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Municipal Podcast recorded on April 17, 2015

Q1 Municipal Market Review

Podcast Transcript

Welcome to the Breckinridge podcast. This is Chris Day and with me today I have Matt Buscone. So Matt, with the first quarter behind us, we thought this would be a good week to look back at what happened and offer some views and thoughts on our outlook for the rest of the year. Thanks for joining us.

Good to be back, Chris.

So fixed income investors are most concerned with the low level of interest rates. What did treasury yields do during the quarter?

We had a very volatile quarter. It was alternating months of falling, rising, and falling rates, and the 10-year treasury traded in a pretty wide band. It started the year at about a 215, rallied to as low as a 165 at the end of January, rose back above 2.25 on some pretty good employment data at one point during February, and then fell back below 2% at quarter's end. So the net result was treasury yields were lower with the biggest drop in the 5-10-year range, but it was kind of a rocky road getting there.

Sure, so what drove that volatility in treasuries?

You know, we had a much weaker string of economic data over the course of the first quarter, mainly from the manufacturing and retail sales side. We have continued to see some decent growth in terms of employment, but that other data has gotten weaker. Inflation readings continue to be very low and wage growth has been muted despite those strong employment numbers. Away from the US, we have had quantitative easing administered by the European Central Bank. That pushed sovereign yields extraordinarily low, negative in many cases, so that has added to the allure of treasuries. So, first quarter growth in the US looks to be weak with low sovereign yields and weaker data rallying treasury markets.

Yeah, some downward pressure there. So how about an update on the Fed?

So the Fed did make some changes during the course of the quarter, obviously no change with regard to the overnight rate, but they dropped the word "patience" from their statement. People had been using that as sort of a marker to say, as long as "patience" is in there, we are at least two meetings away from a rate hike. And now with the absence of "patience", that means they have got the flexibility to raise rates whenever they want, but they replaced "patience" with a more vague form of "forward guidance" that is more data-dependent, and that has injected a little more volatility in the market. We see a strong read on an economic number, treasury rates rise. We see a weaker reading the next week, they tend to fall again. But we did see some changes to the Fed's forecast for inflation growth and the level of the Fed funds rate.

How substantial were those?

They were pretty substantial. There had been a big gap between where the market was expecting the Fed funds rate at the end of 2015 and 2016, versus where the Fed projected it to be. So the Fed closed that gap pretty substantially by lowering both of their forecasts by a half a point for each of those years, and their forecasts for GDP and inflation were also lowered pretty substantially. And it is interesting to note that the Fed's own forecast for inflation, when measured by core PCE, falls short of 2% for the next two and one-half years, so by their own measure of looking to get to 2% inflation growth, their own forecaster is saying we are still not going to be there by the fourth quarter 2017. So the market took all of that as a signal to rally the treasury market a little bit.

Sure, so we have talked about treasuries and the Fed. How about muni yields, did they perform in line with treasuries?

No they really didn't. Munis lagged, and performance was pretty varied across the curve. Yields actually fell from 5-10 years, so fairly in line with treasuries in there, they rose from 12-20 years which was a pretty substantial underperformance, and they rallied on the very long end of the muni curve from 25-30 years.

Yeah, so why that variance across the curve?

The biggest factor is the composition of the new issue supply. Supply has been much heavier this year than expected, we have had over $100 billion issued so far in the first quarter, but over half of that volume was refunding, and new money issuance actually fell slightly versus the pace last year, that is down about 8%. So refunding volume typically comes with shorter maturities. Those are concentrated in that 15-20 year range, while new money issuance, which is typically issued to finance longer term assets, usually comes out with longer maturities, say the 30-year range, so the weakest performance is where the supply came, best performance where there continues to be a shortage of new bonds.

Yeah, so what does that new issuance breakdown tell us about issuers, and what does it bode for the rest of the year?

You know, it tells us that despite low interest rates, issuers are still being pretty cautious with their balance sheets, and they are hesitant to issue long-term debt to finance these much needed infrastructure projects. They are certainly interested in capturing savings and they are doing that, but they are not bringing new deals to market, being very cautious there. For the rest of the year, it makes issuance total very dependent on the level of interest rates. If rates stay where they are or do not rise by too much, then a lot of that refunding volume is still likely to come to market as it still represents savings for the issuers. If rates do start to spike higher, much of that refunding volume will be shelved and you might see a lack of muni issuance in that environment.

Sure. So moving away from the curve and onto performance, what areas were the best performers over the quarter?

So like last year, longer duration continued to be the best performer with the long bond index, and that is comprised of bonds with maturities of 22 years and longer. That led the way for the quarter. From a sector standpoint, hospitals were the best performer followed by resource recovery and industrial development revenue bonds. And generally speaking, sectors with higher relative yields outperformed more plain vanilla bonds with lower spreads and lower absolute yields.

Right. How about credit quality, how is the overall kind of tone there?

The overall credit quality of the market is good, and we would say that the credit environment has plateaued. The microeconomic backdrop continues to support positive credit fundamentals. GDP growth is still going to be in the 2-3% range. That helps revenue growth across a number of sectors, positive employment numbers support general obligation and transportation credits. You have seen that reflected in the upgrade to downgrade numbers. Upgrades have outnumbered those for the last couple of quarters, and while the easy gains in terms of credit from the recession have been made, credit quality is likely to stay stable as opposed to a peak and then a decline.

Right, and so away from the positive credit story, what is lurking on the negative side?

I would say there are a couple of key dates coming up for some credits that have been in the headlines for the wrong reason lately. This just actually passed today, though. There was an expiration of the forbearance agreement between the Puerto Rico Electric Power Authority and their creditors. There is likely to be a restructuring there. Their creditors have offered them another 15-day extension that runs until the end of April but we are certainly in a mode with that credit where they are talking about restructuring and what the payout ratio is likely to look like. The next big question for Puerto Rico is what happens to the GO credit. In early May, the New Jersey Supreme Court hears the pension litigation. A lower court ruled a couple of months back that the state needs to make a substantial contribution to the pension system, about $1.6 billion. The State Supreme Court affirms that decision, that is going to put a big hole in New Jersey's budget.

Without a doubt.

And then in late May, a similar ruling, or similar decision is coming from the Illinois Supreme Court ruling on pension modifications that the state proposed. If the ruling goes against the state, their budget becomes more strained than it already is, and that ruling would have some reverberations, because that might tell other states it has constitutionally protected pensions and hey, you can't go down that road to change those. So a couple of big dates for some credits that have been in the news for the wrong reasons.

Yes, so some headlines for some high profile credits out there. What do we expect for the balance of the year?

So on the rate side, I would say we probably are going to expect continued volatility. You know, we have got a Fed that wants to move the Fed funds rate off zero at some point, but the timing of that is very data dependent, so you are going to see, again, those big swings in rates one way or the other depending on the economic numbers for the week. Hard to see it substantially move lower from treasury yields from where we are now, so I think again, it is more of a timing of when do we start to move to a higher rate environment. It might be longer than a lot of people think. For returns from the muni space, likely kind of low, probably looking at the yield on the portfolio plus in terms of some roll-down, but again, not a lot of big movement in terms of price side. But the good news from munis is they should not outperform in a rising rate environment. We have got very attractive ratios to treasuries, and therefore a big cushion for governments, so munis look very attractive right now and that should help if we do see a rising rate environment. And in terms of new issue supply, again, it is very rate dependent given the high level of refunding volume that we have seen in the market, so that acts as a little bit of a governor in terms of the muni side, if rates start to rise, the market gets cheaper, issuance starts to shut off and then people say hey, there haven't been that many munis issued the last few weeks and start to stretch for it a little bit. So again, a lot of wild cards starting with the rates, supply, and a couple of big credit stories.

Excellent. Well, thank you very much, Matt. We appreciate your time and hope that you in the field have found this informative. We look forward to having you join us next week.

 

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