Discerning Value in Municipal Credits

April 2016

Achieving confidence through comprehensive credit analysis

  • Investors’ preference for municipal bonds
  • Technical factors bolster municipal market performance
  • Achieving confidence through comprehensive credit analysis
  • SMC’s views on municipal debt issuers

The municipal market weathered April in extraordinary fashion. Historically, the month has proven to be a difficult one, characterized by investor apathy and increasing new tax-exempt debt issuance, leading to higher interest rates. The fact that tax payment day occurs mid-month is not a coincidence and a contributing source of market pressure since many individuals liquidate bond holdings during the month to pay their income taxes. Generally, investor interest is renewed in subsequent months as the municipal market regains its footing heading into summer.

For some reason, in 2016 market behavior has managed to defy the norm. There was no April “sell-off.” In fact, just the opposite happened—rising bond prices pushed intermediate and long-term interest rates to their lowest levels of the year. The Barclays Municipal Bond Index has moved 0.69% higher in April, bringing its 2016 advance to 2.37%. Why does the municipal market continue to perform so well while taxable bonds stumble? The question is best answered by the chart below.

Investors have decided the municipal asset class currently affords a safe repository for investment. Municipal bond mutual funds, a good proxy for overall demand, have experienced over six consecutive months of consistent inflows. This 29-week run has been the longest uninterrupted stretch since 2010. Increased allocations to tax-exempt investments have led to higher prices. With the Fed willing to hold off on raising short-term rates following its December move, investor sentiment remains positive. Note that taxable bond and stock mutual funds have had a very different experience, particularly in April, when funds were met with redemptions.

New municipal debt issuance has totaled approximately $121 billion YTD, which is 13% below last year’s pace. While states and municipalities are still selling new debt issues to replace maturing securities, borrowing for new capital projects remains muted, further exacerbating the supply/demand imbalance in the municipal marketplace. We expect this condition to persist over the balance of the year. With fewer security options to choose from, we believe the importance of thorough credit research before purchasing becomes increasingly important and could be a significant factor in portfolio performance.

SMC’s credit outlook for municipal finance is generally stable based on slow but improving U.S. economic growth and better labor market statistics. We favor enterprise revenue-backed bonds (i.e., payable from specific identifiable revenues) and focus on all sectors including healthcare, public and private higher education, infrastructure, toll roads and utilities.

The healthcare industry has stabilized since passage of the Affordable Care Act (ACA), and the growth of the health insurance exchange has promoted demand. Traditionally strong hospital and health systems should continue to perform favorably. Newcomers with strong fundamentals could still face challenges as patients with coverage shop for more affordable plans. SMC favors healthcare providers demonstrating sustained profitability or a competitive advantage in a relatively insulated service area.

The rising costs of higher education have received considerable news coverage and attention from politicians. Higher education obligors, split between public and private colleges and universities, are viewed differently because the former can have considerable reliance on the state, whereas the private university can manage its finances more independently. Private colleges are more price-sensitive, so tuition discounting as well as declining applications are generally considered signs of weakness.

America’s highway infrastructure system has been long-neglected and underfunded. SMC views new toll roads and related projects favorably due to the five-year funding bill passed by Congress last year and lower fuel costs due to the drop in oil prices. Completed toll projects are expected to see revenue growth as traffic and toll rates increase. Airports are another transportation sector with favorable prospects. They will continue to benefit from growth in travel and increased airline capacity. Sustained lower fuel costs could help bolster revenues and lend support to underlying bond ratings.

Essential service revenue bonds rank near the top of the preferred credit list. Water and sewer systems remain an indispensable service with largely captive customer bases and the ability to raise rates as needed. These features enable enterprise systems to generate adequate to strong debt service coverage. Budget pressures have resulted in funding shortages within many municipalities, often leading to service failures. Plans for much needed infrastructure spending have been curtailed for many years. While the post-recession economic recovery has been slow, it is anticipated that more tax-exempt borrowing will be forthcoming.

How does SMC evaluate enterprise revenue-backed credits? The analytic process considers competitive pressures and demand trends in addition to basic financial metrics such as liquidity, cash flow and debt outstanding. Our credit team also incorporates market information to rank potential holdings and review those currently held. Incorporating external criteria to supplement internal methodology helps to differentiate between perceived and actual weaknesses and strengths. The value of in-house credit research is that our analysts dig deeper to fully understand the pertinent factors before making an investment decision. These practices allow SMC to forecast the stability of an obligor with a reasonable degree of confidence for inclusion in client portfolios.

Of course, there are also some municipal sectors that present concerns and necessitate special attention. One exception to SMC’s generally stable outlook for municipal finance is the effect of plunging oil prices on credit. Revenue shortfalls have led to rising unemployment rates and potential declines in oil-related tax receipts for production states. Hardest hit states include Wyoming, North Dakota, Alaska, Oklahoma and New Mexico, although other oil-producing states, namely California, Colorado and Texas, managed relatively better due largely to an economy diversified from energy. The recent rebound in oil prices potentially mitigates some of these effects. A fluid situation like this merits ongoing surveillance and consideration of potentially impacted credits on a case-by-case basis.

Trends in state and local government finances are always being scrutinized for possible municipal credit impact. The municipal market has become increasingly concerned with pension funding pressures. These costs remain a large liability for most states and present an obstacle to achieving balanced budgets. Pennsylvania and Illinois operated without a balanced budget through the middle of fiscal 2016 and other states have used pension contribution holidays—a decision made to divert funds elsewhere in lieu of funding pensions for the year. Solutions to these funding quandaries are long-awaited in coming. State budgetary operations need to be properly understood and incorporated into credit judgments.

No review of municipal credit would be complete without a discussion of Puerto Rico. SMC believes that Puerto Rico’s travails and potential restructuring are more a function of legislative and judicial actions than credit speculation. We believe in the creditworthiness of certain insured credits. Our July 2015 Commentary detailed the factors supporting a favorable view of debt insured by Assured Guaranty and National Public Finance Guaranty. Recently, the Governor instituted a debt moratorium through the end of January 2017. Investors must bear in SMC Fixed Income Management For Informational Purposes Only - Subject in all respects to the disclosures at the end hereof. mind that is a very fluid situation. The U.S. Congress has yet to unveil its decision or outline a recovery plan, which is expected within the next couple of months. A resolution is still not near and SMC continues to closely monitor this situation for developments.

Disclosures

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.

This commentary is neither an offer to sell nor a solicitation of an offer to purchase securities, any other investments or any other product sponsored or advised by SMC FIM, nor does it constitute an offer or a solicitation to otherwise provide investment advisory services. Such an offer or solicitation may be made only by the relevant documents for the relevant investment vehicle and/or investment program. This commentary is not, and may not be used as, a recommendation of any security, investment program or vehicle. There is no assurance that any securities discussed herein will remain in a client's account at the time you receive this commentary or that securities sold have not been repurchased. The securities discussed do not represent the client's entire portfolio and in the aggregate may represent only a small percentage of the client's portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed was or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

Statements contained in this commentary that are not historic facts are based on current expectations, estimates, projections, opinions and beliefs of SMC FIM. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. Unless specified, any views reflected herein are those of SMC FIM and are subject to change without notice. SMC FIM is not under any obligation to update or keep current the information contained herein.

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