September was challenging for global fixed income investors. The municipal market was no exception, as concerns about future Fed rate hikes, announcement of the unwinding of the Federal Reserve’s balance sheet, a pick-up in new tax-exempt debt issuance and possible adverse implications of the President’s tax reform plan combined to unnerve the markets. Consequently, the Bloomberg Barclays Municipal Bond Index (the “Index”) lost 0.51% for the month. Despite this month’s setback, 2017 has been a comparatively strong year for municipal performance. Three-quarters of the way through the year, performance continues to defy skeptics. The Index has increased 4.66% through September 30, better than its 4.49% average annual return achieved during the past ten years. Following January’s discouraging start, tax-exempt security prices rebounded strongly, registering their best performance since 2014.
Bullish maturity selection has delivered the best payoff. Long-term bond returns are approaching 6% for the year. Maturities in the five to ten year range (SMC FIM’s preferred portfolio structure) have produced returns between 3.87% and 5.28%, based on a disaggregation of the Index. Conservative investors have not been compensated as generously and staying too short on the maturity spectrum has proven to be less advantageous. The above chart shows a significant disparity in returns for shorter structures; the three-year tranche has returned only 45% of the ten-year. Likewise, one-year maturities have generated barely more than half the return of three-year maturities. The comparatively better performance of intermediate-term and long-term structures is attributable not only to the higher yields afforded by duration extension but also to the generous roll-down benefit of the curve slope. The aging of a bond by the passage of time produces price protection as it “rolls down” to a shorter maturity. This progression results in a lower yield (higher valuation). The overcrowding of investment flows this year into short maturity securities has been blamed on the fear of rising interest rates. Ironically, not only have intermediate-term and long-term interest rates moved lower over the course of the year, but the interest rate term structure steepened between short maturity and intermediate maturity bonds during the second quarter, thereby creating a potentially more advantageous future roll-down opportunity for investors.
An examination of sector returns highlights the significant underperformance of pre-refunded securities. Post-refunding, pre-refunded bonds generally appreciate in price since the final maturity has been shortened. However, pre-refunded securities often incur price performance impairment due to the larger premium (valuation over par) that has to be amortized over a shorter time period. SMC FIM will often consider selling pre-funded bonds in order to try and capture the valuation premium. Proceeds can then be redeployed into higher yielding intermediate maturity bonds that can then benefit from the curve roll-down. The pre-refunded component of the Index has returned 1.92% through September, which is not surprising since the performance of short maturity bonds has been impacted by two Fed short-term rate hikes this year. A third increase is expected in December.
Earlier this year, in SMC FIM’s 2017 market preview, we discussed the outlook for various municipal sectors in view of the new administration’s agenda. We cautioned that general obligation (GO) bonds were likely to perform worse than revenue-backed securities. The performance of the GO sector has lagged the revenue sector by 34 basis points this year. Individual revenue sectors such as hospital and housing have performed better than the average return of the revenue sector. Budget and pension shortfalls in states such as Illinois, New Jersey and Connecticut have rendered “full faith and credit” GO obligations less desirable than enterprise-funded issues. We expect this trend to continue next year. The President’s ambitious spending plan to address America’s long-neglected infrastructure, including transportation, water and sewer systems and energy projects has not materialized, while the sectors’ performances have been good. Uncertainty surrounding repeal of the Affordable Care Act (ACA) was anticipated to be an impediment to healthcare credits and related bonds’ performance. Failure to either reform or repeal the ACA has proven to be a boost for hospital bonds, the best performing sector this year with a 5.30% gain. Housing bonds have performed almost as well, reflecting a diminishing outstanding debt. Hurricanes this month devastated much of the infrastructure in the U.S. territories of Puerto Rico and the Virgin Islands. Significant portions of Florida, Texas and other southern states have also been impacted. All face years of infrastructure rebuilding and funding needs. In addition to major federal emergency assistance, longer-term financing should be forthcoming for transportation, utility and essential service projects. Tax-exempt financing will likely play a significant role in providing capital. Infrastructure spending could finally get a kick-start in 2018. One silver lining in the aftermath of the recent weather-related destruction is that the necessity to rebuild will trump the heretofore reluctance of politicians to spend. For example, the Puerto Rico Electric Power Company (PREPA) entered bankruptcy earlier this year without a viable plan or means of financing to replace its failing power generating facilities. The destruction from Hurricane Maria has crippled the island and left residents without power, possibly for months. Washington can no longer continue with a hands-off approach to the Commonwealth’s myriad of problems. We believe Washington will likely be a major source of funding and the rebuilding solution.
Today’s “yield seeking” environment has proven most beneficial for lower-rated securities. The high yield, non-investment grade sector (BB and below) has performed very well (7.72% YTD), while the lowest level of investment grade credit (BBB) has outdistanced higher quality by over 200 basis points. Dwindling new bond sales during much of 2017 and persistently strong investor demand have aided overall market performance. September’s performance aside, we do not view the market as particularly vulnerable. Demand is expected to stay robust as evidenced by eleven straight weeks of positive cash inflows into tax-exempt bond mutual funds. A material increase in new debt issuance is unlikely through year-end, according to investment bank forecasts. While it is possible that the market has reached its performance peak for the year, SMC FIM does not anticipate a significant deviation in returns during the fourth quarter. We think financial markets have overreacted to the prospect of meaningful tax reform, or at least to the plan unveiled recently by the White House. So far, the Trump administration has struggled to work with legislators on Capitol Hill. In our view, it’s difficult to foresee a divided Congress coming to terms on significant tax reform. This most recent setback for fixed income markets should dissipate as previous ones have this year. We expect that the tax reform debate should persist well into 2018.
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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