Clipping Coupons

July 2016

Adjusting to a sustained lower interest rate environment

  • Adjusting to a sustained lower interest rate environment
  • The value of holding higher coupon bonds
  • Pension liabilities and their impact on general obligation credits

The search for investment income continues. In an ultra-low interest rate environment, where one-third of global government debt offers negative interest rates, the hunt for higher yielding assets has broadened. The municipal market has been a major beneficiary of this search as evidenced by the flood of money finding its way into tax-exempt mutual funds. According to recent Lipper data, there has been a record 44 consecutive weeks of cash inflows; municipal bond mutual funds have not experienced net investment outflows since last September. Record investor demand for bonds, modest new tax-exempt debt issuance, accommodative global central banks, and benign inflation expectations have been factors positively influencing municipal bond prices this year. A final drop to new interest rate lows ensued in the aftermath of the surprising late June Brexit vote.

Having initially overreacted to the decision by England to leave the European Union, financial markets managed to find their equilibrium earlier this month, leading to a fixed income interest rate rebound that reversed a large portion of the Brexit-induced rate plunge.

The chart and graph above illustrate the rather dramatic change to municipal bond interest rates over the course of this year. At the beginning of 2016, rates embarked on a steady journey to lower levels. The first seven months’ dramatic drop was unprecedented and it led to a significant "flattening" of the municipal yield curve due to the greater decline of long-term interest rates (67 basis points) compared to shorter maturities (39 basis points).

Once Brexit fears subsided earlier this month, global fixed income yields adjusted higher. Municipal interest rates rose by as much as 22 basis points by month-end. Year-to-date, tax-exempt interest rates are still close to their historic low points. The Barclays Municipal Bond Index has returned an impressive 4.19% through July 26. However, the second half of the year should be far less exciting in terms of interest rate movements. SMC anticipates a less volatile trading environment – smaller interest rate movements. Short and intermediate tax-exempt interest rates are not likely to stray significantly from their current levels. However, long-term interest rates might prove to be a bit more volatile. The greater decline in long-term tax-exempt interest rates this year has resulted in an extremely flat yield curve configuration beyond 20 years. Currently, the 15-year maturity spot of the "AAA" municipal yield curve indicates a 1.79% yield, which captures 83% of the 30-year spot (2.15%). In our view, investors are not receiving adequate compensation for the risk of committing to new purchases much beyond 15 years.

As interest rates moved lower (prices higher), we have resisted the temptation to invest in bonds bearing coupons below 4%. As the price of 4% and 5% coupon bonds moved higher during the first half of the year’s interest rate free fall, many investors opted to purchase bonds bearing lower coupons (e.g., 2% and 3%) in order to avoid paying higher premium prices. SMC believes the additional income generated from bonds bearing higher coupon structures (4% to 5%) are best suited to meet investors’ income needs and will lead to better portfolio performance over the balance of the year.

Coupon income should be the primary contributor to fixed income returns over the balance of the year and less total return will be generated from price movement. We expect economic growth to remain subdued and do not expect inflation or wage growth to pressure the Federal Reserve to hike interest rates anytime soon. Demand for municipal securities from both domestic and foreign investors is likely to continue to be robust since municipal bond yields compare very favorably to global interest rates. For the balance of 2016, new municipal bond issuance is expected to be modest compared to prior years’ supply. Barring another Brexit-like shock to the global financial system we are anticipating a much quieter second half of the year.

In addition to impacting investment performance, a sustained low-interest rate environment can dramatically affect municipal issuers. Nearly a decade of low interest rates is beginning to exert an increasing negative impact on many general obligation (GO) credits. Lackluster investment earnings are preventing many state and local governments from achieving a suitable rate of return on their pension plan investments, which has led to increased underfunding of future pension payments to government retirees. Lower investment returns over the past several years mean municipalities have to make up the shortfall by contributing more money each year to meet required pension funding. The confluence of lower investment returns and a significant increase in the number or retiring baby boomers has become a major problem.

Historically, deficient pension plan investment returns were not always fully disclosed in financial statements. The implementation of Governmental Accounting Standards Board Statements 67/68 in 2013-2014, improving the way state and local governments report their pension liabilities and expenses, resulted in a more realistic representation of the full impact of these obligations. The end result has been a more transparent view of many severely underfunded pension plans.

A pension plan is fully funded when the value of its assets are equal to its obligations. When the funds are insufficient to meet the aggregate obligation the plan is considered underfunded. To achieve fully funded status, the plan sponsor will forecast investment returns and set annual contributions based on an assumed investment rate of return. Investment assumptions for public pensions typically range between 7% and 8% – a level that has been unachievable in the post-recession, low-rate environment. The national median for funded pensions is 71%, leaving an underfunded gap of almost 30%.

Many pension plans have reduced their assumed rate of return, but even lowering the target to 6.5% has not offset the shortfall. The largest public pension, California Public Employees Retirement System (CALPERS), just released investment performance results for fiscal year 2016. California’s pension plans still assume a 7.5% annual return but realized only 0.6% for 2016 following 2.4% for 2015. Shortfalls like this could require governments to make larger annual contributions.

States have varying approaches to dealing with their underfunded pension issues. Consider the direction taken by two neighboring states: Pennsylvania (rated "AA-" by Standard and Poor's) and New Jersey (rated "A" by Standard and Poor's). Both have reported lower funded ratios in their official offering statements for GO debt issuance in 2016. New Jersey’s aggregate funded pension ratio as of July 2015 was 48.6% and unfunded actuarial accrued liability (UAAL) was $43.8bn. The state had not made 100% of its actuarial recommended contributions (ARC) in over a decade. In 2015, it made an $892mm pension contribution that was only 23% of its $3.9bn ARC.

Pennsylvania’s funded ratio for its state pension plans stood at 61% at the end of 2014, with a UAAL of $50.5bn. While Pennsylvania had not made its ARC previously, the state implemented a plan in 2010 to increase the percentage of the ARC. For 2015, Pennsylvania made over 70% of its ARC and plans on achieving 100% of ARC in a few years. In contrast, New Jersey has deferred its annual payments, accessed courts to reduce the benefit calculations, and anticipates payment of 100% of ARC no earlier than 2023.

Investors should review issuer approaches to funding pensions and their relative funding status in determining credit quality. An issuer’s general obligation is defined as "full faith and credit" backed debt. This means an issuer is required to utilize all revenue raising means (raising taxes) at its disposal to pay debt. Pension funding, while not technically debt, remains a liability and unfunded pensions undoubtedly affect creditworthiness. All else being equal, the issuer’s history of pension contributions and the willingness and intent to make annual payments equal to ARC can improve its GO credit standing. In our view, the disparity between these two states’ respective credit ratings is in part due to the differing approaches to their pension issues.

How does SMC approach GO credit analysis? Besides looking at the issuer's pension liability, we also make an estimate of the ability to achieve an acceptable funded ratio over a period of time. Our research also considers factors such as other borrowings by the municipal government and willingness and ability on the part of the issuer to honor its financial commitments. We further review the issuer's reliance on "one-time fixes," responsible use of debt capacity, as well as other operational and liquidity measures. There are other factors specific to each issuer that must also be considered to arrive at a measure of overall credit strength and an internal SMC credit rating. A comprehensive view should be undertaken in order to assess potential investment opportunities in state and local government debt issuers.

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.

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