Podcast recorded July 1, 2015
A special abbreviated podcast based on the latest news out of Puerto Rico.
Welcome to the Breckinridge podcast. This is Ariana Jackson and joining me today I have portfolio manager Sara Chanda. Today, Sarah and I will be discussing what we saw in the muni market during the month of June and Sara will also be giving us a quick recap on the second quarter. Sara thanks for joining us.
Thanks for having me Ariana.
So, since we last spoke we have seen increased volatility over concerns that central banks across the globe will be pulling back on stimulus. Do you have a few comments on that?
Sure. So, while the Fed has been vocal about plans to continue their past normalized rates, most recently ECB president Mario Draghi came out with hawkish comments stating that the outlook for the European economy was less risky and factors suppressing inflation would be short-lived. So, the market really interpreted his statement as a signal that the bank would be looking to reduce stimulus and his remarks were really heard around the world as bond markets reacted with the German Bund leading off the global sell-off closing the month at 46 basis points. That was a spike of 20 basis points just in several days, and that caused Treasuries to move in sympathy.
Now the market has been gleaning any signs from economic data and potential impacts it may have on the Feds path. How did the data look for June?
So, we saw some mixed data starting with a weaker May jobs report with 138,000 jobs added that was well below the 182,000 that was expected. JP Morgan actually pointed out that payrolls were soft in both private and government growth, most specifically in the retail sector with a decline of 6,000. That marks the fourth consecutive month of weakening. Additionally, retail sales came in weaker than expected when both March and April figures were revised higher. However, to point out, the unemployment rate has fallen to a 16-year low and now at 4.3% and that really does give the Fed some comfort that one half of their dual mandate is being met. The challenge has really been on the inflation side of the equation where readings for headline and core inflation have both fallen back to 1.9 and 1.7%, respectively, with the core reading actually registering a two-year low. And so the question is really what is pulling inflation lower? So, Fed Yellen had been asked about that. She attributes some of the decline to one-off drops in wireless phone service and prescription drug prices.
Okay, so given the mixed data and weaker inflation readings, did that deter the Fed from hiking in June?
No, so as broadly anticipated, the committee did vote to increase rates to 1 to 1-1.25% range for Fed funds and they did signal they do expect to raise rates one more time in 2017. However, at the end of June, the market was pricing in less than a 50% chance of another hike. In addition to that, officials did disclose plans to shrink its balance sheet later this year. Although the pace of the runoff is slower than many had expected.
And there has been no shortage of chatter surrounding the Fed’s $4.5 trillion balance sheet and efforts to unwind. Do you have some details?
Yes, so the Fed will begin its balance sheet normalization by reducing its asset holdings by $10 billion per month. That is comprised of $6 billion and $4 billion Treasuries and mortgages. The runoff will increase by $10 billion every three months until it maxes out at $50 billion per month. And just for context, the Fed has been adding assets at $85 billion per month during QE3.
Now on the policy side, when we spoke last month, the house passed their version of AHCA. The bill has been sitting with the Senate for their review and vote. Any movement on that front?
So, this has been closely watched, given how divided lawmakers have been in their quest to reform ACA and that said, the Senate did introduce their version of the health care bill. It is called the Better Care Reconciliation Act, or for those of you that like acronyms, it is the BCRA 2017. And while there may be differences in the bills, the key take-away for us is really whether some version of a bill will pass and if so what the impact will be on states and hospital credits.
Now with all that said, what was the impact on Treasuries?
So for the month, Treasuries really remained range bound until the last few days when Treasuries rose roughly 10 basis points, 10 years and shorter on the curve, while the 30-year bond closed the month nearly unchanged. Just as a note, the 10 and 30-year bond both touched year-to-date lows before rising sharply. That was again after all the comments we had heard from central banks. Over the month, the 230 spread collapsed to 143 basis points. That is the tightest in 10 years.
Now, turning over to tax exempts, you mentioned that rates reversed at the end of June, so I assume munis tracked Treasuries higher after central-bank comments. What was the impact in those few days and where did we end up for the month?
So, after hitting year-to-date lows earlier in the month, muni bond yields did spike. The biggest move was in the 2 to 4-year range, with rates rising between 15 and 18 basis points as the curve bear flattened and while munis have been the star asset class over the past few months, they did underperform treasuries, most significantly, in the 30-year range. So, if we do look at the 10-year AAA muni as a gauge of yield movements, the year-to-date low to high, we started at the low of 1.83 that was achieved in early June. The high we had hit was at 2.49 back in mid-March; that is a 66 basis point move and we did close the month with the 10-year at a 1.99.
And what was the impact on ratios?
So, ratios did remain range-bound at or near one-year lows for most of June, really anchored by strong technicals. However, muni underperformance did push them higher sending the 2 to 3-year ratio back to 75%. The five-year was 72%, ten-year at 86% and 30-year closed out the month at 98%.
By strong technicals you are referring to the supply and demand dynamic that has been the proverbial wind in the muni market sales.
That is right. So muted supply has really been a big theme in 2017 lending support to the market. However, this trend has been moderating. So, supply totaled $37 billion in June and that does mark the second largest month of issuance this year, and the third consecutive month over month increase. But I would say despite the uptick, June volume did drop 24% from June 2016 and year-to-date supply stands at $194 billion. That is down 14%. The biggest drag on volume continues to be the significant decline in refunding deals which fell 48% from June 2016, but that said, the market does continue to be supported by positive flows and the reinvestment of coupon payments and maturities.
We finished last month's discussion talking about the dramatic run munis have had with a string of six consecutive months of positive performance, but suggested the pace may slow. How did June’s performance stack up?
Well if you had asked me at the last week of June I would have said we would probably be on pace to have another solid month. However, the last few days of the month changed momentum so muni returns did finish negative for the month. The Bloomberg Barclay's main muni bond index and the 1-10 blend were both down about 35 basis points. A-rated bonds were best performing rating category outpacing BBBs which have been leading the pack for 2017, while AAA rated bonds fared the worst and with heightened volatility later in the month, the more defensive housing sector outperformed, where special tax bonds were the worst performer.
Okay, and while we have provided a healthy recap on the month, would you mind giving us some stats for the quarter as well?
Sure, so over the quarter, we continued to see the Treasury curve modestly flatten with yields rising roughly 5 to 10 basis points in shorter maturities while the 30-year range fell nearly 20 basis points. Bolstered by strong technical, munis did outperform as yields fell 20 basis points in 5 to 10 years and 25 basis points 20 years and longer, and then year-to-date, this is through Q2, the five-year still stands out as the star performer with a 40 basis point drop while the 10-year is down about 25 to 30 basis points or so. On the supply side, we total about $104 billion. That was down 18% from the same period last year, and again that stems from the significant drop in refunding volumes, so for the quarter, down 43%. And while new money has been trending positive up about 5% or so, supply in that category has just not been enough to make up that void. Q2 and year-to-date returned to the 1-10 blend posted a positive 1.39 and 2.96, respectively.
Now moving over to credit, there has not been any shortage of news for certain states, especially with budget season. Can you give us a brief update?
Sure. So, over the month there was movement on Illinois, both from rating agencies and the resulting spread widening after a downgrade and a court ruling. So while Illinois woes have certainly been broadly telegraphed, most of the news really focused on the likelihood of the state succumbing to a junk rating as the governor and lawmakers have continued to battle over the budget. And recall, it has been two years since the budget was passed and in that time, the state has racked up an unprecedented $15 billion in unpaid bills along with an insurmountable sum of pension debt. So adding fuel to an already raging fire there was a judge that ruled that the state was not in compliance with a federal consent decree mandating adequate and timely Medicaid payments for certain providers and recipients. So essentially what the judge was saying is that these payments are on par with debt service payments regardless of state law priorities and so as a result, spreads on the state GO widened between 50 and 100 basis points really in a very short amount of time. We can report that Illinois did finally get a budget passed in early July after lawmakers did override the governor’s budget veto.
Any other states of concern?
I would say states like Connecticut continue to struggle as we make our way through the second half of 2017. In fact, these have been stories that have run in the background for a couple of years, but in typical muni fashion, have seeped into the mainstream media as situations have worsened, but it is not just few states like Connecticut, Illinois or even New Jersey that are fiscally challenged. According to S&P at month end, 15 of the states were working to complete their fiscal 18 budgets.
So, what does this mean for the state of credit?
So, I would say overall credit quality does remain stable across most of the market and that’s really evident in Q1 2017 tax collection data that was released by the U.S. Census, and they do suggest that tax receipts were up in most states during that period of time. In addition, default rates are low, muni debt as a percentage of GDP is declining and away from some of the states that have encountered budget battles many have steady growth in revenues and population while building reserves.
Now Sara, can you talk about what we have been doing here at Breckinridge to combat these credit woes?
Sure. So as we discussed, the market has benefited from most of the year from a tailwind due to manageable supply and positive flows all of which was carried into June. So, our investment team has really been focused on identifying specific sectors and credits that have been pressured and executing credit sale swaps, really taking advantage of the overall spread tightening, and in our view it was really a perfect time to move up in credit quality as we were not really being compensated for taking that additional risk.
And as a wrap up, when we spoke at the end of Q1 we highlighted some factors we would be watching. How have those played out in Q2 and what are we concerned about for the balance of 2017?
So at the start of Q2, we noted continued uncertainty from the administration really related to healthcare, tax reform and infrastructure and while we have seen a bit of movement on the healthcare front, as we discussed earlier, we really have no additional clarity on the other initiatives. So we have been talking internally about concerns we have for the balance of 2017 and how our investment committee wants to be positioned given some of the risks we’ve identified. Recently we published a blog about this subject so it makes sense to highlight our top five trends we see coming due for the next half of this year. They include credit contagion from weaker states. What I mean by that is rating agencies could become quicker to take rating action and more scrutiny is placed on local credits within those particular states. If we see technical reversal, we talked about the manageable supply and the dynamic with a positive demand, but if supply picks up or demand wanes in the second half of the year that could obviously impact the market negatively. Potential tax reform is a third. It is currently not priced in but if the administration gains traction on reform, that could impact the market with a reduction in marginal rates, removing our cap, meeting exemption or lowering the corporate tax rate. The fourth would be investor complacency. In a quest for yield, buyers are dipping down in credit quality without really being adequately compensated and then the fifth is really some combination of the four factors we just discussed. We tend to see outflows, they are prompted by rising Treasury rates so if we do see that occur and a combination of these factors, that could exacerbate an already volatile market.
Thank you, Sara. We hope that you in the field found this informative and we look forward to you joining us again next time.
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Podcast recorded July 1, 2015
A special abbreviated podcast based on the latest news out of Puerto Rico.
Podcast recorded October 11, 2017
In this podcast we cover the month’s market movements.
While the month was brimming with enthusiasm for graduates, the fixed income and equity markets continued to present little excitement, with performance remaining mostly even.