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Investing Perspective published on December 17, 2019

From the Desk - November Recap 2019

Podcast Transcript

Muni Recap

Welcome to Breckinridge Municipal Market Recap and thanks for joining us. I am Eric Haase, a portfolio manager and I am joined today by my colleague, Matt Buscone, a fellow PM on the tax-exempt desk. As we approach the end of 2019, we thought it would be helpful to provide an outlook for 2020. The tax-exempt municipal market earned some impressive returns in 2019 with an intermediate duration investment grade portfolio earning around 5.5% through November. So Matt, do you think investors should expect a similar total return in 2020?

It’s probably tough to think we’re going to replicate the results that we saw this year. We had some pretty unique tailwinds that all combined to produce those high numbers you were referencing earlier. If you look back at the major performance drivers this year, you had Treasury and municipal rates falling quite substantially over 100 basis points on the 10-year Treasury. The Federal Reserve reversed course and after raising rates several times in 2018 actually cut rates three times in 2019 and on the muni side, you had a very manageable number of tax-exempt supply that was counted with record-setting demand for mutual fund inflows. And on the credit side, you know, you had trend growth of about 2% per year, 2% of GDP growth, and as the year went on, you had fading recession fears so really a good environment from a credit standpoint as well. So as we look ahead to 2020, you probably are not going to see rates falling to the same degree as they did last year or as they did this year. The Fed is likely on hold, at least for the first half of the year or maybe longer, and there is the potential for some increased volatility as we go into 2020 with regards to the China and U.S. trade pact, we’ve got an election-year, Democratic nomination in the first quarter and a presidential election in Q4 this year. So while a lot of the rate forecasts are looking pretty benign for next year, it does seem like there is something that could come up that could make it more volatile next year than it was this year. And also with regard to munis, we don't expect to see any changes with tax policy yet that will impact munis either positive or negatively.

So Eric, we we talked about supply a lot in 2019. It was really a story of two halves. What was the main driver on the supply side?

Yeah, it really was interesting how it was so different between first half and the second half. When you’re looking at June 30th midway through the year, total supply was up around 4% year-over-year. Keep in mind that it’s off a lower base year-over-year. But really in the second half of the year, supply picked up pretty significantly and where we’re sitting now, we’re at about $380 billion in total issuance and that’s up around 18% year-over-year and that’s through November. So tax exempt supply was up only around 9% year-over-year so what does that tell us? That tells us that the taxable municipal issuance picked up significantly. We are looking at around 16% of issuance year-to-date through November. Last year over the same time period, it was around 9% of issuance and that's basically on trend with what we’ve seen on an annual basis, kind of around that 10% of issuance each year. If we’re looking forward to 2020, the question is well, are we going to be able to sustain total issuance as well as taxable municipal issuance? Right now, the way it looks is total gross issuance is expected to be around $415 to $430 billion, depending on whose research you’re reading, and really that's around a 5% pickup in what’s expected in total supply this year. So a lot of the research you read thinks that we’ll probably get to $400 billion for the year. And a lot of this is actually coming from an increase in refundings. That comes from taxable advanced refundings and also next year, we expect to have more fundings from callable BABs, taxable municipals issued years ago, 10 years ago. If rates remain low, we expect to continue to see the strength from taxable issuance. Basically what happens is that the math makes sense where there’s still savings from refunding tax exempt bonds as taxable municipal bonds. But if rates do rise quickly, we could see a reduction in refundings which ultimately lower supply.

So Matt, that’s kind of the supply story. What do you think about the demand side for next year?

So much like I was referencing, we don't expect rates to fall as much as they did next year as they did this year. We probably won’t see the same level of inflows into mutual funds as we’ve seen so far this year. There's been $86 billion of inflows into mutual funds, positive flows every week so far this year, and we’re higher than the largest inflow that we've ever had which was back in 2009, I believe. So we are already at record-setting flows, probably unlikely that we see that replicated again next year. Retail demand is likely to remain strong. That's a continuation of the increased demand from the Tax Cut and Jobs Act at the end of 2017 when investors lost the ability to deduct their state and local income taxes. It left them searching for more tax-advantaged assets. Tax-exempt municipals remain one of the most common ones of those so probably still strong demand from retail but on the fun side, remember, too, they have had falling rates and a very strong driver of performance so far this year. That started to fade a little bit as the year ended, the returns were definitely frontloaded towards the first half and first three-quarters of this year, and lower rates generally reduce inflows. If you’re looking at a 10-year Treasury below 2% and a 10-year AAA muni at 1.5%, they aren’t as compelling as they were a year ago or even six months ago, so sometimes that reduces inflows. But on the other hand, if rates increase or if we do see a backup, investors don't like to see negative total returns in their bond funds and that could spark some sort of outflow cycle for munis as well. So overall, if we look at the two together and think of the technicals in the muni market, it was very supportive this year via strong demand and lower levels of, or I’d say manageable levels, of tax-exempt new issue supply. Next year it gets a little bit worse. And one of the nerdy things we talk about in munis is net negative supply and this year, in 2019, it was -$50 billion which meant there was $50 billion more maturing bonds and coupon payments coming back into the market than there was new issue supply. Next year, that's forecast to be only a -$20 billion. So not quite as positive there and probably not as good on the inflow side as well. So probably a little bit weaker technical picture.

The other main storyline that we talked about a lot in 2019 was the returns of lower quality and high-yield bonds and that's kind of tied a little bit together with the economy so what do we expect from the economy in high yield next year?

Yeah, so overall in 2020, we have a positive credit outlook on the year itself. To the points you made earlier, you know, in the U.S. unemployment is at, you know, a +3.5%, payrolls are strong, jobless claims remain near lows, so overall it's a pretty benign credit environment and ultimately it’s based on a strong consumer. Having a strong consumer is very positive for the states or it's good for the states. Generally speaking, state general obligation debt, the main revenue source for, to pay off that debt is personal income tax as well as things like sales tax, etc., etc. So all of those are stronger and we have a stronger consumer. On the local general obligation debt side, we are also looking at, you know, how lower rates are supportive for real estate and housing. So that debt is generally paid off from outflow and property taxes so in an environment where rates are lower and the housing market is stronger, that's a positive for the revenue source for local general obligation debt. What we do think on the growth side U.S. GDP at around 2%, it’s continued but slowing growth and that flows down to the states as well when you look at the gross state product and overall the revenue for the states. So in 2020, we do expect that high yield will outperform investment-grade and really it's not as much due to a kind of reach for yield as more of a kind of carry trade. They have more carry and high-yield in investment-grade and in a benign credit environment, we don't necessarily see any major credit issues that are going to be affecting bonds across the board. One potential credit story that we’re going to keep our eyes on is just the potential restructuring of debt of the U.S. Virgin Islands. This is similar to the story of Puerto Rico, its inability to pay story, and when you look at the issues they have, it’s a shrinking population, underfunded pensions, and it’s a smaller risk than Puerto Rico, but nonetheless something that we are going to keep our eyes on.

Thanks very much for listening and we hope that you in the field found all this helpful. If you have any questions, please reach out to us at

IG Recap

Welcome to the Breckinridge podcast. My name is John Bastoni, I’m a securitized products trader here. Today, we will be going over the month of November and giving you a little bit of an outlook in certain sectors. I’m joined by Khurram Gillani, one of the portfolio managers on our multisector team. And Khurram’s going to kick things off with an overall performance recap in the investment grade market. So Khurram, nice to be with you here today. Can you give our listeners some performance-related highlights?

Thank you, John, it's good to be here with you today. November performance was a continuation of the solid performance in corporates that we saw in October. The nominal spread on the corporate index was 6 basis points tighter on average, due primarily to strong demand and better-than-expected earnings. The nominal spread of the corporate index ended the month at the tightest level since March 2018 as corporates outperformed Treasuries and most others spread product during the month. BBB corporates outperformed As, and longer duration corporates outperformed shorter corporates as the corporate credit curve bull-flattened during the month. So year-to-date total excess returns now stand at positive 5.5%.

That’s great. So it seems like there's been a lot of supply in terms of new issuance over the Q4 here, so I’m curious if demand has kept up with supply at all.

Yes, it did. So according to data from EPFR, investment grade mutual funds had over $17 billion of inflows in November which brings the year-to-date number to over $270 billion which is really a staggering amount and will make 2019 a record year for inflows into bond mutual funds and ETFs. On the supply side, in November supply was close to $100 billion. According to data aggregated by Barclay’s, total investment grade corporate issuance through November has now surpassed total gross issuance from 2018. The majority of the issuance this month came from the pharmaceutical company AbbVie which issued $30 billion across 10 parts to fund their acquisition of Allergan. This was the largest deal of the year and the fourth-largest deal of all time. Orders climbed to over $77 billion at the peak. To give you some context on where it priced, the 10-year priced at a spread of +130 relative to the 10-year Treasury which was roughly 10 to 15 basis points through AbbVie’s credit curve. Most recently, AbbVie 10-year was trading 15-20 basis points through the new issue spread.

Wow, so it seems like there was really strong demand for that deal and for, you know, most deals in general in the month of November.

Yes, it was.

So another story that has continued to play in 2019 is the issuance of reverse Yankee issuance. Can you explain what exactly reverse Yankee issuance is, please, Khurram?

Reverse Yankee issuance is when a company that’s based in the U.S. issues debt in the Euro market. So according to data from Bank of America, investment grade reverse Yankee issuance has been a record €125 billion this year. U.S. issuers are making up a large part of the primary market in Europe. Many investors and analysts expect that trend to continue and maybe be even higher in 2020 given the quantitative easing from the ECB is continuing to support low and even negative yields. This month is one example. We saw Stryker, which is a large medical device company, issue about $5.5 billion of debt in the euro market to fund an acquisition. The 10-year came with a yield of roughly 81 basis points so they are definitely saving money by issuing debt in the Euro market which is why a lot of companies this year have issued so-called reverse Yankee bonds.

That’s great. It seems like something that totally makes sense from the issuer’s perspective.

That’s right. So turning to the securitized market, John, it looks like you’re going to give us your outlook on mortgages, asset backed, and agency CMBS for 2020. Let’s start with mortgages. What do you see in terms of spreads and supply and kind of refinancing, you know, convexity profile, what are your thoughts?

Sure. So we’ll start with agency mortgages which will most likely start the year. At the time we record this, we are, you know, about halfway through December but we are looking at most likely starting the new year near the multiyear wides in spread terms so that sort of flags as cheap, especially relative to other spread products which more or less continue to tighten. It could provide an attractive entry point into the sector as we start the new year. From a refinancing/convexity standpoint, prepayments will probably remain elevated in the near term. One thing we’re watching pretty closely is the technological advances we've seen in mortgages lately. Such as things like property inspection waivers and automated income verification which will ultimately speed up the refinancing process and make it more efficient and cost-effective to borrowers. Refinancing now is a big component of the overall total supply picture. The other half of the equation is typically purchase originations. I mean, given that refis should remain on the higher end of the range, we think net supply projects in the $275 billion to $300 billion range for 2020, which would be a modest pickup over the past few years. The past three or four years in general have been on the higher end coming out of the financial crisis 10 years ago. Lastly, as it relates to agency mortgages, GSE reform continues to pop up in the headlines and is something we’ll continue to monitor. As we head into an election year, however, it's unclear if we will get any more meaningful progress or if it continues to just be chatter.

Okay, great. So let's turn to the ABS outlook. So far this year, spreads, they’re off their tights. We’ve seen a little bit lower supply, but excess returns have been positive and the consumer ABS sector in particular has done well. What do you see for 2020?

We think the spreads will probably continue to be range-bound and tend to probably trade near the tighter end of the range. You know, despite all this, we still see a fair amount of value in some of the top prime consumer sectors such as prime autos and credit cards especially compared to other like duration spread products. The sector so far has performed very well from an excess return perspective and we think this will probably continue albeit at a not quite as strong pace into 2020. On the fundamental side, I would say we will continue to look for more normalization coming out of some very strong years since the financial crisis. We don't really expect any major surprises in some of the highest quality sectors that we track from a delinquency and default perspective, however. Lastly on the supply side, as it relates to ABS, we continue to see another $200 to $225 billion in net supply which again is a number that’s more or less consistent with the last few years. The wild card that I'll mention here continues to be bank credit card supply which has been running anywhere from around 30 to 40% lower year-over-year. Most of the bank issuers have not needed to ABS channel as a funding source since deposit growth and balances remain robust so that is something we will continue to monitor into the new year.

And then finally turning to agency CMBS, you know, valuations have been attractive, we would say this year. They, too, have performed well. We have seen low delinquency rates throughout the year. Do you think that will continue and spreads will continue to remain fairly attractive?

Yeah, we think that spreads will remain pretty sticky here and relatively stable. The outlook here is for the theme to continue, although we could see some rotation out of agency CMBS into agency MBS given how much wider MBS is right now. That could pressure agency CMBS spreads moderately wider if that does ultimately materialize. And that would be sort of a reversal of some of the price action interplay between the sectors we’ve seen over the past few years where it was mortgages that were on the richer end of the range and agency CMBS that looked cheaper. On the supply side, it should remain healthy and will probably come in somewhere around the $150 billion net supply range which is again not all that different from the prior years, and, you know, I should mention that the sector continues to see more and more different and diversified buyers entering the space which has helped support demand side of the equation over the past few years. Lastly on the fundamental side, we see default delinquencies and the like remaining very healthy in the agency space and they compare very nicely to the non-agency sector.

Okay, thank you for that outlook. So it sounds a lot like 2018, 2017 but maybe more potential for a little bit more headwind.

Yes, that’s correct.

Thank you, John, for that update on the securitized market. Thanks everyone for listening to our podcast today. I hope you join us next month for our market update.




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