Podcast recorded March 6, 2015
In light of the recent interest rate volatility, this podcast reviews our portfolio positioning
Thank you for joining the Breckinridge market recap for May. I am Eric Haase, a member of the portfolio management team and I am joined by Matt Buscone, a fellow portfolio manager. Each month we cover three topics which are relevant to the municipal bond market. So, this month, we are going to discuss the substantial drop in rates and the impact on performance, lower levels of bonded debt and how that is reflected in issuance, and some recent tax legislation that was proposed in the state of Illinois. While we’ve noted in prior podcasts that interest rates have fallen this year and benefited performance, the month of May was exceptional for the magnitude of the drop. What were the changes in the yields for the month?
So from two years and longer, if you are looking at the Treasury yield curve, they were lower by just over 30 basis points with much of that coming towards the very end of the month as the tariff rhetoric with China turned more negative and the market began to price in the possibility of one or even two rate cuts by the end of the year. The 10-year Treasury note ended the month with a 2.12% yield, lower by over 50 basis points so far this year. If you are looking over on the muni side, yields also fell sharply though not by quite the same amount as it did on Treasuries. Yields in the 5 to 10-year range were lower by about 20 basis points and yields from 20 to 30 years were lower by about 25 basis points, and just to give you some context for where AAA muni yields are versus the Treasury market, a 10-year AAA yield right now is at about 1.65%. So certainly lower yields have benefited as we have mentioned. Can you give us a quick update on returns for the year, Eric?
Sure, so the numbers look very strong. If you take a look at the Barclay’s 1-10 Blend, which is an index that has a duration of around four years, that was up by about 1.09% for the month of May. That brings the year-to-date total return to nearly 3.5%. So the main drivers of the strong returns were longer duration bonds as well as lower quality ratings. Strong demand and muted supply have also contributed to positive returns in the month. So on the demand-side it has been high. We have seen continued positive fund flows. Year-to-date we have seen around $37 billion coming into mutual funds, that caps off 21 consecutive weeks of inflows, and then on the supply side when you take a look at May, supply is around $132 billion on a year-to-date basis which is essentially flat year-over-year, but one thing to keep in mind is that April and May were lower by 16% and 22% respectively on a year-over-year basis. So we have been trending lower as the year has been going on.
And what that is also showing if you sort of take a step back and look at the muni market as a whole, it does show that issuers are still showing a lot of caution regarding debt issuance. There was a Moody’s report that came out recently that showed a couple of things. One is that the overall size of the muni market still stands at $3.8 trillion which is roughly unchanged from the level in 2010, and net tax supported debt of state governments is at $523 billion, about the eighth straight year of a minimal change in overall debt levels. If you are looking across states individually, about 30 states have seen their total debt loads decline in the last year, something municipalities often get criticized for, but we have seen debt levels fall in the number of those cases. There are a couple states that you saw an uptick in debt issuance. West Virginia's debt level rose by about $2.5 billion dollars. That was due largely to a backlog of infrastructure projects that they embarked on, and New York State’s debt increased by about 4% as well. But while many states continue to have these large unfunded infrastructure needs and public spending is up, in some ways infrastructure categories in many cases they are opting to use cash rather than debt, and that cash is coming from increased tax revenues that they have seen over the last year.
Right. So states are limiting debt issuance in general. They are looking to focus on other areas of stress. So they are looking at their underfunded pension plans and trying to figure out ways to solve that problem. We do look at 30-day visible supply, so for the muni market right now, that stands around $14 billion. That is really a largest number that we've seen since October of last year. So we do expect some kind of pick up in issuance, I guess I would say, to a little bit of supply coming our way. Another thing to keep in mind is just that some of these larger infrastructure plans are still being debated on the state level, so we will hopefully have some more clarity as we get closer to the end of fiscal year. One example is, I know Michigan, they are proposing a gas tax increase for a roads project. So as they move further along the fiscal year for each individual state, we will hopefully have a little more clarity. So the last topic we would like to touch on involves the state of Illinois. So there is some news out of the state regarding their income tax rates that drove spreads significantly tighter in the last month. So what are the potential changes?
So Illinois has joined a number states that have in recent years have increased their tax rates on high income tax earners. Illinois has long had a flat income tax rate of 4.75%. The recent passage by the legislature created six different brackets with those making over a million dollars now subject to a top marginal rate of 7.95%. That proposal now goes to voters for approval at the ballot box in November 2020 and if it passes goes into effect in 2021. So the governor's office projects additional revenue, about $3.5 billion, although that might be a little bit rosy and it is subject to the continued growth of high income tax earners in the state, something which the opposition was saying these graduated brackets might scare some of those folks or businesses away from, but all in all, from a debt holder’s standpoint it is positive for the state of Illinois. They needed obviously to create more revenues to tackle some of their unfunded pension liabilities and a backlog of unpaid bills, so it seems likely that it will get approved. Spreads on 10-year Illinois general obligation bonds, which is still a BBB rated credit, they now roughly call it 135 basis points higher than what you would get on a 10-year AAA rated muni. So if we were referencing that 1.6% before, this brings Illinois to roughly a 3% yield in that 10 year range, and that 10-year spread is probably, you know, 40 to 50 tighter depending on where you call it at the beginning of the year, so a significant improvement in spreads in reaction to the news on the income tax increases.
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Welcome to the Breckinridge podcast. I'm John Bastoni, the securitized products trader here at Breckinridge. Today I am joined by Khurram Gillani, a member of our portfolio management team. Today we are going to talk about the month of May with three main themes. We are going to start within the IG market. First we will talk about performance, both the rally and interest rates and sector specific, and then we will break down M&A related supply. So Khurram, we will start on the IG corporate side. For starters we should probably mention the huge rally in rates that we saw at the end of the month but turning to corporates, how did corporates perform relative to other spread products in April?
IG corporate spreads widened close to 20 basis points during the month, largely due to the growing trade tensions with China, Mexico, and other nations, and the generally lower economic forecasts. As a result, IG corporates underperformed Treasuries by 139 basis points during the month. Still, excess returns are positive 235 basis point year to date, but like I mentioned, all sectors were wider during the month.
So it looks like the yield on the IG index fell by 4 basis points to 3.61% last month. I am assuming that trend has continued so far this month?
Yeah, that is right, so rates rallied pretty significantly as you mentioned. The 10-year Treasury note declined close to 30 basis points during the month. So yes, the yield to maturity on the corporate index fell also this month by 16 basis points to close to 3.5%. The strong rally in rates across the curve did drive solid total returns for the month however, so while excess returns were negative, IG corporates delivered 143 basis points of positive total returns during the month and have generated 723 basis points of total returns during the year which compares to 7.5% total returns for the high yield corporate index.
It sounds like the return differential between IG and high yield has compressed?
From a total return perspective, yes.
Great. So what about ratings and sector, how did corporates perform into those different buckets?
Yeah, so it was mostly a risk off environment as you would expect, BBBs slightly underperformed As during the month. It wasn’t a pronounced outperformance but As did outperform, I would say, modestly during the month. However, BBBs do continue to outperform year-to-date. The credit curve did steepen during the month so front-end corporates outperformed longer duration credit. And from a sector perspective, sectors most exposed to the increase in U.S., and also the retaliatory China tariffs, underperformed during the month, so those are metals and minings and especially autos as well. Also, we saw during the month WTI oil prices fell by about ten dollars, so as a result refiners, oil field services, independent energy also lagged. However some sectors did outperform. So REITs benefited as they are prone to doing when rates decline, and also airlines also outperformed during the month.
It would make sense to me that BBBs have underperformed over the month given the pretty big risk off move but I am wondering if they have become a little more attractive as of late?
Yeah, I would say that it seems like investors are doing a little better job at pricing in the risk, I would say, a little bit more appropriately. So the average price differential between BBBs and As has averaged 62 basis points year-to-date versus 43 basis points in the first five months of 2018. So that’s a 20 basis point differential. From that standpoint, they do seem to be a little bit more attractive. Partly this is due to the ratings migration that we have seen really over the last several years and it continues so far, year to date, where now the BBB market by market values over half the overall IG market. Aside from some sectors such as financials and energy, the overall rating trends have been negative.
So May was another heavy supply month. Bristol-Myers and IBM were responsible for a large portion of that. Could you comment on how those bonds were received given the backdrop in the spread market?
Yes, so IBM is rated A1/A by Moody’s and S&P and for reference, Bristol-Myers is rated A2/A+ by Moody’s and S&P. Both of them came to the market to issue debt for M&A. IBM issued debt to purchase Red Hat, totaling $20 billion and Bristol-Myers issued roughly the same amount, $19 billion, to for their purchase of Celgene pharmaceuticals. So Bristol-Myer bonds actually came with 2 to 10 basis points of negative price concession so those bonds did pretty well versus their initial price talk. The 10-year, for reference, was issued at a spread of 105. That is trading 10 basis points tighter now in the secondary. The IBM bonds which were issued a day after Bristol-Myers came to the market were actually issued with 5-10 basis point of new issue concession, the 10-year coincidentally priced at the same spread as Bristol-Myers, 105, and currently that is trading flat in the secondary market. So overall, I would say Bristol-Myers bonds were definitely better received and continue to trade a little tighter versus the IBM bonds.
Okay, so let us swap gears and talk about the securitized market and how that fared during on the month of May. So we are first going to talk about ABS and how they had a strong month in terms of performance during May. We are going to talk a little bit about the swap curve and finish up with a quick review and performance in the MBS market.
For starters, let's talk about some of the drivers in ABS which actually had a very strong month producing 15 basis points of excess returns according to the Bloomberg/Barclays U.S. ABS Index. The sector actually saw a very strong flight to quality flows given the AAA rated nature of the bonds that are well protected by strong underlying borrower fundamentals and structural protections that are also built into the deals themselves. Now the convention in the ABS market is to quote nominal spreads over the swap curve rather than the Treasury curve as is convention in other sectors. So last month we did see some modest spread tightening over benchmark swaps.
So as I understand it, ABS had a good month mainly because of the fact that we had a rally in rates and the swap curve compressed as a result.
That is right so to explain a little bit about what the swap curve is. An interest rate swap is simply an exchange of a fixed-rate cash flow for floating-rate cash flow. Typically a swap begins with some sort of floating-rate index such as LIBOR, Fed funds, or the new SOFR index which we have mentioned on this podcast in the past. The market is then able to project out and hedge future floating-rate settings mainly due to the presence of futures contracts on these floating-rate indices to construct the swap curve. The swap rate could then be thought of simply as the average of those projected future floating rates. Now you ask why is it a convention in the ABS market to quote over the swap curve and there are a few reasons. The first one is the issue is of these securities, which are typically banks or credit cards or auto lenders, typically have assets that are tied to one of these floating-rate indices. So from a balance sheet management perspective, it makes sense to have your assets and liabilities benchmarked to the same index. Now that’s sort of known as basis risk. Second, again using… historically, some of the biggest investors in the space tend to hedge out their underlying interest rate exposure through the use of interest rate swaps. So the market has adopted the use of swaps as the benchmark rate in this space.
Thanks for that explanation, so, what happened that was notable this month in terms of swaps?
So the two-year swap spread hit 3 basis points over Treasuries which is actually the tightest level ever, going back over 30 years. Now there are a couple of idiosyncratic factors that drive the price action in this space, but last month the most notable was strong demand from the mortgage community to receive fixed and interest rate swaps. When we have a big interest rate move lower like we did in May, mortgages lose their duration quickly. The expectation is the holder of those mortgages will refinance their loans in what was ultimately a prepayment to the mortgage-backed security holder. So for the investors that want to maintain or hedge their mortgage duration, they will typically receive fixed on an interest rate swap to accomplish this goal. Now I just want to be clear that this does not have any effect on mortgage-backed security performance. This is strictly about the hedging of mortgage duration. So if we turn back to ABS to sum it all up, ABS saw nominal spread compression versus benchmark swaps and then the underlying swap spread also tightened versus Treasuries, to the tightest level on record. So the combined effect was significantly tighter spreads versus Treasuries in this sector, which drove ABS to be one of the better performing spread sectors in May.
Great, and you mentioned mortgage duration. How did mortgage-backed securities fare last month?
And again this is now we are switching gears into mortgage-backed securities so while ABS did very well, MBS did not. Agency MBS lost 40 basis points of excess returns versus Treasuries which is actually the worst month we have seen since November 2016. We had the sharp rate rally which stoked the increasing prepayment fears which weighed on the sector.
Got it, so that was the main reason for the underperformance in the mortgage-backed securities is the sharp rally in rates and investors concerned that people are going to prepay their mortgages and that kind of, like you said, weighed on the sector.
That is correct.
Okay great. Well, thank you everyone for joining us today on the Breckinridge podcast. We hope you found this informative and we hope you will join us next month.
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Podcast recorded March 6, 2015
In light of the recent interest rate volatility, this podcast reviews our portfolio positioning
By Peter Coffin
A discussion of three investment objectives in the context of high-grade bond investors.
We continue to closely monitor the impacts of tax reform and expect reactions from equity and fixed income markets to play out over the next several months