September saw another rate increase, but we think emerging market troubles, a noticeably flat U.S. Treasury curve and trade concerns will keep the Fed’s future rate hikes at a measured pace.
Welcome to the Breckinridge podcast. This is Eric Haase, I am a portfolio manager at Breckinridge Capital Advisors and I am joined this month by Matt Buscone, our head of tax-exempt portfolio management. So last month, Matt and Sara touched on the impact of the Tax Cuts and Jobs Act on the California portion of the municipal bond market. This month we thought it would be useful to dig into how this has changed the new issue supply in the municipal bond market and the composition of the buyer base.
And for our third topic this month we thought it was timely to discuss the performance and current opportunities in the market as we have seen a sizable increase in interest rates on the year and more specifically, last week. First off, Eric, how has supply been impacted as a result of tax reform?
Supply is down around 15% year-over-year, so issuance has been around deposit of $250 billion through the end of September. When you look at Q1 issuance was lower by around 30%. So you have had a little bit of a bounce back throughout the rest of the year.
And now a big part of that lower issuance is due to approximately $40 billion of new issue supply which was pulled forward from 2018 into December of 2017 and a fair amount of that issuance was from advanced refunding deals.
Yeah, so in general we have seen about 20% of issuance annually come from the refunding or advanced refunding portion of the market and what we saw actually in 2017 through September that was 30%. In 2018 through September we are down to 18%, so you have seen that this portion of issuance has been pulled out due to tax reform.
So with that overall lower supply we have had to work much harder to find bonds in the market this year, and if you look over the last several years, typically our buying activity is split about 50-50 between the new issue and the secondary market. So far in 2018 we have trended much more heavily into the secondary market with about 70-80% of our buys are coming in that part of the market as opposed to the primary market, and the main way we have been able to do that is by taking advantage of more elevated dealer inventories and bid-wanted items we are seeing from other customers.
And we are also finding some value in crossover opportunities, so when we are looking at accounts that have the ability to buy taxable municipal bonds or U.S. Treasuries, we are doing so kind of in that five-year end maturity range for low tax bracket or medium tax bracket accounts. The after-tax yield compensates you enough to step into that part of the market.
And in a couple of occasions, we have also been buying national names for California accounts where demand has outplaced supply pretty sharply this year as well.
Right. And we have also seen a change in the buyer base in the market as well, right?
Yeah, the second topic we wanted to discuss was really the impact of lower tax rates, and if you look at the lower corporate tax rate, that has made tax-exempt municipals less attractive versus their taxable alternatives. That has led to two things: 1) there is just lower demand from banks and 2) banks have actually reduced their holdings somewhat aggressively during the year. In the second quarter, they reduced them by another $10 billion or about 2%. And year-to-date that reduction is over $26 billion or about 5% of their holdings.
So what we have really seen is on the one hand we have lower tax rate for corporations, which has reduced demand for munis, but on the other hand we have the cap on the deductibility for state and local taxes for individuals which has actually increased demand, particularly in high-tax states like California and New York. So currently the way the market shapes up is that about 42% of ownership comes from households, mutual funds own about 18% of the market, banks 15%, and insurance companies 14%.
So that has had an impact on the overall shape of the muni market and the demand dynamics because that lower demand and selling from banks has pressured the longer end of the market while the buying from individual investors, either through direct purchases or mutual funds, has been focused on shorter maturities resulting in the municipal curve being much steeper than the Treasury curve.
So that really ties in to our third topic that we want to cover, which is the rise in interest rates that we have seen on a year-to-date basis and kind of the performance and opportunities in the market. So interest rates moved higher in the last week and much higher over the course of the year. What does it mean for the returns and the opportunities that we are seeing, Matt?
So municipal yields have obviously followed Treasury yields higher. If you look at 2 to 3 maturities, they are higher by close to 50 basis points. The five-year maturity is higher by 60 basis points and the 10 to 30-year maturities are higher by about 70 to 80 basis points. With that much of a backup in rates, most people would expect returns to look very negative so far this year. But this is when having a diversified maturity structure and reinvesting into a higher yield environment helps to offset some of the negative price returned from rising rates.
What do the data actually look like for that?
So if you look at the Barclays main muni bond index which is a good proxy for the overall muni market, that is down just under 1% year-to-date through last week, but if you look at the underlying maturity performance, it is very different depending on the part of the curve. The one and three-year indices, which are comprised of short maturity bonds, are showing positive returns for the year, while the long bond index which is comprised of bonds with maturities of 22 years and longer, is down just over 2%. So if you look at the 1 to 10 blend index, which has a duration of a little over four years and behaves much like a five-year bond, that is really only down 30 basis points year-to-date.
So people see interest rates rising and obviously, no one likes seeing negative returns, but you look at the up-side associated with it is that investors are able to capture much more yield versus the beginning of the year. So we are reinvesting maturities and adding new capital in the portfolios and we were able to pick up more yield as we build them.
Yeah, and to put that into perspective, at the beginning of the year, a five-year AAA rated municipal bond would have given you a yield of about 1.7%. Buying that same maturity today would earn you about 2.3%. Depending on the strategy and your tolerance for interest rate exposure, if you are looking at bonds in the ten-year part of the curve, that is now at 2.7% which is higher by about 70 basis points than you would have got at the beginning of year and is the highest yield in that part of the curve since January 2014.
So we are able to pick up additional yield by buying bonds and longer maturities, but also, we are able to target more attractive parts of the curve based on our portfolio structure, so that is why I feel that proactive management adds a little value in this situation.
Right, so as a result of the tax law changes that took effect in the beginning of the year, the muni market has had to adjust to diminished new issue supply and different pockets of demand for different maturities, and while the rise in rates has created some short-term negative returns, ultimately higher yields are a long-term positive for long-term muni buyers.
Right, so that’s it for the podcast, thank you for listening.
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