As we enter 2014, we are faced with mixed developments affecting municipal bond issuers. Our firm-wide thesis is that the present slow, uneven recovery will continue, creating both challenges and opportunities for municipal bond investors. As a top-down manager, we have identified the following broad-based macro themes that will likely impact municipal issuers in the year to come.
Household net worth on a nominal basis is higher than in 2007, but it is lower on a real basis. Consumer deleveraging looks to have subsided as households have started to take on more debt.
1. Bonds backed by dedicated taxes (e.g., sales and income taxes) will likely benefit as incomes and discretionary spending increase.
2. Improving home values have stabilized property tax revenues to local governments in well-entrenched areas. We recommend local general-obligation bonds with greater than $30 million in revenues, as idiosyncratic risk is greatly reduced once this threshold is crossed.
With roughly 6 million fewer people currently employed than in 2006 and low levels of business investment and capital expenditures, real GDP growth will likely remain sub-3%.
1. Essential service bonds backed by water and sewer revenues have proven to be resilient investments and have held up well throughout the cycle.
2. Debt issued by public higher-educational institutions with low reliance on state appropriations have performed well due to higher enrollments as demand has increased for relatively lower-cost public schools.
We are unsure of the extent to which federal budget cuts due to sequestration will manifest themselves in lower transfer payments to local governments. Transfers to state governments are meaningful, as roughly 40% of state revenues come from the federal government (Moody’s Investors Service). CBO projects the budget deficit will increase to 3.5% of GDP by 2023 after declining to 2.1% next year. We expect further cuts and some impact to be felt at the local level.
1. The sector least exposed to the federal government is the infrastructure sector (source: Moody’s). Issuers with monopolistic enterprises usually have adequate margin to increase fees, due to inelastic demand for their services. We recommend issuers who can raise fees without government intervention. These include airports, toll roads, and ports.
2. Several issuers have recently raised fees without reductions in user volumes. We view this as enhancing bondholder security. In December, the Port Authority of New York and New Jersey reported higher tolls on its bridges and tunnels without reduced usage. Going forward, we do not expect sequestration to directly impact Port Authority’s ability to raise tolls.
Municipal buyers are fortunate in that the tax-exempt landscape is diverse and variegated. Bonds backed by sales taxes, tolls, water and sewer revenues, and tuition revenues all fall under the umbrella of “municipal bonds” yet bare little direct relationship to each other on a sector-wide level. This greatly enhances the diversification potential of municipal bond portfolios throughout the economic cycle. As we start the new year, we continue to look for these attractive opportunities for our clients.
Happy New Year.
Michael Comes, CFA, Portfolio Manager & Vice President Research