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Municipal Podcast recorded on July 12, 2019

From the Desk - June Recap 2019

Podcast Transcript

Hello and welcome to the Breckinridge municipal market recap for the month of June. I am Matt Buscone, a portfolio manager here Breckinridge and today I am joined by Sara Chanda, a fellow portfolio manager. For this podcast we are going to give you an update on the size of the municipal market and who holds the outstanding debt, some recent legal challenges to both Puerto Rico and Illinois general obligation debt, an update on the Miami-Dade Expressway Authority, and a quick recap of municipal bond returns for the first half of the year.

So to get started, the Federal Reserve flow of funds data for Q1 2019 was released last week and it showed some interesting figures in both the outstanding size of the municipal market and the breakdown of actually who holds them. So Matt will actually take us through some of those figures.

So according to a breakdown from SIFMA of long-term debt issued by municipalities, total municipal debt outstanding is just over $3.6 trillion at $3.675 trillion. Well, that's down just slightly from Q4 of 2018. What is notable is it is down very sharply from its peak back in 2010 when the size of the outstanding municipal market was just over $4 trillion. And while other debt markets have grown substantially in recent years, thinking Treasuries and corporate bond issuance, the muni market has actually shrank during a time when household wealth has grown substantially, and we have seen that over the last couple of years and really the increased demand for both new issue municipal market bonds and offerings in the secondary market. Something else that has changed a little bit since the onset of the Tax Cut and Jobs Act of a couple years ago is a breakdown of the holders who hold municipal bonds. Individual investors subject to income tax rate hold about 70% of the outstanding debt, and that's done 47% through direct holdings, which includes SMA managers like Breckinridge, 18% through mutual funds, 3% in money market funds, and 2% from closed-end funds.

The biggest change in that breakdown of the debtholders over the past 10 years has really been on the mutual fund side. Direct holders have increased only marginally about 2%, or $33 billion, since Q3 2009 but mutual fund assets have increased by 63% or $285 billion, and that shift in mutual fund assets does seem to suggest some more concern over municipal credit environment and the desire for professional management.

So moving on to our next topic we wanted to highlight the ongoing willingness risk in the municipal market. When we assess muni credit, we are always evaluating both an issuer's ability to pay its debts and its willingness to do so. Now 10 years out from the recession we still see signs that repayment norms in the muni market have changed a bit. In the last few weeks we have seen three good examples of this dynamic in Puerto Rico, Illinois, and Florida.

That’s right, so let’s start off with Puerto Rico. So in Puerto Rico the oversight board in charge of the Commonwealth’s restructuring announced an agreement with some bondholders that includes lower recovery for holders of $6 billion worth of GO bonds. So the island did say in January that these bonds were issued illegally in breach of the Commonwealth’s debt service limit. So as a result of that the board is actually looking to limit the recoveries on this debt to about 35 or 45% and that is compared to recoveries on vintage debt, is what they are terming it or the debt that was actually issued prior to 2012 and that's estimated at 64%.

Then moving on to Illinois, a hedge fund in a conservative policy group actually sued to invalidate some of the states GO bonds, that was following this lead of the oversight board in Puerto Rico, and really in our opinion the lawsuit is unlikely to go anywhere. It is a legal long shot. It really does illustrate that sophisticated and deep-pocketed high-yield investors are likely to remain a presence in the market, really possibly a destabilization of one of the weakest names if the strong economy does turn sour. And lastly in Florida, the state actually passed a law to alter the governance structure of the Miami-Dade Expressway which is a highly rated toll road. This law will actually make it more difficult to raise tolls and displaces the existing board and again rating agencies actually took action on that, downgrading the bonds in May and that was when the bill was proposed but the governor actually still signed the bill anyway into law and more downgrades as a result may follow. So despite today's economic tailwinds all three of these are really good examples and they illustrate the issuer's commitment to bondholders really remains relatively weak. Low yield and strong demand for tax-free income challenges the market's ability to discipline wayward issuers and so willingness does remain a latent credit risk. And for our last topic we will turn over to the first half of returns and so munis have actually performed well year-to-date and so we will just take a few minutes to review some of those returns and discuss what segments provided the positive momentum.

So a lot of what we saw in Q1 continued again during Q2, another strong quarter for performance as overall yields continue to fall and demand remained very strong for municipal bonds. If we are looking at just the second quarter we look at the return for the 1 to 10 blend index, which has a duration of right around four years, that index was up 1.64% for the quarter bringing the year-to-date total to 3.88%. If you are looking across the maturity spectrum, long maturity bonds were the best performers at up 2.89% while the one-year index was up just 0.76%. To Sara's point earlier, lower quality bonds continued to perform exceptionally with BBB bonds of over 2.9% for the quarter and now up 6.6% for the year versus their AAA rated counterparts were up just 1.8% in the year-to-date figure up 4.5% for them. Of note, Illinois and New Jersey with both particularly strong performers, credits that we've often highlighted as being weaker on the credit side to their pension liabilities, but they have not been penalized for that as such yet this year. Municipals also benefited from very strong revenue performance bounce back in Q2 and continued inflows into high-yield mutual funds continue to drive those strong lower quality returns.

Thanks for listening. We hope you found this information helpful. As always, please don't hesitate to reach out to us at CR@breckinridge.com with any questions or comments. Thanks.

 

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