February 23, 2016
What is the outlook for munis in 2016?
We think 2016 could look a lot like the second half of 2015 from a technical standpoint. That’s an important distinction because 2015 was, in many ways, a tale of two markets. The first half saw heavy supply as issuers took advantage of the unexpected drop in rates to refinance earlier than they might have otherwise. In the second half of the year, supply was basically flat relative to the five-year average.
The market also notched the majority of its performance in the second half. At mid-year, the Barclays Municipal Bond Index was up a meager 0.12%. By year-end, it had returned 3.3%. This compared to returns of less than 1% for long-term Treasuries and -0.7% for corporate bonds.
Supply/demand was a big driver of the turnaround, as was the macro backdrop. As the Fed signaled liftoff, stocks and other risk assets retreated while investors flocked to high-quality fixed income. Munis, given their less volatile nature, outperformed Treasuries. The appeal of tax exemption also drew the interest of a large and diverse investor base.
For 2016, we’re forecasting supply to be down approximately 3% relative to 2015 and demand steady. That’s a good technical backdrop that should continue to support pricing.
Overall, we see carry (the payment of income) as a key theme for fixed income investors in 2016. With that as our thesis, if you have a theoretical yield of 2.90% on a 30-year municipal bond, that’s 5.11% on a tax-equivalent basis. In a world where we’re fighting to achieve 2% inflation and rates on Treasuries remain low, a yield above 5% is pretty attractive.
How will Federal Reserve interest rate hikes impact the municipal bond market?
That’s the question on everyone’s mind. The Fed has promised to be data dependent with the path of rate hikes, and that means it’s likely to have more impact on the front end of the yield curve than the back end. Historically speaking, munis tend to do well in this environment.
In fact, history tells us that the trends in place for the 12 weeks preceding a rate hike tend to prevail for 12 weeks post-hike. (See chart above.) The curve was flattening leading up to liftoff, and it continues to flatten. Credit spreads were tightening ahead of the Fed, and they continue to do so.
That’s not to say there won’t be uncertainty and volatility. In fact, as in 2015, the Fed is going to distort and inject volatility into the market, if only because we don’t know how many hikes are to come. The central bankers have specifically noted a “gradual” tightening, not a “measured” and predictable program of 25-basis-point hikes like we’ve seen in the recent past.
All of that said, we don’t think it matters much whether it’s two rate hikes in 2016 or four. You still have a fed funds rate in the area of 1% or slightly higher. That’s not restrictive monetary policy, and certainly not enough to push long-term rates higher. So, the Fed may matter, but mostly to the front end of the curve.
Why is the long end less vulnerable to rate hikes?
Typically, the aim of a rate-hiking cycle is to tighten accommodation. And that generally comes with a sense of increased inflation. This time, people aren’t afraid of inflation. In fact, inflation measures were falling on Dec. 16 precisely as the Fed was announcing interest-rate liftoff. While short-maturity bonds will naturally react to changes in the federal funds rate, longer maturities will trade on inflation expectations, which are hovering below 2%. In fact, the Fed doesn’t see inflation hitting its 2% target until 2018.
In addition, the current backdrop of lower commodity and oil prices, along with a stronger dollar, represents a major disinflationary force. There is also question around the strength of the global economy and the impact that might have on the U.S. All of this may temper Fed action. You also have an aging population, which means more retirees propping up the demand for high-quality fixed income assets, and that should further assist in anchoring the price for longer-term bonds.
Returning to technicals, what underscores your positive outlook for supply/demand?
We expect supply to be similar to or lower than in 2015. The election may play into that to some extent. In election years, as hopefuls seek office and administrations sit in flux, you generally don’t have a lot of issuers adding debt, and that may help to keep supply muted.
Meanwhile, we expect demand will be driven by an acceptance that rates aren’t going to go up appreciably. Waiting on the Fed had some dire implications for rates, but once investors grew comfortable that rates weren’t going through the roof, demand picked up. And as noted earlier, demographics point to a greater need for income, and that should also support demand for high-quality income vehicles such as munis.
One additional anecdote: Munis were the best-performing fixed income asset class in 2015. That bodes well for demand, because muni demand tends to follow performance. Our analysis finds that every 1% return draws about $3 billion of flows into municipal mutual funds. In 2015, we saw $5 billion in inflows for every 1% of performance. Those are good, steady inflows. This positive demand dynamic is a tailwind for municipal performance going forward.
So technicals look good. How are fundamentals in the municipal market?
Creditworthiness among most issuers of municipal debt continues to improve. State revenues continue to do well as the economy progresses, albeit slowly. Housing stabilization has helped local issuers by boosting property tax collections. Balance sheets are better: Issuers have deleveraged, added jobs, avoided debt. Chapter 9 cases, at four in 2015, are down 60% year over year and defaults are down 57%. So fundamentals for the market broadly are pretty strong.
The big differentiator continues to be pensions. Unfunded pension liabilities are weighing on long-term fiscal stability in certain locales. Increasingly, we’re seeing the rating agencies factor this into their calculations and that’s leading to more ratings volatility. Last year, Moody’s took Chicago down multiple notches to below investment grade. We may not see more drops of that magnitude, but we may well see more ratings volatility.
Pension reform, meanwhile, has been slow. Illinois, the most pension-indebted state, made attempts at reform without success. We still think reform is what’s needed to alleviate the long-term problem. For those states with large unfunded liabilities, the options are either to raise taxes significantly to pay for the future obligations or initiate some kind of reform to reduce them.
What is the outlook for Puerto Rico, the major headline maker of 2015?
Puerto Rico has a long way to go. It already missed a portion of its debt payments that were due Jan. 1. The good news is that the broader market realizes Puerto Rico is an isolated, special situation.
What’s really interesting and informative, we think, is that the market proved its resilience this past year. Even though the Barclays Puerto Rico Index was down 12%, nothing else followed suit. Whereas the market at one time worried about a systemic risk related to that single credit, we’ve now seen Puerto Rico is an island of its own. It’s a debt problem different from any other and, as such, market participants have been wise not to draw conclusions about the broader market based on Puerto Rico. The fact that a credit can lose 12% and investors look the other way and understand that issue, speaks volumes about the tenacity of the municipal marketplace. In fact, looking at returns by sector, the next biggest “loser” had a positive return of 1%.
Our overarching view on Puerto Rico has not changed. We continue to believe debt restructuring and economic reform are the long-term solutions to long-running problems.
How has the high yield sector been affected by Puerto Rico?
Puerto Rico represents roughly 24% of the high yield municipal market. While it’s been a drag on high yield performance, the sector has done quite well outside of that.
Tobacco, which makes up 19% of the high yield index, was actually the top-performing sector of the year, returning nearly 16%. High yield overall had a return of 1.8%. If you invested in high yield ex Puerto Rico, you would have done quite well in 2015.
We continue to believe an allocation to high yield makes good sense; it offers a great deal of positive income carry. But how you own high yield is important as well. We believe it’s prudent to own it in a well-diversified vehicle, such as a high yield municipal bond mutual fund.
How do muni and corporate high yield compare? Did energy exposure weigh on munis?
The high yield muni market is generally uncorrelated to the taxable high yield market and didn’t experience any of the volatility that the corporate market did due to energy exposure in 2015. In fact, less than 2% of the Barclays Municipal High Yield Index is exposed to energy.
In the corporate credit market, the implied default rate is creeping up rather quickly. Investors are trying to identify and avoid names and funds that are going to suffer losses as default rates move higher. We don’t have that in the muni market; default rates have fallen. Plus, we have a great supply/demand dynamic: There’s just not enough high yield municipal debt being produced to meet the demand. In addition, the fact that the market has recently rejected certain junk-rated new issues tells us we’re later in the cycle than the corporate market. During mid-cycle, investors are still diving on names they know are probably too risky.
It’s also worth noting that corporate high yield has equity-like characteristics, including greater volatility. The high yield muni market is very different. As shown in the chart below, the VIX index (a measure of equity market volatility) and the corporate bond spread largely move in tandem. The VIX tends to direct spreads in the corporate market; not so in the muni market.
Will the election reignite talk of muni-related tax reform?
The rhetoric may pick up after primary season, once the candidates are set, but any type of tax reform is unlikely to be undertaken before 2017. House Speaker Paul Ryan has been engaging conservative Republicans in discussions around tax reform, but we know from experience that individual tax reform is very complex and challenging. It would be difficult to target and carve out munis for change. So we don’t see much happening beyond talk, but we acknowledge that talk alone can stoke market volatility. One final observation: If you look at broad tax reforms that have taken place in the last 50 years, they generally start from the executive branch, not at the congressional level.
Why should investors own munis in 2016?
It’s hard to see why you wouldn’t have munis in your portfolio. Munis are a high-quality, relatively low-volatility source of income with an attractive taxable equivalent yield, particularly for longer maturities. We believe the asset class deserves a place in every investor portfolio, especially those in high tax brackets seeking to keep more of what they earn. And with real ratios above 100%, you’re achieving more income with a lower level of volatility than might be expected in the corporate or Treasury market today.
How should they position their allocations?
We think yield curve positioning will be important again this year. We’re no longer worried about when the Fed goes, but the market will try to price in exactly where the Fed goes. We expect the front end of the curve to bear the brunt of this, while the intermediate to long end remains relatively anchored amid muted inflation.
Against this backdrop, investors should pursue income via exposure to both the longer end of the yield curve and to credit, where improving fundamentals bode well. We believe it makes sense to own some high yield, but advocate for diversified exposure to the sector through a professionally managed vehicle.
A somewhat new nuance to consider: In the past, investors hunkered down in general obligation (GO) bonds, generally seen as the having the highest priority of payment. But given the large pension liabilities in some states, and Chapter 9-related decisions witnessed in Detroit, for example, we think the best value may be found in revenue bonds, which comprise the largest part of the market.
Any other advice for investors?
As in recent years past, we’d urge investors to approach the market with proper perspective. Focus on income and the tax benefit that is unique to the municipal asset class.
Total return should be seen as a fringe benefit, and one that investors have been fortunate to enjoy in recent years.
With interest rates likely to remain low for longer, it makes sense to have some allocation to high yield, but balanced with higher-quality investment-grade bonds for liquidity and trading flexibility. We would avoid the extremes: Don’t take on more risk than you can stomach, either by extending too far out on the curve and/or by taking excessive credit risk. At the same time, don’t get too defensive. There’s no upside potential in exiting the market to hold cash. It typically is best to stay the course during periods of market dislocations based on your long-term goals and investment outlook. Volatility is a normal occurrence for all asset classes and often creates longer-term opportunities.
Finally, know what you own. Credit research is a must and is at the core of our process here at BlackRock. In addition to referencing the agencies’ ratings, we assign an internal rating to every credit and issuer before considering it for inclusion in our portfolios. Ultimately, avoiding the wrong credits is as important as owning the right ones.
Peter Hayes is BlackRock’s managing director and head of the Municipal Bonds Group, and Sean Carney is BlackRock’s director and head of municipal strategy.
Huge thank you and congratulations to our ABLE Committee Chairs @MOTreasurer @Eric_Schmitt and @ILTreasurer Mike Frerichs for their great job..