At its quarterly meeting earlier this month, the Federal Reserve Open Market Committee (FOMC) opted not to raise the overnight bank borrowing rate. “Caution is appropriate when raising rates” was the dovish statement uttered by Chair Janet Yellen which sent stocks soaring and interest rates lower. Not only did the Fed signal more patience, but indicated the financial markets should not expect four rate hikes this year, contrary to its previous signal. Given the more cautious tone, most Fed watchers are now forecasting no more than one or two rate moves in 2016. The consensus call is now in concert with SMC’s 2016 forecast of more limited Fed activity due to the lack of inflation pressures and subdued economic growth.
Financial markets endured much more price volatility during the first quarter of the year. Equity markets experienced significant price moves. The S&P 500 Index fell into official “correction” territory on February 11, when it closed at the 1829 level, more than 10% below its year-end close of 2044; however, its 2016 loss was erased late in the first quarter. The price snapback was aided by four major factors: significant monetary stimulus by the Chinese government; a sharp rebound in the price of oil; no increase in the Federal Funds overnight bank lending rate; and the dovish comments from the FOMC at the conclusion of its March 16 meeting.
Fixed income markets fared significantly better during the quarter. The Barclays U.S. Aggregate Bond Index, a representative composite of all investment grade U.S. taxable bonds, has returned 2.39% (as of 03/28/2016). Its tax-exempt counterpart, the Barclays Municipal Bond Index, posted a 1.23% return for the same three-month period. Maintaining this performance pace over the balance of 2016 would generate a total return in excess of 4.50% for the year.
The path of interest rate changes has been dramatic in both directions. From 2016’s outset, strong individual investor demand and limited new tax-exempt debt issuance in January helped propel prices of municipal bonds significantly higher (lower yields). Tax-exempt interest rates reached their 2016 low point on February 11 before reversing, but the increase was not as dramatic as the initial decline, resulting in higher valuations versus year-end. The extent of the interest rate drop and the subsequent recovery is highlighted in the following table and chart.
The greatest performance, as measured by the absolute change, was registered in the five-year segment of the “AAA” municipal yield curve: from 1.26% on 12/31/2015 to 0.79% on 02/11/2016, a decline of 47 basis points (0.47%). From the lows reached in early February, tax-exempt bond yields rebounded higher, due to a significant pick-up in new bond issuance. The move later in the period (between 02/11/16 and 03/28/16) was 33 basis points higher, resulting in a 14-basis-point net interest rate decline during the first quarter.
The five-year maturity range achieved the best performance primarily due to the steep slope of the yield curve and resulting roll-down benefit. (In previous Commentaries, we highlighted the potential profit to investors from capturing the interest rate roll-down.)
Despite heightened interest rate volatility during the first quarter, the net effect was evidenced by modest interest rate declines along the entire maturity term structure. While the largest reductions happened in short and intermediate maturities (2 to 10 years), long maturity bonds also achieved modest price gains (yield declines).
Looking ahead, we believe the combination of strong municipal market technicals, benign inflation, and continued tepid economic growth should sustain municipal bond prices near current interest rate levels with a bias towards further gains.
Sustained strong individual investor buying of the municipal bond asset class has caught many investment managers off guard. Historically, the start to any new year is characterized by strong investor buying in January, followed by significant buyer retrenchment through April tax season.
Thus far, 2016 has proven to be an anomaly. Stock market volatility has led to a significant asset shift from stocks to bonds. Individual investors have kept their foot on the accelerator and have been buying more tax-exempt investments. We track the weekly reporting of mutual fund sales data for a measurable proxy of overall municipal market demand. Through this channel alone, $22 billion has been invested over the past two quarters. With the conclusion of tax season in two weeks, we anticipate buying interest will accelerate.
Not coincidentally, the better market performance of the intermediate and shorter maturity ranges is a reflection of investors’ desire for shorter duration (lower risk) tax-exempt securities. Typical first quarter bearish seasonals (too much supply or insufficient demand) have bypassed the market so far in 2016.
While the majority of U.S. equity markets did manage to erase their YTD losses this month, most global stock indices are still in the red for the year, and the revised lower second quarter earnings forecasts portend more equity market pressure. It is possible investors will continue to show a preference for fixed income products, thereby sustaining purchasing enthusiasm and municipal market momentum.
While demand is increasing, net new tax-exempt debt issuance has not kept pace. A close analysis of recent new bond sales shows the majority of debt sales have been for the purpose of refunding higher-cost outstanding debt or replacing maturing issues. Issuance of debt for new projects has increased only gradually since most states, counties, and local governments are still hesitant to borrow for new projects. Several years of sustained subpar economic growth following the Great Recession (2007 to 2009) have been a significant restraint on capital expenditures. Furthermore, many states are grappling with underfunded pension plans and rising benefit costs that together threaten to further drain scarce financial resources and impinge on borrowing ability.
So, what types of municipal securities look to be the most compelling? Given the still tight spread between investment grade and high yield (rated “BB” or lower) bonds, investors are receiving less yield compensation for dropping down the credit spectrum. Future economic weakness would likely exert an even more pronounced negative effect on lower-rated credits.
With increasing scrutiny being given to the pension and related healthcare liabilities of the states, the sanctity of G.O. (general obligation) issued credits, backed by unlimited governmental taxing power, continue to receive much greater credit scrutiny than was warranted in the past. Neither Illinois nor Pennsylvania had an approved budget three-quarters of the way through their respective 2016 fiscal years. General obligation bonds undergo a greater degree of analysis before purchase now due to mounting employee and retiree benefit obligations and the prospect of rating downgrades.
Tax-exempt issues supported by a dedicated income stream pledge, and where there is less political risk and no commingling of revenues, are popular with investors. Additionally, essential service (e.g., water and sewer) revenue bonds generally offer a predictable revenue stream that permits more tangible and reliable credit analysis. Likewise, long-deferred infrastructure spending for roads, bridges, tunnels, and other transportation projects should continue to increase in light of rising problems with failing systems. A similar rationale supports public power issuers where revenues also tend to be non-cyclical and potential revenues identifiable. With the Affordable Care Act in operation for a number of years, much of the political uncertainty surrounding not-for-profit hospital bonds has been removed. Seasoned healthcare analysts should be able to identify value within this sector that can offer significant additional tax-exempt income.
In anticipation of a fairly benign interest rate environment, stemming from a less aggressive Fed and moderating economic growth, investors should anticipate a continuation of the municipal market status quo: interest rates should be expected to vacillate around current levels, and investment performance for the year will mainly be determined by the income component.
The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management ("SMC FIM"), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.
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