As we enter 2019, portfolio manager Matt Buscone discusses what’s top of mind in the muni market for our investment team.
Welcome to the Breckinridge municipal market recap. I’m Sara Chanda, a portfolio manager here and I'm joined today by Matt Buscone, co-head of portfolio management. Thanks for joining us today. So September was a volatile month in the market. We will start off with a quick recap on market movements, performance review across September in Q3, followed up by a discussion on taxable municipal issuance, and will wrap up with a couple of credit-related stories including the federal court's dismissal of a case brought by several states, and a Virgin Islands update. So Matt, let us get started with the market recap.
So after yields hit historic lows in August, municipal yields moved higher by about more than 20 basis points over the course of the month but did manage to still finish the quarter modestly lower in shorter maturities and lower by about 15 to 30 basis points lower in the longer-range. We have talked about the technicals a lot throughout the course of this year and we have seen a little bit a reversal on the new issue supply side with issuance surging in August and September, closing the quarter with $103 billion worth of issuance, an 18% increase from Q2, and that pushed the year-to-date total to just over $275 billion. Demand continues to flow into the municipal space although at a slower pace than we had seen through much of the first half of the year and high-yield funds actually saw an outflow for one week during September of $167 million, but we did end the quarter with our inflow streak intact, 38 consecutive weeks with just over $68 billion worth of money flowing into municipal mutual funds. And that strong technical environment that has propelled munis for much of the year did begin to fade in September which pressured tax-exempt municipal ratios with regard to government bonds, and Sara is going to provide us with an update on that.
That is right, so munis did show strong performance versus Treasuries earlier in Q3 that really pushed ratios lower. So just for some context, the five year dipped as low as 60%, that is munis versus Treasuries, and the 2-year actually felt the mid-50% range. However as rates rose, both on the Treasury side and the municipal side, munis actually fell behind, really pressure with supply that we had seen come into the market and so ratios actually cheapened up to the mid to higher 70% camp in that 2 to 5 year space. As a result, returns now for September were actually negative for the first time this year. So looking at the Bloomberg Barclays Municipal Index, which is our main muni bond index, that posted a total return of -80 basis points, but managed to actually year-to-date still posting a really strong return of almost 7%, 6.75% there, and munis actually out-performed the U.S. Treasury Index which posted -85 basis points over that same period. The intermediate part of the curve was actually the worst performer, really no advantage relative to sector whether it is GO or revenues, both of those spaces actually give about 80 basis points or so. So in talking about ratios, they were rich, like the earlier part of Q3 we did initiate some crossover trades where appropriate for accounts, using either Treasuries or taxable munis, really assessing those after-tax implications. And while higher ratios and tighter sprints on taxable munis made crossing over less compelling at quarter end, it is really a good segue for us into taxable munis as we have seen an uptick in issuance this year, and Matt is going to take us through some of that.
Yes, so we noted how tax-exempt supply really surged in August and September and with that we saw a marked increase in taxable muni issuance as well. Since the enactment of the Tax Cut and Jobs Act in December 2017 issuers have been restricted from issuing advance refunding deals, a mechanism that many municipalities had used to refinance higher interest-bearing debt. To work around this constraint of not being able to use tax-exempt debt, the local governments have been using the taxable market to refinance their existing tax-exempt debt. Per Bloomberg, state and local governments issued $11 billion worth of refunding bonds in September and close to $13 billion in August, more than one third of the sales issued over that two-month span were taxable. And year-to-date we have now seen $32 billion worth of taxable municipal supply, higher by 45% from 2018 and September, alone, saw just over $6.5 billion dollars’ worth of taxable issuance. With Treasury yields falling so precipitously this year, it has been economically beneficial for municipalities to issue taxable debt to refund higher interest-bearing tax-exempt debt. That is something that has been highly unusual in the municipal market in the last decade or so with taxable rates being lower than prior deals that were issued with tax-exempt deals. If rates stay where they are now, that trend is likely to continue through the rest of the year. This brings us to our last topic for today, the dismissal of a lawsuit brought by several states regarding the SALT deduction and a quick update on a potential credit problem from the muni market. Sara will start with the lawsuit.
Throughout many of our podcasts this year we have discussed the state and local tax deduction cap and implications it has had on the municipal market and at month-end actually four states lost their legal battle to block this cap when a federal judge threw out the case. And so the states we are talking about are Connecticut, Maryland, New Jersey, and New York. So the argument was really about Democrats in Congress and some state lawmakers saying that the change targeted Democratic led states which tend to have higher taxes like the four states that were in the lawsuit. In fact, New York Governor Cuomo called it “economic Civil War”. Per Bloomberg. state and local governments are concerned that the $10,000 SALT cap will limit their ability to enact future tax increases to pay for things like public services, infrastructure projects really financed by bonds, and so why was the suit thrown out? Well, the judge ruled that states remain free to exercise their tax power however they wish, it does not prevent states from taking steps to lessen the burden in other ways and so what does this really mean for states right now,for the states that are concerned with lawsuit? Governor Cuomo actually did comment that his state is evaluating other options, possibly including appeal. According to him New York already pays the federal government $36 billion more than it gets back and the cap is actually costing New Yorkers an additional $15 billion each year. Now I will turn it over to Matt for an update on the Virgin Islands.
So in late September, Moody’s downgraded the senior debt issued by the Virgin Islands Water and Power Authority 8 notches below investment-grade to Caa3 and they noticed an increased risk of default due to unsustainable capital structure with very tight liquidity, high debt load including a substantial amount of unfunded pension liability. If that sounds pretty similar, it should. Certainly it sounds like Puerto Rico and specifically to the Puerto Rico Electric Power Authority that got a lot of traction over the last several years. It is a smaller deal. There has been much less debt issued by the USVI so there is little bit of a smaller impact. And while it does face similar headwinds like shrinking population and severely unfunded pensions, it is a territory with roughly 24,000 people on private payrolls, a billion and a half in revenues and $2 billion in dept. And this is not a willingness issue but more than ability to pay story, given that the territory has been hit hard by several hurricanes in recent years. And while it may not be a default story yet, it does beg the question of what other potential options may the territory have?
Right, so as Matt points out, obviously, Puerto Rico is certainly a story we have talked a lot about. The Virgin Islands actually declined help from PROMESA, which is what Puerto Rico ended up going into, but a nonvoting U.S. rep suggested “debt restructuring” as a solution. And why do we highlight this type of credit to folks in the field? We do not buy this type of debt, but really just underscores the risks of stretching for additional yield in lower rated credits as spreads have compressed.
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