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Investing Podcast recorded on December 13, 2018

From the Desk - November Recap 2018


Muni Recap

Welcome to the Breckinridge podcast. I am Matt Buscone, a portfolio manager here at Breckinridge Capital Advisors, and today I am joined by one of my colleagues, Eric Haase. Given that we are close to the end of 2018, we thought this would be a good time to review some of the major market themes of the year and discuss what to expect for 2019. Today we are going to focus on the potential supply and demand patterns, the relative value picture for tax-exempt munis, and the health of municipal credit quality. To lead it off, Eric is going to walk us through some of the changes to the supply side of the market this year.

Thanks, Matt. So, it was an unusual year for supply and that is primarily due to the Tax Cuts and Jobs Act that was enacted in the end of 2017. So, year over year what we have seen is that new issue was lower by about 17.5% and that was through November which puts the full year 2018 issuance on pace for around, call it $335 billion, and that overall relative to last year is lower by 23%. Tax reform has caused a much lighter year in issuance primarily due to about $40 billion of issuance that was pulled from 2018 into 2017 and that is a result of the elimination of advanced refunding in the market through the Tax Cuts and Jobs Act. Another trend that we have actually seen in the new year is that the percentage of new money issuance has increased, and that is natural due to the lower amount of refundings we have seen. So what we have seen is a percentage of total issuances, 47% has come through new money last year and this year that is up to 70%.

So we had substantially lower levels of new issue supply in 2018 so that obviously begs the question for what we are going to see next year. There is a little bit of a range of estimates coming out from the street and some of the sell side analysts and they are in probably the $360 billion to $400 billion range. Much like this year, we would expect to see new money issuance remain a larger component of the total issuance again due to lack of the ability to bring advance refundings. The wildcard obviously with the with the amount of new issue supply that we see, is what happens with interest rates. Obviously lower rates make it more beneficial for issuers to either borrower or do refundings, and in this case we would be looking at a level of current refundings that could be brought to market. So, remember that there is a large backlog of unfunded infrastructure projects that need to be done. Depending on the estimates you look at it is anywhere from $2 to $3 trillion, so certainly there is the need there to borrow. The question is, are municipalities willing to borrow, and will that issuance surprise to the upside. Likely going to be higher than this year, the drop-off will not be as substantial due to some of the changes we saw in the tax law but it is likely the composition is the same with more new money issuance and less refunding issuance.

So along with supply, the tax reform has also impacted the demand side as well, and that looks like it will continue into 2019.

That's right, if you look at the demand side, it was really bifurcated so far this year. For much of the year, we had mutual fund inflows that were positive and, in fact, we reached about $12 billion of inflows by late September and that was driven primarily by retail interest in munis, given the tax law changes. But away from mutual funds, banks and insurance companies were active sellers for municipals and they continue to show a reduced appetite given that taxable alternatives are more compelling now for them given the lower tax rates.

And the story remains the same in 2019. So, the cap on state and local tax deduction of $10,000 for the retail investors makes tax exempt municipals much more attractive. And one thing that we are keeping an eye on is that we could see an actual increase in demand in that 10-year and in space where the traditional retail buyer purchases bonds, and that is due to higher than expected tax bills that may come in April when people go to pay their taxes. On the other side of the ledger, looking at banks and insurance companies, they will continue to right size their allocation to tax exempt municipals in their investment portfolios, so we could see some more selling. It will be at a slower pace but we could see more selling come from the bank space. Additionally, their appetite, being that they are not buying as much, will remain lower further out on the curve.

So the changes to the supply and demand dynamics had a big impact also on the shape of the curve and the relative value of munis. What does the relative value picture look like for munis, Eric?

So, we look at the ratio of municipal and Treasury yields for the same maturity and what that does is it gives us a gauge of relative value, so the lower that value is, the lower the ratio is, the less attractive it is to own municipals, versus the same maturity U.S. Treasury. Based on our supply and demand expectations, we could see ratios in the shorter part of the curve tighten in a little bit. So we are a little rich there to begin with, meaning that the ratios are fairly low but additional retail demand could keep ratios firm or even a little lower. The longer end goes back to the whole story of the bank and insurance companies reducing their allocations to muni bonds. What we could see is less buying or continued less buying in the longer end of the curve as well as additional issuance, so a lot of new deals or new money deals that come have a higher proportion of the deal come in longer maturities. So that could actually, the combination of those two factors, push ratios slightly higher in the longer end of the curve.

And as far as the shape of the curve, we saw some different performance this year when you look at the Treasury curve and municipal curve. On the Treasury side, the slope of that curve has gotten very flat, mainly due to the Fed raising interest rates several times this year. So we have seen rates rise in short bonds, say 2-, 3-, and 5-year bonds but we have not seen much of a rise in that 10- and 30-year space. So that curve is very flat from 2 to 10 years and also slightly inverted in the very short end, where you have got a situation where very short bonds, 2- and 3-year Treasuries, are actually out-yielding 5-year treasuries right now. If you look at the muni curve however, that actually steepened in 2018, given what Eric was just laying out with the different demand patterns, strong interest in retail from the front, less interest from banks on the long end and so we have seen a steeper curve. We do expect to see some flattening from the muni curve in 2019 particularly if the Fed continues to raise rates in the short end, that may continue to influence the muni curve.

So for our last topic, we wanted to touch on the near and long-term picture for municipal credit quality. So Matt is going to cover the near-term picture.

So the stronger performance of lower quality muni bonds thus far this year has been a major theme and if you look at the near-term credit picture for most municipalities, that does seem justified as their revenue and liquidity outlook during the year was very good. Again if you look at state credit, the performance of state credit is largely driven by income and sales tax receipts so strong growth on the employment side and continued strong GDP growth drives both of those metrics. And if you are looking at the local level, that is really driven by property tax increases, so as the residential/retail market continue to be strong throughout most of the year, those property tax receipts higher, so again, their near-term liquidity and revenue outlook is very good, so you would say some of that performance is justified so hence the tightening of spreads. But as we look at it, it is really unlikely that you are going to see credit continue to improve from here. We are very late in an economic expansion. We have had a good run of growth and now you are starting to see more people talk about a potential recession, probably not in 2019, but maybe at some point in 2020. So in our minds, the overall credit health of municipalities is likely as good as it gets right now.

And when you look at the longer-term picture for state finance really what we are looking at is the state pension funding and the level of funding. That is what drives a lot of our long-term outlooks. It is really the largest credit concern in the market to be honest with you. What we have seen in the using the last couple years is that we have had strong economic growth overall and strong stock market returns. The problem with that is that we have still seen the underfunded status worsen for some of the weaker states that we look at or the weaker credits, and those include states like Illinois, Connecticut, Kentucky, and New Jersey. This has been masked slightly due to the search for yield, so investors will overlook things like this in order to pick up yield. May not be willing to take on additional interest rate risk by moving further on the curve or liquidity risk, but they have been willing to take a little bit of additional credit risk in the portfolios. So, we have seen spreads either tightening on those names or remain fairly reasonable. 2019 could be a year where the long-term outlook and looking into the pension funding really comes back into focus, and that could be expedited if we have an equity market sell-off and funding statuses look worse.

That is right. Well we hope you in the field found this helpful. Thank you for listening and we will talk to you again soon.

Corporate Recap

Welcome to the Breckinridge broadcast. I'm John Bastoni, one of the traders here at Breckinridge. Today I'm joined by Khurram Gillani, one of our portfolio managers on the taxable side. And we're going to start today with talking about corporates. We have three themes that we're going to talk about today, the first one being performance. So, corporates, you know, had a tough month in October. I'm curious how the month of November played out.

That's right. So corporates posted negative excess returns again in November due to the uncertain state of the tariff negotiations, sharply declining oil prices and rising concerns over Brexit, as well as the Italian fiscal situation. So taken together, volatility increased in November, this was actually the largest monthly excess return loss for corporates since January 2016, the IG corporate spreads widened 17 basis points during the month. IG corporates did outperform high yield corporates, however, but Treasuries, supras, and local authorities were among the best performing sectors within fixed income as they benefited from a flight to quality.

You know, it's interesting that despite the underperformance, we continue to see record amounts of supply coming month after month. We saw supply come in last month at about $89 billion versus $54 billion last month and $72 billion November 2017. I assume that led to some greater new issue concessions?

Yeah, so new issue concessions did increase during the month by an average of 2 basis points but remember that in October, new issue concessions also increased significantly so overall, issuers are definitely paying a little bit more than they would have to come to the market. On the supply side, it was definitely a negative technical and then also on the demand side, we saw fund outflows from high-grade bond funds. There were about a little less than $1 billion this month. Most of those outflows came from intermediate to long bond funds but short duration bonds actually had positive inflows. We had negative supply/demand technicals in November.

I want to turn to some sector-specific stories that we saw play out in November. The main theme, one of the main ones, I believe, that played out was the decline in oil prices. WTI oil declined over 20% during the month to $50 a barrel and how did that affect the various energy subsectors?

That's right, so it was a tough month for WTI oil prices so I would say spreads in the oil fuel servicing sector, which includes names like Schlumberger and Halliburton, that was the worst performing sector during the month, independent energy also fared pretty poorly so names such as Occidental and EOG resources, spreads also widened there. Overall, generic spreads in both sectors were between 25 to 30 basis points wider during the month, so pretty meaningful.

That does seem like a large intra-month move. Most energy names are rated in the BBB bucket so I would assume that has led to some spread tiering between the BBB's and the A spreads that we've seen lately.

That's right. They are, the energy sector tends to be a little bit more skewed to BBBs, so because we've seen spreads widening in the energy space, the spread between BBBs and As has also widened during the month, so now it stands at 63 basis points which is actually the biggest difference in two years. The average for the year is about 47 basis points so we're definitely higher than the average so far this year. This is a sign that the market is beginning to really differentiate between As and BBB's more in terms of credit risk in a post QU world than they did before.

Lastly, were there any credit-specific stories of note in November?

Yes. This month was PG&E, Pacific Gas and Electric. This month they were sued by multiple victims of the Camp Fire which was the largest and most destructive fire in California history. Rating agencies have also responded with S&P downgrading PG&E to BBB- and placed the company on credit watch negative on the increased wildfire risk. Moody's downgraded PG&E to Baa3 and kept the rating on review for downgrade, so typically utilities are able to recover costs from natural disaster damages such as hurricanes, floods, etc. However, in California it's only one of two states that operates under what's called an "inverse condemnation rule” which basically means that the utility is liable for property damages, legal fees, and firefighting costs if their equipment is merely found to have contributed to the fire, even if the equipment was in good working order. So if gross negligence is found in this case, parties can also sue for lost business income and other damages so the stock, PG&E stock, was down as much a 60% this month. It looks like they're going to be on the hook for, you know, billions, maybe tens of billions of dollars for this wildfire and they're already on the hook for $15 billion from wildfires that occurred in 2017.

That's a lot of detail, thank you for that specific to PG&E.

Great. So, let's turn to securitized markets. So performance was also obviously a big theme there. Can you tell us what happened within the MBS and ABS market this month, John?

Yeah. November got off to a rough start for mortgage-backed securities, and it was really a spillover from October with the major themes being realized interest rate volatility, really shooting higher into the broad interest rate selloff, but perhaps the most importantly, the net supply/demand imbalance and part of this is just the first part being the organic net supply picture, which is simply mortgage loans being securitized into mortgage-backed securities and the other part is the Fed balance sheet runoff which we have discussed numerous times in this podcast and just to remind our listeners that the Fed is effectively net-buying zero of mortgage-backed securities for the first time in multiple years. Mortgages did rebound late in the month following Fed chair Powell's speech which the market interpreted as dovish and provided a boon to all spread products including mortgage-backed securities. MBS ended the month flat, Treasuries on excess return basis despite being down 17 basis points as late as the 23rd of November so we had a pretty nice rally from there. Turning to ABS, really, despite all the volatility over the past two months, ABS continues to be a relative safe haven. We have no real notable headlines in the prime space and to end the month, ABS produced only -2 basis points of extra returns to end the month.

Interesting. So you mentioned organic net supply as a very important part of the overall supply/demand equation for mortgage-backed securities. Are there any leading economic indicators that you use to gauge net supply and what that's going to be like in 2019, and also, can you tell us, you know, what is organic net supply and what significance does that have for MBS?

Yeah, so organic net supply is simply the creation of mortgage-backed securities from mortgage loans that originated and then securitized into those pools. At the end of the day, if there's higher supply, that means more mortgage-backed securities are going to need to be absorbed by the market and that leads to wider spreads. To back up and answer your first part of the question about the economic indicators that we look at, the first part is, well, it certainly helps that we're entering the slow seasonal part of the year. Winter historically for home sales and refinancing activity is very slow but there are some economic indicators that we do look at to monitor for clues on possible future home supply, first being the National Association of Homebuilders. This index printed a 60 last month versus expectations of a 67. And the index printed a 68 in October so we did see the largest one-month decline since February 2014. Second, housing starts came in at up 1.5% versus 2.2% expectations, but if you look in the details there it's the single-family component decline 1.8% month over month so the headline gain that we saw there was driven almost entirely by the multifamily component and just to remind our listeners, agency mortgage-backed securities are made up entirely of single-family loans. Third, existing home sales most recently posted a 1.4% gain versus a 1% gain expectation and the headline gain is great, but it was actually the first rise in seven months. And lastly, new home sales for October dropped sharply at -8.9% month over month, but perhaps the most concerning part of this report was the acceleration in the month supply to a 7.4 level which is a level we have not seen since early 2011.

So overall it looks like a pretty mixed picture for supply. We have the homebuilders mix which is down, housing starts are down, existing home sales are slow and steady but there, you know, it's not double-digit gain by any means, so what does that tell you about kind of organic net supply for 2019?

Yeah, so at the end of the day, there's no denying that the housing fundamental picture is weaker and continues to weaken but these indices that I mentioned, in and of themselves they don't solve the net supply problem that the market is facing, but it could potentially point to lower organic supply. Right now, early estimates for net organic supply, which again is the first part of the equation, are about, for 2019 are about $225-250 billion. Fed runoff, which is the second part of the equation, should peak next year and add about another $175-200 billion on top of that.

The forecast for 2019 seems like it's pretty flat to 2018, is that right?

Yeah, that's right, but you know, we are, just to remind our listeners, from a net supply picture agency mortgage-backed security sector is facing, we still are operating in a very high supply environment.

Got it, thanks. Well, thanks everyone so much for tuning into our monthly Breckinridge podcast. Join us next month when we will wrap up 2018 and opine on what's to come in 2019.




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