Welcome to the Breckinridge Market Recap. I am Sara Chanda, a portfolio manager here, and I am joined today by Matt Buscone, co-head of portfolio management. You know, we have seen some big market moves over the last month and quarter and so to start, we will provide a brief performance review for Q1 before discussing our three themes for today which include; lower Q4 state revenues, state support for infrastructure projects, and finally outlook for Q2. So, Matt will start us off with a performance review.
So March continued the strong run of recent muni performance that we have seen. And in fact, March’s muni rally was the largest muni price gain in the last 30 years and the strongest end to a quarter since 2016. The Bloomberg Barclay’s Municipal Bond index returned 1.6% for the month, pushing the year-to-date total returns to just under 3%. Really, this is a continuation of what we saw starting back in last November 2018. For the month and the quarter, longer duration was the star performer with longer maturities outperforming shorter maturities by a wide margin and just for a proxy, the 10-year index returned over 3% for the month. In a reversal from what we saw in the 4th quarter of 2018, lower quality municipals also outperformed higher quality by a wide margin. BBB bonds returned just over 3.5% for the month while AAA bonds returned just over 2.6% for the month. So while the performance was very strong in Q1, there was a potential warning signal for municipal credit in regard to state revenue and Sara is going to take us through some of those numbers.
That's right. So if you think about state and local tax deduction cap, we call it SALT, and the impact on the market, it really does continue to be a topic of conversation and while many taxpayers are feeling the effects, recent figures have actually shown that states are facing a decline in revenues generated by taxes really for the first time since 2016. If you look at personal income tax revenues, they have dropped more than 9%. That is due in part to residents paying taxes early before the cap took effect. Another point to make is that the stock market volatility we saw in Q4 that also contributed to the decline, and so not surprising, states whose budgets really rely heavily on those high-income earners were really most impacted. In thinking about Cal and New York specifically, in California, personal income tax revenues fell about 17% while New York saw a 25% decline from Q4 of ’17. And so the question then becomes, what is the impact? So some states may face budget shortfalls with many facing fiscal year ends in June and this could really crimp infrastructure spend, as states continue to grapple with other long-term liabilities like pension or OPEB, and as Moody’s actually stated, like unfunded pension liabilities rising OPEB expenses threaten to further crowd out other local government spending priorities like for infrastructure spending. To underscore the point, per Merrill, on recent research report, while state and local government infrastructure investment reached record levels on a nominal basis in 2018, hitting nearly $400 billion at annual rates in Q4 of ’18, or nearly 2% of GDP, that is well below the peak levels of 2.6% GDP back in the second quarter of ’09. And so, again, with limited federal government support, and deteriorating infrastructure, the question really becomes will we see state and local governments take matters into their own hands and begin to borrow in the face of these rising liabilities. So, Matt’s going to take us through some of that.
Sure, and despite the widespread acknowledgement about the need for increased investment in infrastructure and some high hopes at the beginning of the most recent administration that we would see infrastructure being a priority, nothing has been forthcoming at the federal level and that likelihood unfortunately looks low right now in the current partisan political environment. So given that lack of investment from the federal side, it is not surprising that the age of state and local government fixed assets has increased, whether you are looking at commercial structures, residential, water and sewer assets, or transportation, all those have continued to age as many state and local governments have opted for maintenance instead of replacement and new assets, since maintenance is typically cheaper than building out new assets. In many cases, states have begun to take these matters into their own hands. Governors in at least 11 states including Michigan, Ohio and Connecticut are pushing for new taxes, bond sales, and tolls to raise money for long-needed work on roads, bridges, and transit systems. One of the most common ideas has been to raise the gas tax as the gas tax at both the federal level and in many cases the state level is not indexed for inflation and those have remained stagnant over a multiyear period. But there are now proposals in 22 different states to boost different types of motor fuel taxes per the American Road and Transportation Build Associations. Other ideas include tolling in Connecticut, congestion pricing in New York City to help in aiding the Metropolitan Transit Authority, and a severance tax in Pennsylvania. Another sign of state and local governments taking this into their own hands has been the increase in new money issuance that we have seen over the past several years. Toggling back to performance, a big part of the driver of the strong performance of the muni market has been the tepid supply and strong demand recently. Do we expect that to continue into the second quarter, Sara?
That is a good question, you know, technicals really have driven performance and that piece of the equation on the supply side, supply has been contained and that trend continued even in March. We had $24 billion in issuance. That is down about 7% from February. If you look at the Q1 numbers for the year, $75 billion is up 14% from the first quarter of last year, that is 2018, but again we had a lower base in 2018 due to deals being pulled forward in anticipation of pending tax reform. So that is the supply-side of the equation. On the demand side, it has been record-breaking. We had 12 consecutive weeks of positive fund flows totaling nearly $23 billion at quarter end, that was really the best start to the year since the data recording began back in 1992, and so, again, with strong technicals the question will then become, will that continue? In fact, in the face of the next months, possibly more supply to come, but however balancing all that out over the next 5 to 9 months will see record maturities which could offset that uptick in issuance. So for a couple of data points, the second quarter of this year we are expecting about $65 billion in cash flows from maturities. That is the largest second-quarter cash flow ever. It is an 18% increase from last year and a 55% increase from 2010 and then for the remainder of the year we are looking at nearly $200 billion expected, that’s a 7% increase from last year and a 44% increase, again, from 2010. So while munis have had this strong run, it is really kind of hard to see what would drive them cheaper given the strong inflows in the likelihood of credit event, the biggest risk, I think at this point would just be a rise in Treasury rates.
Thanks for listening and we hope you found this informative. Please do not hesitate to reach out to us at CR@Breckinridge.com with any questions or comments.
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