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Investing Perspective published on November 18, 2019

From the Desk - October Recap 2019

Podcast Transcript

Muni Recap

Hi, welcome to the Breckinridge municipal market recap. I'm Sara Chanda, a portfolio manager here, and I am joined today by my colleague Eric Haase, a fellow PM on the tax-exempt desk. Thanks for tuning in. So we will start off today’s podcast with a recap on October's market followed by conversation on housing bonds and finally a discussion on climate risks and specifically what we are seeing in states like California. So I know we closed out Q3 with some volatility in the markets, Eric, what did October look like?

So we ended the last quarter with volatility in the markets and September was the first negative month of performance in 2019. So depending on what your duration was in your portfolio, returns ranged from about -20 basis points to -1% and overall the standard intermediate portfolio was down around three quarters of a percent. So now, fast-forward to October and returns were back to flat or actually positive across the curve. So muni yields fell in the shorter maturities but they rose 8 years and longer, so one thing this did do was reverse the inversion that we had in the front end of the curve. Overall, the best performer over the month was the 5-year part of the curve which turned around half a percent and the long end was flat to negative. Now on the credit side of the story we did have a reversal with higher quality actually outperforming on the month. So credits with AAs or better credit ratings were up around 20 basis points and As were only up around 15 in the month of October. But when you wrap that up into the whole year, A-rated still outperformed AAAs by over 130 basis points.

Right. Another story that kind of continued even into October was really the technicals in the markets, so on the supply side one of the big stories of the month is really $52 billion in issuance is what we saw. Really brought on by a deluge of taxable muni issuance, and that is really after two back-to-back months of $30 billion in supply. And really what we are seeing is that issuers are coming to market really benefiting from these lower rates and using the taxable market as a mechanism to refinance debt, something no longer allowed in the exempt market post tax reform. So that is why we saw that big uptick in the taxable side. Over the month actually, according to The Bond Buyer, more than $13 billion was taxable, 25% of the total that we had seen and so through year-to-date October supply now is about $330 billion, that is a 13% increase from the same period last year and looking at the 30 day visible which is a good metric for us to look at to see what is to come. Starting in November it was more than $17 billion. That is actually the largest number we have seen since 2008. Now on the demand side of the equation also continued to be the same kind of pace that we saw. Demand has not really slowed at all. Mutual fund flow is a good proxy for us to talk about demand, there has been 43 consecutive weeks of positive inflows, that was through the end of October. That pushed year-to-date fund flows to about $75 billion or so, continuing on that record streak. So now, turning our attention to our second topic of today, we usually tend to highlight a sector that we feel offers some additional value and this month we thought it would be interesting to talk about housing bonds. So Eric, let us kick it off with that.

Sure. So, you look at the housing sector of the municipal bond market, really it is originated by local housing authorities in individual states. So the best way to think about it is that an agency will issue bonds, the proceeds from those bonds are then loaned out to housing companies or to eligible borrowers. It is really broken into two sectors, there is single-family and multifamily. And basically the way the market is constructed now, about 60% of issuance falls in that single-family side and 40% falls in the multifamily side. These are generally considered special revenue bonds and the revenue from the mortgage payments and accounts and reserves that are established under each individual issuers indenture, as well as investment an equal number of balances support the revenue to pay down the debt. So what is really the purpose of the housing sector of the muni market? Really it has an affordable housing purpose, the idea is that with these proceeds, you can provide mortgage options for lower-income applicants, you can provide down payment assistance for first-time homebuyers, and also on the multifamily side there is also a portion, that is primarily on the multifamily side, which is for construction loans. So assuming that you want to build an actual development, the borrower can lend capital to a construction company or builder to help build these individual housing facilities. One thing to think about are kind of the factors, so there are single-family and multifamily, what is really the difference? On the multifamily side it is a more diversified loan base so there is a little less concentration risk as you would see in a single-family borrower. And when we look at these deals, there are there a number of ways to participate in this portion of the market. These bonds and these deals can come taxable or they can come tax exempt as well. On the tax-exempt side, generally we are seeing a 15 to 25 basis point yield pick-up, or additional yield relative to a similarly rated GO or revenue bond. And really what are the risks that are paying that additional yield? One, these par bonds, so there is de minimus risk on them. Also, there is prepayment risk and one way to mitigate that risk or those risk factors, are focus on shorter maturities that mature five years and in. These bonds do have shorter calls, but because of the shorter maturity on the overall structure you do have limited prepayment risk.

Right, so outlining a number of reasons why we would actually want to invest in some of these structures, in the segment in general, and thinking about issuance, we just talked a little bit about that, and it is really a growing segment of the market. And as we saw muni to Treasury ratios decline, these lower ratios actually really increased the value the subsidy that some of these programs provide to borrowers. So based on some data that we collected from The Bond Buyer, looking at a 5-year span from 2013 to 2018, issuance has actually increased about 150% and went from $14 billion up to $21 billion. Now it had been running about 4% of our total issuance back in 2013, 2014. Now that is up to about 6.25% in 2018 and the run rate we are seeing for this year is about the same, about 6.25%. In fact, from 2019 now about $21 billion in issuance through October. And actually thinking about performance this year in general, Eric, I know performance has been very good for munis, how has this segment of the market performed?

It has performed well. So overall, again, we have had a lot of demand for munis, and when you look at this sector of the market even though it has been higher than traditionally seen, it is still an attractive part of the market so what we have seen is that over the course the month the housing sector is up around 38 basis points and the rest of the general market was up about 13, which is the broad index. You think year-to-date the housing sector is up a little over 7% and the general market is up a little under 7%. Part of that is due to the fact that the housing sector generally has a longer duration and longer duration has outperformed on the year, but still, with additional supply we have seen some support for this sector of the market. So lastly, we have seen some news lately about climate risk and how this may impact credit quality in the municipal market. Most recently, California has been in the headlines with fires and power outages and the implications on state resiliency, so we do invest in the state of California on behalf of our clients and these are issues that underscore the importance of looking beyond the basic fundamental analysis and incorporating a broader view of risk through the lens of ESG.

Right. So we thought Cal is actually a really good example of that, you know Cal, obviously a vibrant state, fifth-largest economy globally, but it has had its share of challenges especially in recent months. Many of those headlines as Eric points out, stemming from this climate-related issue, so we thought we would take a moment to talk about them at the state level, but also at the local government level as well. So thinking broadly, the state with 40 million people, the third-largest by land, with $3 trillion in gross state product, that faces significant pressures across a budget, economic and political landscape. So starting from the budget perspective, there has been chatter about them possibly bonding out to help finance the cost related to the fires, helping out PG&E. The state itself, while it is stable, that could see some negative implications in the face of a modest downturn or recession. From an economic perspective their growth rate has outpaced the U.S. since 2010. Now, however, it is estimated at around 2 to 2.2% for 2019 which is actually below U.S. GDP at 2.3%. What is interesting is that PG&E’s CEO had come out recently stating that it could take as long as 10 years for that company to really improve its electric system. So these sustained power outages could cripple businesses and prevent new business from entering. And then lastly, on the political front you know, it’s really the first test Newsome has seen in his newly minted governorship. He is really facing pressure from a coalition of cities who want to turn PG&E and are talking about taking some of the assets over and maybe turning into more of a municipal utility.

So that is a nice transition to what we are seeing on the local government front as well.

That is right. We know we do invest in local governments in California but in light of this uncertainty especially what has been created by the utility companies like a PG&E, local governments, say, like San Jose, are taking matters into their own hands. They are joining forces to discuss the takeover of assets. But why are we seeing them act? Well, there is clearly an impact on a number of fronts for the local government one of which would be property values. A good example there would be Santa Rosa, 5% of its housing stock was destroyed by fire. They had recently had a bond measure out about a year ago on a ballot that was actually defeated back in November 2018 but it was really to help advance housing recovery by financing acquisition and improvement of real property for affordable housing. So clearly, they are still facing some challenges in how to rebuild. On the insurance front, there was actually a journal article, Wall Street Journal, that had talked about wildfires costing insurance companies more than $24 billion over the past two years which is not an insignificant number. And then lastly on the school district front, again we do invest in some school districts in the state of California, and there was an article again with the Wall Street Journal citing over 1,300 schools which serve over 480,000 students had lost power, and of those schools about 400 schools with 135,000 students closed their doors, sending kids home. So why is this important to us? Well, generally speaking many school districts have debt with longer dated maturities and a slower amortization schedule. So what that means really is those debt payments are based on a district's ability to keep enrollment at a certain level. So those risks may alter those projections and really create problems down the road.

So while in the short run, state and local governments should be able to absorb these costs. However, over time, these financial currents have the potential to strain governments. These issues highlight the reasons why we employ a bottom-up research approach and integrate ESG into our overall investment process to account for risks such as these.

Thanks for listening. We hope you found this information helpful. As always, please do not hesitate to reach out to us with any questions or comments.

IG Recap

Welcome to the Breckinridge podcast. My name is John Bastoni. I am a securitized products trader here at Breckinridge Capital. Today I am joined by Khurram Gillani, one of the portfolio managers on our multisector team. We are going to start with overall performance in the IG corporate market which we typically do. Khurram, nice to have you today, can you give our listeners some performance related highlights for the month of October?

Thanks John, it is good to be here with you today. Corporate bonds outperformed Treasuries again this month. Corporates have continued to outperform Treasuries generating positive excess returns in eight of the last ten months this year. Overall spreads were 5 basis points tighter on average across the index. This month’s spread tightening is due to a combination of lighter than expected new issuance, better than expected earnings and lower uncertainty surrounding the Fed’s actions. In fact, spreads year-to-date in the corporate index have generated 4.75% of excess returns, or nearly 14% of total returns given the movement of rates that we have experienced this year. However, a heavy month of new issuance is expected in November, roughly around $100 billion, and that does have the potential to put some pressure on spreads which closed the month only 4 wider than their year-to-date types.

Great. Thank you for that overview. Were there any sectors or trends that stood out in October?

Yes. So, the trend of lower quality and longer duration investment grade corporates outperformance continued as a result of the flattening corporate credit curve as well as strong demand as indicated by continued robust fund inflows. Higher beta, more cyclical sectors such as metals and mining, chemicals, refiners, outperformed on an excess return basis, as did the healthcare sector. Integrated energy names and consumer cyclicals such as retailers and restaurants underperformed.

Great. So one thing that you mentioned earlier that I wanted to pick up on a little bit was corporate earnings. Can you provide basically just a quick summary of those? I understand that expectations were pretty low for Q3 earnings, but were there any surprises to that?

Yes, you are right, expectations were lower for companies reporting in the third quarter due to the trade tariff ordeal, as well as overall global slowdown, led by the euro zone and China, but so far about 85 to 90% of the companies in the S&P 500 have reported corporate earnings. Roughly 3/4 of those that have reported, have reported better-than-expected earnings according to data from Bloomberg. However from a bond-holder perspective, we tend to focus a little bit more on the topline revenues and that has actually still been positive, and averaging about 3% versus the third quarter of 2018. The healthcare and communication sectors are seeing mid- to high single digit growth whereas energy and capital goods so far have seen your over year declines.

Great, and you said that issuance was lighter than expected but were there any notable deals that came?

Yes, so issuance you're right, was lighter than expected likely because of the fact that issuance was pulled forward in September. September was a record month for new issuance. There are a few noteworthy deals this month. So Danaher came to the market to issue $4 billion of debt to fund their acquisition of General Electric’s bio pharma unit. The deal did well and was four times oversubscribed on average and the 30-year yielded 108 basis points above Treasuries. Ford also brought $1.5 billion of 5-year notes. This was their first deal after being downgraded to high-yield by Moody’s back in September. It is still rated low triple by S&P. The deal price of the spread of 240 basis points compared to a 5-year Treasury, it had pretty minimal new issue concessions, I would say, and performed well in the secondary, tightening 10 basis points on the break.

All right, so I wanted to switch gears here and talk a little bit about taxable munis. They have been another sector that has been gaining more and more attention in the investment-grade space, specifically on taxable munis as I mentioned. Supply seems like it is really increased so far this year. I was wondering it you have any numbers you can put behind that?

Tax municipal supply has jumped this year to $46.2 billion or 15% of total municipal issuance according to data from Bond Buyer. That's a 90% increase versus the same time last year. So taxable muni bonds have been averaging about $32 billion of new issuance since 2011. The main reason this year has been elevated is due to municipal issuers refinancing or refunding previously issued tax exempt paper with taxable paper.

So previously issued tax-exempt paper with taxable paper. Can you walk through some of, I guess, the economics of that a little bit, or how that all works for the issuer?

So what has happened this year is that the combination of low interest rates and the elimination of the advanced refunding mechanism as part of the 2017 Tax Cut and Jobs Act, has really caused the increase in the taxable muni supply so far this year. So what this means is that prior to 2017, issuers could refinance or refund existing tax-exempt debt with new tax-exempt debt, as long as the refinancing was done 90 or more days in advance of the call or maturity date of that particular bond. But like I said, the Tax Cut and Jobs Act changed that. Now they must issue taxable debt when they are seeking to refinance existing tax-exempt debt, more than 90 days in advance of the call or maturity date of the bond. The elimination of this advanced refunding mechanism as well as the significant drop in yields that we have seen so far this year is really what is driving the elevated new issue of supply.

Great. Thank you for that, Khurram, that is great insight for our listeners.

Okay, so let us switch to the securitized market. So first can we just maybe start with a brief recap of what happened in October and what drove performance there?

Yeah sure, so for agency mortgages you know, despite some of the headwinds that we have mentioned several times in this podcast that have been facing this sector, namely faster prepayments driven by lower rates and in turn higher interest rate volatility, agency MBS actually performed relatively well last month, producing 9 basis points of excess returns. Most of the strength, however, came in the second half of the month after the 10-year Treasury bottomed out around the 152 level early in October. Once rates started to slowly climb higher which led to volatility dropping, mortgages found their footing and spreads started to tighten. It is worth pointing out, however, that you know, mortgage spreads still remain near the multiyear wides, which again reflect the headwinds that have plagued the sector for most of the year. One of the metrics that we do look at to gauge the general level of spreads is the current coupon mortgage nominal yield spread, versus the blend of the 5 and 10-year U.S. Treasury yield. This metric, and again there are many metrics you can use in mortgages to gauge performance, but this generic metric is widely used and it ended October north of 100 basis points which is a level we have not seen since 2016. We think that you know, right now the wider spread in the agency mortgage sector presents a relatively attractive entry point right now, compared to others spread sectors that still remain stubbornly tight, and we have some signs of flows beginning to tilt into the space to take advantage of this relative cheapness that we see in mortgages.

That makes sense, so let us take that one level down, so what part, what subsectors of the MBS currently look most attractive?

Well generically you could think of agency mortgages broken up into 30 years, 20 years, 15 years, and to a lesser extent 10-year maturity sectors. The interest rate curve shape is a big driver of performance differences between these subsectors. You can think of it this way, 30-year mortgages have more partial interest rate exposure to the longer end of the Treasury curve while 15 years have more exposure at the shorter end of the curve which I think makes sense. So you know, as the curve has flattened and become inverted over the summer with longer interest rates falling more than shorter interest rates, 30 year bonds have performed better than 15 years so right now with 15 years underperforming, 15 year spreads look relatively cheap to 30 years. Generically just to put some numbers behind it, 15 years are trading around 70 basis points over Treasuries and as you mentioned earlier, 30 years are around 100 basis points over. This is a pretty tight spread differential based on historicals and with the curve actually beginning to steepen out here a little bit lately, that would in turn benefit 15 years more than 30 years, so we think 15 years look like a relatively attractive investment at this point.

That make sense and so what other factors do you think are going to be responsible for near-term performance in the mortgage market?

There are couple of things we are keeping our eyes on as we head into year-end. First, rates seem like they are headed higher. At the time of this recording of this podcast, the 10-year Treasury sits around the 190 level, so up pretty considerably off the lows of the summer and up pretty considerably from where we were in early October as well. Higher rates and a steeper curve project higher forward rates which would again project slower future prepayment speeds which would benefit the sector. In addition, we have also sort of passed the strong seasonal part of the year where summer is always a busy time for homebuying which ultimately leads to a higher net supply which has been one of the issues plaguing the sector so far this year.

That make sense. Well, thank John for that update on the securitized market. Thanks everyone for listening to our podcast today. I hope you join us next month for out November market update.




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