We’d like to share another municipal bond market update from one of our bond managers, Tom Dalpiaz. Enjoy and, as always, feel free to contact us with any questions!
Tom Dalpiaz, Managing Director, Granite Springs Asset Management (June 4, 2015)
The month of May was the second straight month of negative total returns for intermediate municipal bonds but I wouldn’t call in the paramedics yet. Even with back-to-back challenging months, total returns for intermediate municipal bonds remain in modestly positive territory for the year so far. The Barclays Municipal Bond Indexes in the five- to ten-year range have year-to-date total returns ranging from +0.31% to +0.33%. Of course, this is not a reason to throw a parade but it is not reason to run for the hills either.
The upward movement in municipal bond yields occurred in the first three weeks of May, with the remainder of the month seeing yields fall modestly from their highs. Municipal new-issue supply was off from April levels but much higher than a year ago. Demand for municipal bonds, as measured by net outflows from municipal bond funds, was relatively subdued. These municipal-specific supply/demand fundamentals help to explain the underperformance of municipals to Treasuries last month.
The usual suspects for municipal credit headlines – Chicago, Illinois, and Puerto Rico – had a busy month in May. Moody’s downgraded Chicago’s rating to below investment grade. The rating agency concluded that the city’s proposal to reduce pension benefits was conclusively denied by an Illinois court decision to uphold the state constitution’s guarantee of pension benefits. Though S&P and Fitch maintained their investment grade ratings of the city, spreads on Chicago paper widened significantly. Similarly, the intractability and messiness of Illinois state budget talks were also on full display last month. Negotiations and legislative efforts to devise a meaningful turnaround plan for the Puerto Rico Electric Authority also continue. For good measure, paper backed by annual appropriations from the state of New Jersey (my nominee as the fourth municipal credit problem suspect) also traded off, with spreads widening significantly.
The credit news on these four credit suspects will ebb and flow, and continued credit spread volatility is to be expected. Here are some big-picture thoughts to keep in mind. Chicago’s pension challenges are real, substantial in size, and not to be dismissed. However, even as we recognize that the city’s large pension payments are due next year, we should also realize that any entity’s (including Chicago’s) unfunded pension liability is not due in full at once. Rather, it is an obligation to be paid out over many years. While cities and states have time to formulate solutions, the measures they craft to rectify these problems will only become more draconian and difficult to implement should they forgo acting now.
That is why making steady progress in improving the funding ratio, and not necessarily bringing the ratio back to 100% in short order, is the key for these municipalities. All solutions to remedy Chicago’s budgetary woes will involve pain and the accompanying politics will be ugly each step of the way, but the city is not a dying carcass by a long stretch. It has a large, modestly growing population, a vibrant downtown, a diverse economy, commuters with above-average income levels in its metro area, and a host of tools to improve its financial health.
Regarding Illinois and New Jersey, they are states after all – large governing entities with diverse economies and broad powers and tools to solve their budgetary issues. Historically, annual appropriation credits from low-rated states have offered attractive value plays in the municipal bond market. Puerto Rico’s challenges are well-known and too numerous to summarize here. Whatever plans materialize to shore up the finances of the commonwealth and its bond-issuing authorities, true recovery will come when tax incentives and other solutions are implemented to revitalize the island’s economy and reverse population outflow. It is difficult to imagine any solution for the electric authority that will NOT include a renegotiation and restructuring of what is owed to creditors. Investors who hold insured Puerto Rico paper will count on insurers to step in and make any missed payments as they come due. The overall municipal bond market will root for any restructuring that is contained to the electric authority and does not spill over to the island’s other bond-issuing authorities.
Municipal bond yields have clearly risen in the past two months. Will this be the best entry point for all of 2015? It’s an interesting question but experience has taught me not to get tangled up in exact pronouncements. Markets will regularly confound you. I will say this: intermediate municipal bond yields are the highest they have been in the past 11 months and the demand for municipals should be strong over the next two or three months given the high volume of scheduled bond redemptions and maturities. Federal Reserve action and Treasury bond yields are of course wildcards. A Fed move in September to raise the Fed Funds rate could produce a spasm higher in rates, while Fed inaction in 2015 (the prediction of some market observers) could keep Treasuries range-bound. The seasonal increase in new-issuance volume, which municipal bond investors have come to expect each October and November, could also prompt higher municipal yields in September. Whether the present time is the best or second-best entry point for intermediate municipal bonds in 2015 will only be clear at year-end. Perhaps it is best to keep in a mind an old Italian proverb: “Don’t let the best be the enemy of the good.”
MUNIS BY THE NUMBERS
(Sources: Bloomberg, Barclays Capital)
When does 2.80% = 4.95%? When you are an individual investor subject to the top Federal income tax brackets and you capture a 2.80% yield from tax-exempt municipal bonds.
The 2.80% yield stated above is our conservative estimate for an average yield-to-maturity for a municipal bond portfolio constructed under present market conditions with the following parameters: all investment grade credits, average credit rating A1/A+, all bonds mature within 15 years, average maturity 6 to 7 years, portfolio duration range 3.7 to 4.7 years.
10-year High Grade Muni bond yields as a percentage of 10-year Treasury bond yields: 106% (compared to an average ratio of 98% for the past ten years).
-0.21% March total return of the Barclays 3-Year Municipal Bond Index (+0.16% YTD, +1.51% for all of 2014)
-0.34% March total return of the Barclays 5-Year Municipal Bond Index (+0.31% YTD, +3.19% for all of 2014)
-0.55% March total return of the Barclays 7-Year Municipal Bond Index (+0.30% YTD, +6.09% for all of 2014)
-0.32% March total return of the Barclays 10-Year Municipal Bond Index (+0.33% YTD, +8.72% for all of 2014)
-0.33% March total return of the Barclays Long Municipal Bond Index (+0.29% YTD, +15.39% for all of 2014)
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The opinions expressed are those of the Granite Springs Asset Management LLC Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. This material is for educational purposes only. Granite Springs Asset Management LLC is an investment adviser registered with the US Securities and Exchange. Registration does not imply a certain level of skill or training. More information about Granite Springs Asset Management LLC can be found in its Form ADV which is available upon request.