supportive in the IG space?
That's right and I think that’s another reason why corporates performed so well this month. Both primary and secondary market performance was strong, so first we had solid inflows during the month across all of fixed income. In particular high-grade bond funds which includes high-grade corporates, high-grade aggregate funds, and excludes high-grade short-term bond funds, averaged over $2.5 billion per week in July. The vast majority of that was into agg funds so that indicates a strong demand obviously from the fund side and indicates that investors have a good amount of money that needs to be put to work. So at this point, we are edging closer to the record inflow set in 2017. I think we are only about $30 or $40 billion shy of that. That, coupled with net dealer holdings which declined during the month and were generally negative throughout July offset the higher than anticipated primary market corporate supply.
So one example that it seems like we should highlight is Pepsi, which came with a new 10 and 30-year. Can you elaborate a little bit on the price talk and the spread price action from announcement to pricing?
Yes, so Pepsi, this is a company that's rated a A1/A+, they brought a 10-year and 30-year to the market, $1 billion in each maturity. The 10-year priced at 58bps which had basically zero new issue concession, and plus 80bps in the 30-year, which had a few basis points of negative new concession. This was the tightest 10 and 30-year corporate spread in 2019 and given that Treasury yields are lower on an all-in, absolute basis, Pepsi's funding costs were fairly low for this $2 billion issuance that they had.
That’s pretty impressive price action. I would imagine given the rally in rates we will continue to see more supply come out. Last month, did we see heightened supply and do you have any numbers behind that?
Gross supply was $103 billion per Barclay’s, bringing the year-to-date total to close to $800 billion so it looks like at this, you know, if we continue at this pace, we will surpass the $1 trillion mark for the eighth year in a row. Now supply is down, but it's down only marginally. So far this year, it's down about only 2% according to data from Barclay’s. August is typically a quieter month and expectations for this month are a little bit on the lower side, you know, call it $65 to $75 billion, but we should highlight that there are a few large debt-funded M&E deals such as AbbVie’s $80 billion dollar plus offer for Allergan as well as Occidental Petroleum's purchase of Anadarko that could cause these numbers to be adjusted upward.
Thank you, Khurram, that’s a great recap of the IG market for the month of July.
Great John, thank you. So, let’s turn over to the securitized market. So first, let’s talk about how did securitized products perform in the month of July?
Well, securitized products across the board had a strong month when you measure by excess returns which again is the return above similar duration Treasury. Agency MBS was the strongest at +43 basis points which was actually the best month in 4 years. Interest rates, namely the 10-year Treasury was relatively stable which the 10-year Treasury traded in a range of 1.95 to 2.15%. That range all month ultimately translated into lower volatility which is a key input into MBS performance. I mean, the way to think about this is the more volatile Treasury rates are, the more volatile mortgage rates will be, which means there’s a bigger chance that more homeowners will get a refinance opportunity. Ultimately, the more refinancings, the worse that is for MBS bondholders.
That’s right, that makes sense. And in terms of trends, you know, we have global banks that have been cutting rates, the Fed has also cut rates by 25bps so can you talk a little bit about how that is affecting MBS securities?
Yeah, I mean obviously the trend is for lower rates globally, and particularly when you talk about the Fed’s cutting of rates and some of the forward guidance that has come out since the end of July and at the time of this recording, the landscape has obviously changed a little which we’ll recap next month. But without getting too far ahead, lower rates ultimately mean more and more homeowners have the ability to refinance their mortgages, which we just mentioned, and that's obviously detrimental to MBS valuations. So right now, we see upwards of about 50% of all agency MBS and again, this number is climbing given rates continue to go lower. Right now, we see upwards of 50% of all agency MBS outstandings as having at least some economic incentive to refinance. And this number is up from as little as 10% to start the year, and obviously this naturally has started to weigh on spreads a little bit.
So, a few months ago that number was obviously a lot lower, to start the year, for example, we were at only about 10% of homeowners had intended to refinance, that number has climbed up to 50% as you mentioned. What are some of things that investors should look for in terms of prepayment protection?
There are a few things investors can look for for protection in a refi wave, which is what we are in now, one of the main things people look at is specified pools that have types of attributes with the most widely known being low loan balance pools. The way these pools work is that the bonds are made up of loans that have a maximum loan size of say $85,000 or $150,000 or $200,000, among others, and the theory goes, the lower the loan size, the greater the interest rate incentive a borrower would need to get over a refinancing hurdle. The way to think about that is there is there a fixed cost to refinancing between the application fees, legal processing fees, appraisals, etc. plus it’s time and effort to call your bank or our mortgage broker to refinance. So to put some numbers behind this, let’s say mortgage rates drop 50bps. On $100,000 loan, that may only save you about $20 a month but on a $700,000 loan that same drop in rates may be worth upwards of $100, $150 a month and you know, these are just made-up numbers to illustrate the example, but you know, the latter example, it would be much more worth it for the homeowner to pursue a refinancing.
So that makes sense. So, the lower the loan balance, the less likely you are to refinance your loan given the X percent drop in rates and that does offer MBS buyers some prepayment protection. What about agency commercial mortgage-backed securities, is this something investors should look at as a diversifier, do they offer a yield pickup or an advantage?
Yeah, I mean, there's obviously a lot of stories in the agency MBS specified pool universe that have similar attributes and we also wanted to highlight the agency CMBS sector which can act as a strong diversifier within the securitized products umbrella. Agency CMBS is, at a very high level, these are multifamily loans that are securitized throughout GSE programs with an emphasis on multifamily homes so these are not loans to build shopping malls or other retail outlets that you see traditionally in the more conduit CMBS space. These loans typically have some sort of hard structural prepayment protections built into them such as a yield maintenance, which can be manifested itself into a point upfront prepayment protection. So in other words, if a borrower wants to prepay their loan, they may have to pay a dollar price of 104 instead of par which is typical when a borrower refinances, so the additional four points upfront will act as a strong deterrent to refinancing that loan and that will inevitably protect the investor expected cash flows. We have seen this sector grow quite significantly over the past decade and the other thing we're seeing come out of these deals is more green-type deals which, for an ESG-focused investor like Breckinridge, is great.
Great, well, thank you John, and thank you everyone for tuning into the Breckinridge podcast this month. We hope you will join us next month.
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By Laura Lake
What do bond investors need to know about their options for duration as rates rise?
In our latest commentary, find out what January's rebound in risk assets meant for the investment grade fixed income space.
October saw another rate cut, lower ratios, increased muni new-issue supply and a decline in IG corporate supply from September.