In August, U.S. Treasury yields fell, while high grade corporate spreads widened and muni ratios ticked higher.
Hello this is Natalie Baker vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. In today's podcast, I'm joined by two of our portfolio managers Sara Chanda and Khurram Gillani, and we will be discussing market events in the investment-grade space for the month of November. So Sara, while November shaped up to be a busy month with the nomination of a new Fed chair and an equity market that seemed unhindered by continued drama from the Trump administration and sustained threats from North Korea, one theme took center stage - tax reform.
Yes, Natalie, that's right. Tax reform and the potential passage of the long-awaited bill really has dominated the air waves for most of the month and continues to do so today and we really haven't seen far-reaching changes in tax code since 1986 when Reagan was in office. So now Congress is really attempting to reduce taxes for corporations and many Americans, and the market has been waiting for clarity really for most of the year around these various agenda items that Trump has been touting really since the campaign trail. So, while as we all know, health care reform did fall flat, infrastructure spending really has been a nonstarter, both the House and Senate have gained traction on tax reform with each branch of Congress passing its own version of a bill.
Okay so that brings us to the next question. What are some of the provisions of the bills to highlight and how do the bills differ particularly in the muni side, we can talk more about the corporate side later.
Sure. So clearly to pay for these extensive changes to both the marginal tax and corporate tax rates, both the House and Senate versions are seeking a cost cut with a couple of things, the elimination of the state and local tax deduction. Taxpayers actually can deduct up to $10,000 in property tax, the curtailment of mortgage interest deductions. While many of these provisions have been expected, the curtailment of specific bond issues within the muni space was a surprise. Now specifically, both versions are looking to eliminate advance refunding deals while just the House is calling for the elimination of private activity bonds or PABs, as we refer to them. While Senate Republicans narrowly passed its version of the bill, lawmakers are going to need to reconcile the differences between those versions before a vote can occur.
I got you, and then also when we spoke last month, Jerome Powell had been selected as the next Fed chair. Any other Fed news to report?
Yes. So, the FOMC actually left the Fed funds rate unchanged at 1.25. A December rate hike is highly probable, I would say more than 90% at the end of November and sits there today at nearly 100%, that's per Fed fund futures. And while the Fed has indicated that there are more increases to follow with about three additional hikes projected, some analysts on the street are actually calling for four hikes while the market right now is just pricing in two. At month end, Chair Yellen actually delivered an update before Congress, maybe one of her last, stating that the economy’s expansion had strengthened broadly across sectors and she does expect that growth to continue and then as you mentioned Jerome Powell was nominated as the next Fed chair replacing Yellen. She announced, however, she will step down once her term ends and like Yellen, Powell is expected to continue on a path of normalization while reducing the Fed's balance sheet. So now with Yellen being replaced there are vacancies that need to be filled from other members as well like vice-chair Stanley Fisher, who left in October. We have William Dudley who is the current New York Fed president and he is set to retire in 2018. In all, about four Fed seats will need occupants and so whereas Powell reflects more of status quo, there is some sentiment across the market that other seats will be replaced with more hawkish candidates.
Okay and as you cited, Yellen remarked that the economy continues to improve. Any data over the month to report?
On the economic front indicators still point to signs of strength evident in the third-quarter GDP print of 3.3% and per Morgan Stanley, fourth quarter GDP is tracking around 4%. Now looking on the jobs front, while nonfarm payrolls came in at 261,000, which is below the 313,000 consensus, the 90,000 upward revision over the preceding two months is a positive. And lastly, November's consumer confidence figure was strong at 129.5 and that does surpass the estimate of 124 and did mark a new 17-year high.
So, with positive data in the Fed poised to hike, how have Treasuries responded?
So looking over the month, Treasury yields rose across the shorter maturities while the 10-year and longer-range really remained in a tight trading range. As expectations of December rate hike remain elevated, not surprisingly, the short end, the 2 to 5-year maturities, did jump around 10 to 20 basis points and, again, as I mentioned, the 10-year really held in trading between a 2.30 and a 2.43, kind of the monthly average was about a 2.35. The 30-year part of the curve was really the clear out-performer, closing out a few basis points lower to 2.82. That is after hitting a month to date low of a 2.73. With the 2-year spiking more than 50 basis points since early September, while the 10-year really remained in the trading range of about 15 basis points, the curve is flat and really at levels we haven't seen since 3rd quarter of 2007.
Okay, and as you mentioned, Treasuries encountered more volatility in the front end of the curve how about munis? How did they fare over the month?
So similar to Treasuries muni yields did track higher really again with a sharper move in the short end as the curve flattened to a multiyear low. Munis did underperform Treasuries really weighed down by a huge amount of issuance before year-end, we can get into that in a minute. Over the month 2 to 5-year maturities, they spiked about 30 to 44 basis points while the longer end, really anchored by limited inflation fears, rose about 13 basis points in 10 years and actually fell 3 basis points in 30 years. So by month end, looking at the 10-year AAA, that settled at around 2.07. That's off 26 basis points from the 1.81 year to date low which was set back in early September.
Okay so after months of outperformance causing muni ratios to plummet, ratios reversed course, is that right?
That is right. So, we kind of hit the year-to-date lows say, in mid-September, mid to low 60% range and that 2 to 5-year space. It did really reverse course in dramatic fashion, closing the month 88% in 2-year and 82% in the 5-year space and the 10-year range moved to an 89%. So maybe a 4 ratio move higher, and then the 30-year range again because it had been anchored and really ended up outperforming closed unchanged at 98%.
Okay, so with this reversal have we been able to take advantage in any meaningful way?
We have. So for months we really were talking about that tailwind propelling munis, really due to the tempered supply, strong demand and again, some of that was created back from May to September with an uptick in bond maturities, but now with rates having backed up especially in the shorter end, again looking at the 2 to 5-year range, yields are nearly 40 basis points higher in two years and 30 basis points higher in five years. That is just over the month. Ratios have turned dramatically so what was once that mid-60 range over the summertime is now back to that mid 80% range. That has really been a catalyst for us to reverse some of the crossover trades we had put on in that August and September timeframe by executing Treasuries. So, we ended up on the crossover buying Treasuries, now reversing those, trying to buy some munis at better attractive prices.
Okay and on the technical side we can also talk about supply and demand. Supply has been running behind 2016’s pace, and with the backup in rates did this deter issuers?
Reversing nine consecutive months of declining supply, November posted just under $37 billion in volume, that was an 11% increase from November 2016 and actually surpassed the $30 billion average over the past 20 years for that timeframe. So while we are still lagging year-to-date from 2016, we had about $364 billion in volume which is a 15% drop. That trend may reverse in December as tax reform looms large and potential elimination of both advance refunding deals and private activity bonds, issuers have actually started to pull forward some deals that would otherwise come in 2018. That is really evident in the 30-day visible supply figure that stands at $30 billion which is well in excess of the $12 billion year-to-date average and it is really the highest in more than a decade. Some the things we had seen over the month, like last month Illinois continued to tap the primary market. They had several issues that came including Chicago Board of Ed., and Illinois Toll.
If supply has already been challenged, what impact may we see if advance refundings and private activity bonds are restricted from the tax-exempt space on the back of some of the new tax reforms?
That is a good question. So, while we have been living in this environment of constricted supply, most recently from the steep drop in refunding deals that we had seen last year, in fact year-over-year through November refundings were actually down about 37%. So, looking at a piece I had seen from J.P. Morgan they are citing over the past 10 years both advanced refundings and private activity bonds have accounted for by $105 billion of annual supply which represents 27% of total issuance. While the prospect of less issuance causing the overall market to shrink would put a downward pressure on ratios, we may be in a continued pattern of elevated ratios as issuers race to close deals prior to year-end with this additional supply.
And the prospect of muted supply then heading into next year has certainly played out in mutual fund flows, is that right?
That's right mutual fund flows started off the month with a large outflow after several weeks of modest inflows, that trend did reverse over the course of the month with some subsequent weeks of over $400 million posted to the weekly funds. So that will push year-to-date aggregate inflows to nearly $18 billion so clearly a sign of strong demand.
So, with the dramatic backup in rates over the month, how did performance stack up?
Municipals posted negative returns not seen since November 2016 post-election, and it marked the third month of negative returns for the year, that's following June and September. So, month to date returns for the main muni bond index were -54 basis points and then if you look at some of the intermediate indices that we follow, the Bloomberg Barclays 1 to 10 Blend and the Managed Money Short/Intermediate were both down 92 and 111 basis points, respectively. If you look across sectors, resource recovery and special tax fared the worst down 71 basis points and 65 basis points, and interestingly lower quality actually held in the best while more of the higher-quality AA, AAA credit quality underperformed.
Although we have seen rates rise recently, credit spreads have compressed dramatically for most of 2017. As a result, hospitals have been one sector of the market we have discussed as providing additional yield in an otherwise challenged environment. Has this sector continued to offer value?
So, at the prompting of our Investment Committee, we had started adding to our hospital exposure when we were compensated appropriately. And to your point, this sector has traditionally offered more yield to investors given the riskier nature of some of the credits. However, as you mentioned, over the course of this year we have watched spreads collapse pretty dramatically and so some of that value has disappeared. Heading into 2018, while there are limited new credit concerns, some things we have already established, hospital credit quality does seem likely to weaken over the next several months as more mergers are announced and margins continue to be squeezed. And also thinking about policy risk, like ending the individual mandate that could increase the number of uninsured so will have to remain cautious when adding to our exposure in this space.
Okay, and any other credit risks to highlight?
One other area we’ve talked but over time has been our monitoring of pension and OPEB risk across the credit spectrum and while public pension funds have been hit hard during the recession as many were heavily invested in equities, we have seen sort of a turnaround with equity returns. They have been stellar this year. The S&P 500 in fact marked its 13th consecutive month of positive total returns and that's actually the longest streak on record. So, while those long-term liabilities are still challenged, and funding costs continue to rise, there may be a slight improvement over time given the returns we have seen in the equity market.
Okay, so with 2017 rapidly ending, we started to see analysts publishing their 2018 outlooks. What are some of the themes there?
That's right. So, looking at some of the street reports that have come out and it's always interesting to catch that glimpse of what the sell side does expect for the year to come. Many of the pieces pertaining to municipals draw attention to the impact tax reform may have on the market including the supply deficit which stands to occur barring any sort of glitch from the congressional leaders passing this tax reform. While a limited supply picture can strain an already shrinking market, it does portend a stabilizing force which could support a muni rally, like something we saw earlier this year. J.P. Morgan did, in their piece, offer up some other items to watch in light of tax reform, one of which was the fact what muni’s will richen relative to Treasuries as issuance falls, really just a technical, and this does ebb and flow over time. It can be more magnified. We did see that again occur in the middle part of this year. The muni curve can continue to flatten as they shift to the shorter dated non-call structure versus the longer dated callable bonds we typically see, and the last thing would be standard call options are typically 10 years but now that issuers potentially would lose the ability to advance refund debt, they may start to issue debt with shorter calls.
All right, thanks, Sara.
So Khurram, let us move on to the corporate side. I know that we have seen spread tightening for most of 2017, what about month of November? How did corporates do?
So during the month of November, corporate spreads widened by 2 basis points to close out the month at +97 basis points which is the tightest level since mid-2014. Corporates slightly underperformed Treasuries during the month as well. The corporate index returned -15 basis points on a total return basis, and in terms of extra returns generated -3 basis points of excess returns. Financials generated better excess returns than industrials and utilities, so they outperformed there. However, while spread movement overall was modest, this masks plenty of movement in the spreads during the month. Spreads widened as much as 7 basis points leading up to the first couple of weeks of the month even though there was some improvement in oil prices and a strong jobs report. The softening was likely due to some new issue fatigue as new issue supply was over $70 billion the first couple weeks of the month, which was above expectations, and also dealer inventories were already at the higher end of the range for the year. In addition, there were some negative credit-specific news, mainly M&A which I will talk more about later. By the end of the month though, spreads rebounded back to close to where they started the month, as primary activity slowed going into the Thanksgiving holiday and optimism about tax reform was also supportive of spreads. We will touch on that later as well.
Okay, could you give us some specifics on which sectors outperformed or underperformed?
So looking at the Barclays Corporate Index, the best performing sectors were metals and mining, supermarkets as well as packaging. So, metals and mining benefited from improving commodity prices. For example, iron ore prices during the month were up 16% as were oil prices. WTI Oil was up at $4 per barrel in November to close at about $58. The worst performing sectors were oil field services, midstream cable, satellite and technology. So even though oil prices during the month did increase and that tends to benefit oil companies, the energy sector lagged the corporate index this month. In particular, oil field services and midstream widened 7-8 basis points generically amidst rising geopolitical tensions in the Middle East, including Saudi Arabia the world's largest oil producer. Cable and telecom also underperformed widening 6 basis points generically partly due to M&A headlines, in particular news that Sprint's owner Softbank was calling off merger negotiations with T-Mobile because the two companies could not agree on ownership terms for the combined entity bled into the overall sector. Technology also lagged the index partly due to event risk, partly due to unexpected new issue supply, so on the M&A side, Broadcom, which recently issued debt for M&A earlier this year was reported to be making a $100 billion bid for mobile semiconductor manufacturer, Qualcomm. Bonds of both Qualcomm and Broadcom widened 15-20 basis points immediately following the news. Also, Oracle and Apple came to the market unexpectedly issuing $17 billion of combined debt. Apple came to the market for the fifth time this year with a deal that was well received, virtually paying no concession and pricing its 10-year at +72, but the new 10-year Apple bond traded as much as 9 basis points wider from the new issuance price shortly after the deal priced. The next day, Oracle raised $10 billion but had to pay a significant concession ranging between 20 and 25 basis points to get the deal done. So, a combination of this new issue fatigue and poor secondary performance on new deals and technology, was the likely culprit there for underperformance.
So, what other noteworthy events happened during the month in relation to credit?
I would say two of the main stories during the month were surrounding M&A. So CVS announced that it would purchase Aetna for $69 billion in both cash and debt financing. This led to widening in CVS spreads. CVS, which is a high BBB name, their 2026 bonds were about 10 basis points wider during the month while Aetna, also BBB insurance company, their 2024 bonds were 10 basis points wider during the month. Aetna bonds are trading about 5 basis points inside of CVS bonds on average. CVS has traditionally been a retail pharmacy and a pharmacy benefit manager. They are looking to vertically integrate by buying a large health insurer like Aetna. If the regulatory authorities approve this deal, it could lead to further M&A in the pharmacy/benefit management space. Also in credit-specific news regarding M&A, on November 20th, the Department of Justice announced it is filing a lawsuit against AT&T over its pending $85 billion acquisition of Time Warner Inc. So, AT&T announced its intent to fight the lawsuit in court and current expectations are if the company follows through on these plans the case is expected to be heard by a judge sometime early next year and is expected to last about a month. So per news reports, this is the first time in 30 years a vertical integration case will be taken to court. Recall that back in July of this year AT&T issued a little over two $22 billion of the debt portion for the Time Warner Inc. acquisition. The market currently is putting the odds of the deal taking place now at about 40% versus 80 or 90% when the deal was first announced. If the deal does not go through AT&T would have to put back the bonds it issued back in July at 1.01.
Okay, well switching gears now, could you give us some overall supply and demand numbers for the month of November?
So again, per Barclay’s, the November supply totaled $117 billion versus $138 billion in October, but that’s up from 68% from November 2016 when only $72 billion was issued. So, the demand side per Wells Fargo which uses EPFR data, investment grade funds reported a little over $18 billion inflows, bringing the year-to-date inflow total to $317 billion. Deals continue to be well received in the marketplace.
Okay, and what about the rating spectrum? The story from most recent months has been better performance by lower rated names. Did that continue in November?
So actually in a change, no. Higher-quality single-A corporate bonds outperformed low-quality BBB bonds during the month. So, BBB’s were a little over 3 basis points wider on the month, whereas single-A’s were 2 basis points wider and AA’s were 2 basis points tighter on the month. And in terms of total return, BBB’s had -18 basis points of total return whereas single-A’s generated -11 basis points of total return during the month.
We talked a lot about tax reform with Sara on the muni side. Can you give us some thoughts on the corporate side and the impact that the bills could have on the corporate market?
So like we've been saying in previous podcasts and our white papers, we think that overall the tax reform will be a net positive for corporates. So specifically looking at two things - one, the corporate tax rate, that's expected to decrease from 35 to 20% so obviously that's going to increase after-tax corporate earnings which only have an effective tax rate of about 27% if you look at the S&P 500 index. So, U.S. based and domestic focused corporate sectors like banks, transportation, retail, telecom, utilities, could benefit the most given that they generally have a higher effective tax rate the U.S. multinational corporations. Also, the repatriation of cash from overseas will have a net positive impact as well especially for companies in the technology and healthcare sector which tend to out-proportionally have the bulk of their cash overseas. So, the current plan calls for a repatriation tax of 12% on cash and 5% on liquid assets which will be phased in over eight years. Compare that to 35% tax rate that companies would have to pay if they wanted to repatriate the cash today. So, we believe overall it will have a net positive impact. Now, it all depends on what they do with the cash. Some companies will undoubtedly use some of the money to do special dividends or increase their share buybacks, but presumably some of them will also use it to pay down debt, and it could also lead to potentially lower supply next year depending on the magnitude of cash that is brought back from overseas.
Okay, well to wrap up, what are some thoughts on the overall IG market?
So in general, the IG corporate market continues to be supported by solid economic growth, low cost of borrowing for issuers, and expected stimulative effects of tax reform. We do remain cautious and up in quality given spread compression that has occurred between single-A and BBB companies. Credit fundamentals we believe remain mixed, with rising profits and potential for tax reform but this is offset by elevated debt and shareholder enhancements. In addition, we do have several trends we are keeping close watch of, such as the relationship between equities and investment grade bonds has become more correlated over time. We encourage our listeners to see our recent blog post from Nick Elfner, our co-head of research, titled “Five Pivotal Themes in the Corporate Bond Market.”
All right, thanks. We hope that you in the field have found this informative and we look forward to you joining us on our next podcast.
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