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Municipal Podcast recorded on January 12, 2016

Q4 Municipal Market Review

Podcast Transcript

Hello, I'm Natalie Wright, a product manager here at Breckinridge, and welcome to a special edition of the podcast where we will discuss some of the most impactful market events for municipal bond investors in the fourth quarter of 2015. Today, I am joined by Matt Buscone to talk through some of these events. So Matt, certainly an eventful quarter for investors on a number of different fronts. What were some of the items that impacted fixed income during the quarter?

Well, certainly the big story in the fourth quarter was the collapse in commodity prices, specifically oil, the slowing economic growth out of China, the devaluation of the yuan; all of these weighed very heavily on high yield bond markets and led to increased volatility across equity markets globally.

Gotcha. And finally, we have lift-off. We also had a hike in the Fed funds rate for the first time in seven years.

We did, ending probably over a year of speculation over will they or won't they at every meeting, the Fed finally raised rates in mid-December. The overnight Fed funds rate is now in a band of 25 to 50 basis points, and the Fed's internal projections see four more rate hikes coming this year.

Well, did the hike in Fed funds have an impact on Treasury yield?

Well, the move was certainly widely expected, but it did have a big impact on the front end of the Treasury curve and most of that happened leading up to the Fed hike. The Treasury curve flattened substantially over the quarter as yields on 2-5 year bonds rose by over 40 basis points. Ten-year yields were up close to 30 basis points and 30-year yields were up roughly 20 basis points.

Okay, and what about changes to the muni curve, similar to what we saw in Treasuries?

Similar in terms of trend, in terms of curve flattening, but munis saw their yields fall across most of the curve and were able to outperform Treasuries quite substantially in many maturities. So 2-3 year maturities, those performed most in line with governments, those yields were higher by about 20 basis points. The 5-year muni was unchanged, 10-year muni yields were lower by 10 basis points, and the 30-year spot was down by over 20 basis points.

Oh, so significant tightening. How did that tightening shake out in terms of returns for munis during the quarter?

It really gave munis some really strong returns for the fourth quarter. Outside of the Barclay's 3 and 5-year indices, which were just slightly negative, longer maturities all showed positive returns with longer duration returns performing the best. The long bond index was up 2.4% for the quarter, and some intermediate indices, say those with durations in the 4-4.5-year range, were up around 80 basis points for the quarter.

So longer duration was the return leader on the curve. Well, what stood out on the quality and sector side?

So if we start on the quality side, despite the weak performance that we have referenced quickly about lower rated and high-yield corporates, lower quality munis did very well over the course of the quarter. Baa bonds showed the best returns at up over 2% while Aaa bonds were up just over 1% so the higher the quality, the lower return you had for the quarter.

And what about on the sector side?

Pretty consistent with what we saw on the quality side, with non-traditional sectors leading the way. Industrial development revenue bonds, lease backed bonds, and hospitals were the best performing sectors for the quarter, and there were also some favorable developments in terms of legal rulings that helped tobacco bonds—those that are backed by the master settlement agreement—performed very well as well. So not what you think of in terms of core municipal in terms of general obligation and water/sewer, again, more non-traditional sectors leading the way.

Gotcha. Well, these strong returns are occurring in the face of Puerto Rico defaults and some well-telegraphed pension problems in New Jersey, Chicago, and elsewhere. So how is it that lower quality did well in this kind of environment?

Yeah, it is somewhat counter-intuitive. Puerto Rico, as you mentioned, they did default on some of their smaller, less well secured obligations. Important to note that they did not default on their general obligation or sales tax bonds yet, and the market is doing a very good job of treating Puerto Rico as a unique case and that's not seen as affecting other credits. And so far, its impact on the broader muni market has been minimal. So while you've had people leaving Puerto Rico and, to some extent, Illinois and Chicago credits, they've been buying many of the other lower rated credits in muni-land. Those have performed very well as the credit environment is seen as more positive for many of those credits.

All right, so not necessarily systemic.

Correct.

All right, well, what else helped to drive muni performance during the quarter?

Really strong technical backdrop over the last few months on the demand side particularly. After the Fed passed on raising rates in September, inflows came back into municipal bond funds for the rest of the year in the neighborhood of $3-4 billion over the fourth quarter. I think it was 14 straight weeks of inflows I saw, and we were up over $13 billion year-to-date, so a lot of demand for munis in the fourth quarter.

All right, well how did supply keep up with the demand?

It did not keep up with it. It really fell off in the fourth quarter. If you remember back to the beginning of the year, both the first and second quarters saw over $100 billion worth of issuance. The third quarter saw that fall back a little bit to $91 billion, and the fourth quarter this year fell even more. There was just over $80 billion of new issue supply. That total was down almost 25% from the total that we saw in the fourth quarter of 2014. So those increased fund flows that we mentioned just a moment ago came in an environment of declining supply.

Well, how do we view the overall credit quality of the market going forward?

So while there are certainly some outliers on the negative side, sort of leave Puerto Rico off to the side on its own, but Illinois' problems have been very well written about, Chicago, the State of New Jersey, most credits are stable and the credit environment is about as good as it gets, and we'd likely view credit as not even plateaued so far. There are many good metrics. If you look at state and local government debt as a percentage of GDP, that's down to 16%. Reserves are up, but a couple of these make us think they’ll plateau as some of these trends have started to slow. That percentage of debt is unlikely to climb much further, and the reserve improving trend has slowed down. On the negative side, some of the bigger issues that are facing many municipalities have not gone away. Pension and retiree healthcare costs continue to rise, and as the infrastructure continues to age, they are likely deferring many maintenance and new projects that they are going to have to do; we’re likely to see more debt sometime soon for many of the state and local governments that have not been borrowing much the last five years.

Okay so as good as it gets with a few fault lines to watch for. Well, the recent outperformance of munis has come with some concern about valuations. Where do valuations stand now?

So munis are definitely less attractive from a valuation standpoint than they were a year ago. The outperformance has pushed muni ratios to Treasuries back towards the averages that we saw pre-financial crisis. Now post 2008, municipals have traded very cheaply and most of the time, that has been in excess of 90% of government bonds across the curve and in many instances, they were well over 100%. So where do we stand now? At the end of Q4, 2-7 year maturities were all in the low to mid-70 range when looking at the Aaa scale. The 10-year ratio is closer to 85, and the 30-year is down at 93% so while rich compared to the environment that we've seen in the last six years, these ratios are much more in line with what we see in the longer term averages for municipal bonds.

Okay, well what's the main take-away about muni performance in a quarter like this when the broader market is exhibiting such crazy gyrations?

Yeah, I'd say, you know, munis have performed well in an environment where you would hope them to do so. So when equities and high yields are selling off, you want to be able to look at your muni portfolio as a source of stability and as a counterbalance to your riskier assets. Returns were strong in the fourth quarter and in 2015, and while valuations are less compelling than they were at the beginning of the year, munis are likely to benefit still in 2016 from lower volatility when compared to other asset classes, a stable credit environment, and likely positive technicals for the near term.

Great. Well, it sounds like munis certainly held their own as a counterbalance to volatility in the broader market during the quarter. We certainly hope that you in the field found this informative, and please contact Breckinridge if you have any thoughts or questions.

 

DISCLAIMER: The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification.