The municipal bond market's performance has reversed course since November and the improvement continued through the first month of 2017. The cessation of large-scale bond liquidations, motivated by tax considerations, led to a more stable January trading environment. Cash proceeds from year-end selling are now being redeployed in the municipal market. Bond prices have been lifted by the reappearance of institutional and retail investors. For the month of January, the Bloomberg Barclays Municipal Bond Index returned 0.66%, beating the performance of U.S. Treasury and corporate debt.
The market's recovery has now spanned two months, placing it on much firmer ground. Much of the price rebound has been fueled by the need to invest stockpiles of cash raised in December and the market's "seasonals" (sizeable month of January coupon payments and bond maturities). In February market technicals should become more balanced due to the reduction in bond coupon payments and redemptions while new bond issuance picks-up later in the month and into March.
Investors will continue to be focused mainly on President Trump's aggressive agenda. Financial markets will have to consider the possibility and implications of less government regulation, accelerating economic growth, and possible tax reform. For example, more infrastructure spending, the revival of the Keystone XL and Dakota pipelines, and significant changes to the Affordable Care Act (ACA) could impact some credit sectors.
The President's first 100 days in office could be significant in determining investor sentiment and the market's direction for the year. Investors are anxious. Without definitive details forthcoming from Washington, anxiety will likely persist for some time. SMC anticipates volatility will persist through the end of the first quarter and our near-term investment strategy will remain cautious until a clearer picture emerges.
Given the number of unknowns and the potential for market-moving policies and directives emanating from Washington, we provide views on the likelihood of their implementation and possible impact on related municipal sectors. This month's Commentary addresses tax reform and the ACA. Next month we plan to present summary assessments of other tax-exempt credit sectors.
In short, we believe the municipal tax exemption will survive, issuance will mimic last year ($400bn plus) with refunding issues slowing down, and most municipal sectors will remain stable. The healthcare sector may face volatility if the ACA is repealed without a replacement; the transportation sector will benefit from the publicized infrastructure improvement programs; higher education will note mixed performance between private and public institutions and enterprise revenue-backed bonds will generally perform better compared to general obligation (GO) full faith and credit securities, which we believe will remain unchanged.
Regarding the tax reform agenda and municipal tax exemption, SMC believes the municipal exemption will remain unaffected. Last month, at a U.S. Conference of Mayors meeting, President Trump expressed his support for maintaining the tax-exemption. The obvious logic behind eliminating the benefit of tax-free income is the additional much needed revenue to the U.S. Treasury to address current Federal deficits. The consequence of making the bonds taxable to the investor is the additional cost of financing to state and local governments. Since the income received from owning U.S. Treasury and corporate bonds is not exempt from federal income tax, yields are higher relative to municipal (tax-exempt) bond yields. In order to compete, municipal issues will have to pay more in the form of higher yields on new debt issues if the federal tax exemption is lost.
Tax-exempt bonds have been the primary financing mechanism for state and local infrastructure projects, and their use dates back more than 100 years. Various industry analysts have estimated the impact of eliminating tax exempt bonds on state and local governments would have paid $495 billion in added interest costs for the $1.65 trillion in bonds issued over a ten year period. We believe state and local governments would not support higher interest costs. Higher financing costs have potential to slow much needed infrastructure projects as well. In addition, the higher costs will be passed directly to taxpayers. The municipal exemption already in place, along with the capital investment options available for governmental projects, may not be optimal but has proven efficient for state, county, city and local governments to finance operations and we expect it to remain in place.
The new administration's potential relief for personal and corporate taxes includes investment gains but limits interest and itemized deductions. While we understand that tax cuts are positively received, it should be noted that reducing a tax burden comes with consequences. While tax relief measures are expected to boost economic growth, they will be counterbalanced by a reduction in federal tax revenues, reportedly in the trillions over a decade. If economic investment does not yield the results intended, budget deficits are sure to occur. While the new administration has demonstrated incisive and abrupt moves in issuing executive orders and bans, we do not believe myopic tax reform is imminent. We will provide ongoing analysis and actionable takeaways as plans unfold.
President Trump's first executive order sought to repeal the ACA by instructing the executive branch of government to take all legally permissible actions to reduce the economic and regulatory burdens and costs of the Act and create a "more free and open" healthcare market.
The repeal of ACA provisions would undoubtedly affect the healthcare sector but the impact of the executive order issued by the President is questionable. While there was an expectation of a simultaneous repeal and replace strategy, there are challenges expected both in terms of Senate support and delays in passing legislation. As the process unfolds, there may be an effect on state finances as well as provider metrics but we note that general rating agency healthcare sector outlooks are cautiously stable. Fitch Ratings and Standard and Poor's articulated "negative" and "stable" outlooks, respectively, but both agencies note elimination of the key provisions of the ACA without appropriate replacement provisions will be a credit negative. The longer the executive order stands without an actual replacement alternative offered, public confidence along with what is a functioning system will likely falter.
Changes to the ACA provisions are easier said than done. The ACA's benefit to providers included higher volumes with the availability of insurance at subsidized levels. The Act helped healthcare providers with improved volume and reduction in charity and uncompensated care, but insurers took the burden of providing reduced cost insurance to individuals with pre-existing conditions, effectively increasing the risk factor of a given insured pool. The recent executive order by Trump may decrease the number of insured and increase the risk factor of insured groups as individuals who are relatively healthy will seek to eliminate the cost of health insurance from their budgets and also avoid the tax penalty.
The elimination of ACA provisions may be followed by measures to reduce federal subsidies to expand Medicaid programs. This reduction, in addition to the departure of insurers previously participating in the healthcare insurance exchanges (HIE), will cause the uninsured patient pool to grow. As a result, providers and local governments may have to absorb the brunt of charity and uncompensated care.
After reviewing multiple market studies, we include the market participants' estimate of the potential effects of repealing the ACA without an alternative and eliminating the Medicaid expansion. These effects could include the following over the next 5-8 years:
Changes to the ACA, if passed, would take time to implement, and we estimate the changes could not be implemented until 2018 at the earliest. Providers with a disproportionate exposure to uninsured patients prior to ACA could experience declining volume, weak operating margins and increased bad debt. That said, SMC's healthcare exposures coalesce at the stronger end of the credit spectrum and are not expected to be overly sensitive to potential repeal actions. For the intermediate time period and until the dust settles, we advise a conservative approach to minimize volatility from the sector:
In addition to evaluating the impact of changes to the ACA on the healthcare sector as a whole, SMC routinely considers the criteria mentioned above in determining the appropriate allocation to our client portfolios. We will, in the course of our general practice, monitor situations and take action as warranted.
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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