The financial markets' summer slumber ended abruptly in September. Worries about a possible short-term interest rate hike by the Federal Reserve at its September meeting, failure by the European Central Bank to increase Eurozone monetary stimulus, and tightening of the U.S. presidential race have been blamed for investor nervousness and financial asset price declines during the month. Additionally, the municipal market had to absorb a hefty amount of new debt issuance which contributed to the increase in tax-free yields.
The largest price adjustments occurred at the front end (shortest maturities) of the municipal yield curve, where the rise in short-term rates outpaced the moves experienced by intermediate and long-term maturities. Over the past several weeks, debt issuers' and bank liquidity providers' inventories of tax-exempt money market securities (maturity < 1 year) have been rising. Assets in tax-exempt money market funds (MMF) are falling due to redemptions, forcing the sale of securities held by MMFs. The MMF industry is entering the final stage of a multi-year transformation, a result of regulators' efforts to embed a higher level of safety into MMFs following the 2007-2009 financial crisis. Effective October 14, 2016, institutional tax-exempt MMFs will no longer be permitted to fix their share prices at $1. Only funds holding U.S. Government debt will be permitted to do so. MMFs have been preparing for a move to a "floating" Net Asset Value (NAV); however, only more recently have investors been accelerating the redeployment of their MMF holdings into U.S Government short-term investment vehicles that will not be affected by the new regulations.
The new rules affecting the funds have been many years in the making. In view of the pricing change to a floating NAV and more stringent rules governing MMF management, assets have been leaving the funds. Likewise, the amount of money market securities held by MMFs, such as commercial paper and variable rate notes, has been steadily declining to meet fund redemptions. According to market research, tax-exempt MMF industry AUM totals $136 billion currently, down 46% year-to-date, and 73% less than at the peak in 2008 ($506 billion).
In response, tax-exempt money market interest rates have climbed precipitously and now provide more income than high grade municipal bonds bearing longer maturities (1-3 years). The graph above highlights the spike in short-term tax-exempt money market interest rates. (Note that money market instruments generally trade in $100,000 minimum denominations.)
The SIFMA Municipal Swap Index, an index of high-grade municipal securities maturing in seven days, has been adjusting higher to accurately reflect the asset flow out of MMFs and the higher yield adjustments needed to place redeemed securities with non-MMF investors. Currently, the Index stands at 0.84%, a 43 basis point increase during the third quarter. This rate spike represents a possible opportunity for investors seeking to earn extra income on their "cash" holdings.
In July's Commentary, we discussed SMC's approach to general obligation (GO) bond analysis in light of pension funding pressures faced by many issuers. We continue this month by demonstrating some of the work undertaken by our research analysts to better understand the pension continuum as it relates to states. We compiled data on the Public Employees Retirement System Plan from 49 states and calculated funded ratios (FR), years-to-depletion (YTD), and contributions as a percentage of actuarially required contributions (%ARC). We used FY2015 plan statements and comprehensive annual financial reports (CAFRs) to derive this information.
The funded ratio (FR) reflects the assets on hand compared to the aggregate liability to the pensioners. A higher ratio indicates strength; the median calculated for the group was 76%. Years- to-depletion (YTD) indicates the years of resources available to fund annual benefit payouts without replenishment. A higher number indicates a greater balance of funds and is viewed favorably; the group median was 14 years. Lastly, SMC compiled the annual contribution of the plans compared to the actuarially required contribution (%ARC). A higher %ARC is viewed positively, with 100%, the group median, or higher, reflecting a best practice.
The data in the following tables was compiled from the pension plan statements of 49 states with ratios derived by SMC. The states' public credit ratings were sourced from S&P, Moody's, and Fitch rating reports.
As shown above, SMC compiled data and calculated the relevant metrics for the top five and bottom five states in each category. The similarly colored boxes indicate the grouping of credit characteristics of a given state. SMC notes the following summary conclusions:
The chart above shows the GO debt ratings assigned by the three major rating agencies for the five highest and five lowest rated states in terms of %ARC. There are multiple factors considered in assigning a state a GO letter-grade debt rating. Similarly, SMC routinely reviews multiple sources of data and research to arrive at its own independent credit decision that weighs all inputs appropriately. Our approach to credit analysis is unconstrained by rating agency opinions and our internal ratings are subject to change when material events occur.
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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