As the third quarter comes to an end, we observe municipal bonds, the Federal Reserve (Fed), and interest rates in the spirit of Yankees Hall of Fame catcher Yogi Berra.
When you come to a fork in the road, take it.
In our opinion, the Fed blinked when they came to the fork in the road and did not embark on raising short-term interest rates. There are challenges in the financial markets, but after seven years the need for a liftoff is with us. Headline consumer prices are very low because of the oil-price drag. CORE CPI on a year-over-year basis has trended between 1.5% and 1.8% for the past two years, with a slight upward trend in the past few months. Unemployment has trended downward, as we see in the headline unemployment figure, now at 5.1%. The broader measure of unemployment (U-6, which captures part-time workers, people looking for better jobs, and those who have quit looking for work) has also trended downward. We feel small hikes in the federal funds rate will ultimately begin to get a larger supply of loanable funds into the market and will add to the health of smaller and medium-sized community banks.
Nobody goes there anymore, it’s too crowded.
The muni new-issue market was very crowded in the first half of 2015. There was a record issuance of nearly $220 billion – ¾ of which refinanced older, higher-coupon bonds. The ratio of long-maturity tax-free yields to US Treasury yields has been very compelling this year. Yield ratios for issues rated AAA have been over 100%. Many AA-rated revenue bonds have offered 4% yields, which has been a yield ratio to Treasuries of over 130%. If taxable interest rates increase down the road (although they have started to decrease recently), a defensive yield cushion is presented that should buffer performance. As we have discussed in previous posts, the largest refunding supply bulge is behind us. We feel that this ratio will continue to fall as second-half supply falls. To wit, the yield ratio for the highest munis has fallen from 113% in late January 2015 (as Treasury yields plummeted with oil prices) to 106% today. Furthermore, if the past interest-rate cycle of Fed hikes (2004-2006) is any indication, muni/Treasury yield ratios should also fall with the rise in interest rates. Since muni yields have a tax exemption benefit, it is necessary for them to increase by only 65 to 70% of the necessary increase in taxable yields. On the other hand, many people have crowded into the front part of the yield curve where ratios to Treasuries are much lower and therefore more vulnerable to a correction during a monetary tightening cycle.
We have seen other investors add to their municipal holdings this year. This includes foreign investors, property and casualty companies (who have become more profitable, therefore adding to their need for tax-exempt bonds), and individuals. These groups helped make up for the lower amount of holdings by bond funds.
There are some people who, if they don’t already know, you can’t tell them.
This succinctly sums up the race for the presidency. Different candidates have different proposals that could affect municipal bonds. It is too early to get focused on any one issue, but it is important to note different stances.
Candidate Hillary Clinton’s proposal to reduce student debt represents funding by the curbing of expenditures, one of which is is capping the exclusion for muni interest at 28%. This would increase the cost of borrowing for state and local governments, as investors in the top tax bracket would need to be compensated by additional yield to offset the value of the lower tax exemption. On the other hand, Governor Jeb Bush has a proposal that would reduce the top federal tax bracket to 28% and limit deductions and exclusions for the highest income earners. This proposal would also limit the value of the tax exemption from its current levels. Reducing this exemption from 35% to 28% could mean a rise in yields from 20 to 50 basis points, depending on quality and placement on yield curves. Longer tax-free bonds are trading at relatively cheap levels and should be shielded from any damage.
Bernie Sanders and John Kasich both support programs to rebuild the nation’s infrastructure. They focus on water infrastructure and transportation projects.
You can observe a lot by watching.
One thing we have learned is that Congress does very little. Over the years, we have seen various congressional measures to install a flat tax, limit tax exemption, and put into place other roadblocks. In the end, the safest bet is that Congress hardly moves and there is more of the same. It is government by inertia.
It ain't over till it's over.
The poster children for distressed government this summer have been Puerto Rico and Chicago. The Puerto Rico Electric Power Authority (PREPA) reached agreement with some large bond holders (read, hedge funds) re a haircut on the principal and an exchange to a bond with a lower interest rate. Both uninsured as well as insured Puerto Rico bonds have traded higher by 4-6 points since this announcement, as the market has taken the agreement as evidence that a solution that stops short of default can be reached.
Chicago legislative leaders are very aware of the pension issues that are buffeting the city’s finances. In the past week they have now proposed a significant hike in city property taxes to make a dent in the pension shortfall. More to come.
Its déjà vu all over again.
We have already been down the path of very cheap muni bond yields, especially on the longer end. Over the years, the cheapness has come from different sources and in varying degrees. In late 2010 it was the bond fund selloff when investors were scared by bank analyst Meredith Whitney’s warnings of impending municipal bankruptcies. In 2013 Federal Reserve Chairman Ben Bernanke’s comments that the Fed might start to taper its quantitative easing program earlier than expected triggered a “taper tantrum” and rampant bond fund selling. This was in spite of the fact that inflation was falling and real GDP growth was slowing. And this year, while we didn’t see nearly the selloff of the other two episodes, there was a huge amount of supply as issuers called in older, higher-coupon bonds and replaced them with new issuance.
Overall, we expect municipal bond finances to continue to improve. Refinancings help that. We also expect that the current cheapness in the muni market will not be there by the end of 2016. In a world of slowly rising short-term interest rates, taxable interest rates in the intermediate and longer end of the yield curve are likely to rise modestly. Longer-term tax-free yields will likely move sideways, or perhaps drop.
Finally, a personal note on Yogi. I was privileged to play golf a few times in Yogi Berra’s Golf Tournament for Disabled Boy Scouts. Several of the golfers took pictures with Yogi and the late William “Moose” Skowron (the great Yankees first baseman from the late 1950s). As we stood on the course with Yogi standing between Moose Skowron and me, Yogi, right on cue, quipped, “I’ve always wanted my picture taken between two mooses.”
R.I.P. Yogi.
John Mousseau, CFA, Executive Vice President & Director of Fixed Income.