So far in 2017, the municipal market is performing pretty much as our outlook anticipated. Year-to-date, the Bloomberg Barclays Municipal Bond Index has risen 1.36% (through February 28) and has rebounded 2.55% over the past three months. The benchmark U.S. Treasury 10-year bond yield has fallen 25 basis points, from a high of 2.60% in mid-December to 2.35% at the end of February. Such stability within the bond markets suggests that investors are not worried about the risk of rising inflation, the primary determiner of intermediate and long-term interest rates. Looking back over the past decade, the municipal bond market has consistently recovered from a significant market correction, signified by a decline of 6% or more. (see SMC FIM’s December 2016 Commentary).
In addition to supportive economic data and inflation readings, the technical condition within the municipal market has been well balanced in terms of supply/demand fundamentals as shown in the graphs above. Investors have been actively reinvesting cash since the beginning of the year while new debt sales have declined; February’s issuance was approximately 30% lower than the same period one year ago. We expect bond issuance to increase into March, historically a month with large volume of new deals. The 30-Day Visible Supply of new municipal debt sales is currently $14 billion, compared to $6.5 billion at the beginning of the month.
The market spent the past three months recovering from a post-election sell-off. While municipal bond yields have declined over the past few months, the adjustment has not been uniform along the maturity spectrum. The shortest maturity (five years) yield has declined more than intermediate-term and long-term maturities.
While still early in the year, adhering to the time-proven adage of “staying the course” with respect to the municipal segment of an investor’s portfolio may be beneficial depending on portfolio structure. SMC continues to favor the intermediate portion of the yield curve of 5 to 12 years. This part of the municipal yield curve is steep, offering Incremental yield over 100bps.
In last month’s Commentary, SMC FIM presented its assessment of proposed tax reform and changes to the Affordable Care Act (ACA) under the new administration. This month, we present our views on other municipal credit sectors. Large-scale infrastructure projects will likely benefit. We believe the transportation sector merits attention. Higher education will be characterized by mixed performance between private and public institutions, and enterprise revenue-backed bonds should generally perform better compared to general obligation (GO) full faith and credit securities.
The Trump administration’s arrival in Washington underscores the need for focused municipal credit analysis. The newly-elected president has very ambitious plans for overhauling much of America’s infrastructure. Large-scale infrastructure spending plans—covering a myriad of energy, water and transportation needs—were highlighted in the President’s speech to a joint session of Congress. However, payment sources for $1 trillion of spending have yet to be identified.
Funding through private/public partnerships seems to be the preferred method of project financing. We think roughly 50% of development needs are anticipated to arise from private sources, possibly creating thousands of jobs in the process. Treasury Secretary Mnuchin said recently that enhancements are forthcoming for municipal private activity bonds (PAB). These could be employed to attract private investment for the infrastructure program, similar to what arose after the last recession. This means the other half could be funded utilizing more traditional means such as tax-exempt bonds. In the near-term, states may exhibit a “wait & see posture” in expectation of federal assistance. The lack of economic growth combined with an increasing budget allocation to pension obligations has motivated states to continue a more conservative fiscal policy.
Unfortunately, we believe only a limited amount of municipal infrastructure projects fit the mold of a private/public partnership. For example, private entities might be willing to participate in projects that have dedicated identifiable revenue sources such as toll roads and airports. However, more mundane projects such as schools and county roads do not fit the model because their funding sources generally come from state appropriations. In fact, we believe there will be disappointment that only a fraction of infrastructure projects will ultimately qualify.
Transportation could merit special attention from analysts given the new administration’s ambitious infrastructure spending plans for America’s roads, bridges and airports. Some of these ideas could potentially work under the private/public model. A significant portion of the promised infrastructure budget could be allocated to new transportation projects over the next several years.
Currently, SMC FIM maintains a stable outlook for transportation projects. This opinion could improve once more specifics on funding are made available. Our preference is to own transportation projects that are seasoned and are of critical need given the service area. For example, airports, ports and train terminals that act as regional or international hubs for major markets are preferred. Our analysis also considers other factors such as alternative modes of travel, barriers to entry and the quality of the management team. Included in these positive factors are histories of stable demand, consistent financial performance and excess earnings that can fully support debt service coverage.
General obligation and related credits (e.g., lease and appropriated debt) will be under greater scrutiny. For now, the state GO sector should remain stable and ratings mostly unchanged, but we expect credit quality weakening in states carrying high pension liabilities and a lack of substantive remedies to make material improvements in their credit profiles. One concern for states is the formula used to assist them with Medicaid funding. Currently, the federal government pays states for a specified percentage of program expenditures called the federal medical assistance percentage (FMAP). FMAP varies by state based on criteria such as per capita income. One idea under consideration, due to efforts on “repeal & replace” of the federal healthcare law, is to provide funding via block grants. The grants would be fixed amounts given to states, and the states would then manage Medicaid needs as they see fit. This new formula could put budgetary pressures on states if they do not estimate their needs accurately. We believe that states could have increased costs if the change occurs. SMC FIM’s hierarchy of state credit rankings incorporates such a scenario.
We expect states that have not made strides to improve their pension situations with sustainable funding actions will continue to be scrutinized and penalized by rating agencies. SMC FIM’s September 2016 Commentary provided a detailed examination of state pensions. Illinois and New Jersey continue to be downgrade risks due to the lack of a budget (Illinois) and pension pressures.
While not as dire as a year ago when energy prices were plunging, energy-based state economies (Arkansas, Oklahoma, Alaska and Wyoming) still face budgetary challenges as prices are still relatively low, taxes collected from mining operations have been reduced and there is more domestic supply in the form of fracking and onshore drilling. One of the president’s first orders of business after taking office was reviving the shuttered Dakota and Keystone XL pipeline operations. We anticipate additional supply coming onboard in the next few years.
States with substantial export trade exposure might experience revenue declines as a result of trade renegotiations, border taxes or protectionist policies. Louisiana, Kentucky, Michigan, Tennessee, Indiana, Mississippi, Texas and Washington have annual exports that account for 10-21% of annual GDP. All have trading relationships with China and Mexico that could be affected. SMC FIM’s general obligation credit exposures are concentrated in northeastern states whose economies are relatively less reliant on trade with these countries.
We believe Trump’s executive order to withhold or restrict federal assistance to “sanctuary counties and cities,” defined as areas where most of the estimated eleven million illegal immigrants live, will not materially affect the states’ and counties’ ability to pay debt service. However, if any of these entities have had existing deficits and budget shortfalls, any reduction of assistance from Washington may exacerbate the social assistance component of their expenditures.
Overall, SMC FIM does not foresee much in the way of change for this sector. Student matriculation trends in higher education continue to favor public institutions. Public universities rely on federal and state aid for about 40% of their revenue and their credit ratings will reflect the stability of the federal government and respective state government financial trends. For instance, the public universities and community colleges in the states of Pennsylvania and Illinois experienced credit stress during the state budget impasses in recent years. During this time, public ratings were lowered to reflect the uncertainty that component districts experienced. When the impasse was resolved in the case of Pennsylvania, the related support ratings were upgraded. Public colleges and universities, save those in stressed states (e.g., Illinois), will continue to reflect stability as they remain the affordable alternative to higher priced private education options.
Private universities, which have more debt outstanding per student than their public counterparts and rely on student-derived revenue, also tend to have higher liquidity levels and endowment fund balances. However, institutions that are too narrow in focus will face stresses unless they occupy the top tier position in their specialty. Larger private institutions, especially those with name recognition, will remain stable. We are particularly mindful of non-fee income. There could be stress on investment income as endowment investment portfolio performance has lagged expectations for the past few years. Lower-tier private colleges and universities, unless backed by foundations with assets or a strong fundraising program, will experience pressures due to competition and price discounting to attract students.
Private universities tend to be less affected by state travails but by no means are they exempt from a growing sensitivity to price and tuition discounting. Increased discounting along with declining applications is considered a sign of weakness, even if the general operating trends are positive. Balance sheet strength, operational profitability and demand trends are monitored for existing credits and new potential exposures.
Essential services, such as utilities, water, sewer and electric systems, are underpinned by their necessity from a credit standpoint. During the past several years of sub-par economic growth, commercial and residential property valuations recovered somewhat and stabilized along with tax collections. In turn, these improvements tempered concerns about general obligation credit profiles. In contrast, essential service enterprise revenues (e.g., water and sewer) continue to grow. Consequently, SMC FIM’s credit and trading disciplines view this sector favorably.
Our view of power system revenue bonds is generally stable. Environmental Protection Agency (EPA) initiatives can drive up costs of operations for electric utilities, as generation systems with large carbon footprints could be subject to regulatory requirements and refitting upgrades leading to rate increases or reduced operating profitability. That said, most systems are operated with an eye on public service, and deregulation initiatives from Washington could have a positive credit impact.
SMC FIM’s view on essential enterprise revenue bonds is positive based on the fact that these bonds typically finance the projects of an essential and sole service provider to a region. Credit analysis will consider factors such as service area, rate setting independence, competition, plant and facility sufficiency and compliance with EPA regulations.
SMC FIM’s outlook for dedicated tax-backed bonds remains stable. We prefer to hold securities backed by taxes for essential purposes (e.g., sales and use, motor vehicles, fuel and oil). We prefer to see that tax collections are set aside in a lock box or flow to a trustee for debt service payment purposes before disbursement to the benefitting issuer. Noting that tax-backed bonds may be supported by secondary sources of revenue and could include general fund appropriation from overlapping municipal entities, our focus extends from credit analysis to legal rights to funds. Analysis involves assessing the benefit to the bondholder from both a credit and legal perspective as it relates to the priority of payments and perfection of a lien on revenue pledged to debt service.
We are encouraged by the municipal market’s resilience and price rebound. Favorable economic data, contained inflation and a good technical posture support our constructive outlook. Historically the spring period has been a ripe time for investors to re-focus on the benefits of tax-exempt securities. This year the picture is a bit murkier due to the aforementioned uncertainties surrounding proposed tax reform and changes to healthcare delivery and a shift in domestic spending priorities. Details should be forthcoming in the next few months that will help inform our analytics and investment strategy.
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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