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Tax reform and technicals support the municipal market
Municipal bonds underperformed U.S. Treasuries during the first quarter, but we believe this dynamic will prove temporary. The effects of the 2017 Tax Cuts and Jobs Act will take time to influence the general economy. However, the legislation triggered a sharp jump in municipal supply in late 2017 while demand remained constant. As this excess supply works itself out, we believe the cheaper valuations and growing scarcity value of tax-exempt bonds bodes well for strong performance going forward.
Economic growth falls short of heightened expectations
The markets entered 2018 expecting real gross domestic product (GDP) growth of at least 3% for the year. The first quarter seems to have fallen short of these arguably overblown expectations, with annualized growth expected to be approximately 2%.
Most factors supporting economic growth remain in place, and any recession risks seem remote. The effects of tax reform should gradually filter through the economy later in 2018. The tax cuts are significantly skewed to corporations, and corporate hiring and investment are not immediate. Meanwhile, global growth continues to improve in Europe, Japan and through Asia.
The economy faces headwinds, including rising interest rates and a flattening yield curve. We expect both of these trends to continue. U.S. government, corporate and consumer debt is already high, at a record 250% of GDP. Servicing this debt at higher interest rates could slow economic growth. We have not yet seen the pending impact of higher rates on high debt balances.
The economy is operating at close to full capacity based on some measures. The unemployment rate has remained at 4.1% for six consecutive months. Net new jobs added have averaged approximately 200,000 per month, and the labor force participation rate has ticked slightly higher. Further acceleration must now come from labor force growth or increased productivity.
For financial markets generally, it has been positive to see businesses tapping into the underemployed and individuals who had dropped out of the labor force. This additional supply of workers has helped keep average hourly earnings moderate, at a 2.7% annual rate of growth. This, in turn, helps contain rising inflation pressures.
Inflation is not rising rapidly
While core indicators show inflation is slightly rising, it is unclear whether prices are accelerating in a meaningful way or if the Federal Reserve tightening is behind the curve. Core CPI (excluding food and energy) increased by 1.8% over the trailing 12 months. During the fourth quarter of 2017, this reading was slightly lower at 1.7%. Similarly, the most recent core PCE deflator reading for the trailing 12 months was 1.6%, somewhat higher than the fourth quarter 2017 reading of 1.5%.
Inflation pressures are worth watching, as both fixed income and equity markets are highly sensitive to any perceived or actual changes. The Fed is not behind in its tightening as long as the economy is not overheating and more underemployed people or discouraged workers are participating in the labor force. If this trend continues, it would support a gradual pace of rate increases.
The current expansion is about to become the second longest on record.
The Fed raises rates as expected
The Federal Reserve (Fed) raised the fed funds rate at the March meeting by 25 basis points, as expected, with a modest upward revision to plans for future hikes. This was the sixth increase since the post-recession tightening cycle began, bringing the current fed funds target to between 1.50% and 1.75%. The Fed foresees two additional rate hikes this year and it slightly increased expectations for hikes in 2019 and 2020, making the overall path steeper with a higher peak.
The marketplace is understandably skeptical that this path will be as smooth and prolonged as the official forecast shows. While an overheating economy could quicken the pace of rate increases, how much further can rates rise before they have the intended impact of slowing the expansion? The current expansion is about to become the second longest on record. Issues like expanding deficits or trade wars have the potential to knock the economy off track, but these risks currently appear manageable.
The global economy is strengthening
U.S. economic growth has been consistent and resilient in part due to the synchronized global recovery. The International Monetary Fund (IMF) recently upgraded its forecast for global economic growth to 3.9% for 2018 and 2019. This represents a 0.2% increase from the 3.7% growth rate in 2017. “Notable upside surprises” in both Europe and Asia drove the revised forecast.
The risks to the global economy are similar to those in the United States, including a potential increase in core inflation and geopolitical issues. These similar performance drivers and downside risks highlight the correlations between U.S. and foreign markets.
U.S. Treasuries maintain a significant yield premium over foreign developed country bonds such as Germany (0.59% 10-year yield) and Japan (0.05% 10-year yield). This yield premium would be necessary to create markets for larger Treasury issuances over time as the U.S. deficit expands. Treasury rates may be pushed higher if monetary policy in Japan or in the eurozone shifts materially or unexpectedly tightens.
Municipals underperform treasuries
Municipal bond yields rose more than U.S. Treasury yields during the first quarter. The 10-year AAA municipal yield rose from 1.98% to 2.50%, while the 10-year Treasury yield increased from 2.41% to 2.88%. The 10-year municipal-to-Treasury ratio increased from 82% to 87%. The 82% ratio is higher than long-term 10-year historical average. Similarly, the 30-year AAA municipal yield increased from 2.54% to 3.07%, while the 30-year Treasury yield rose from 2.74% to 3.11%. Ratios also increased at the long end of the yield curve, from 93% to 99%.
We believe this dynamic will prove temporary, with municipals well positioned once again outperform in 2018. As tax reform legislation was finalized in December 2017, a great deal of uncertainty arose around the potential new rules for tax-exempt municipal bond issuance in 2018 and beyond. Specifically, private activity bonds (PABs) were under intense scrutiny by Congress, as well as advance refunding bonds.
Issuers wanting to remove that uncertainty accelerated issuances into December 2017, for a record total one-month supply of $65 billion par. It has taken the entire first quarter of 2018 to fully distribute these bonds, making for heavy secondary market supply despite light primary market issuance.
First quarter longer-term Treasury yields were driven higher by continued robust employment reports, accelerating global growth, tax cuts and a new budget deal. The U.S. federal government has cut taxes but has not curtailed spending. This should put upward pressure on the deficit. As the rest of the world economy grows, key central banks such as the Bank of Japan (BOJ) and European Central Bank (ECB) are tapering their QE programs.
The yield curve is flattening. Rising short rates can slow the economy and inflation. Longer bonds generally respond less to Fed policy and more to changes in long-run inflation expectations. As such, long-term interest rates tend to decline if there is fear of a recession, inverting the shape of the yield curve. The yield curve continues to slope upward, but additional flattening could be forecasting a slowdown.
The absolute AAA municipal yield increases would be expected given the movement in Treasury rates. However, the relative cheapening of municipals even in comparison to Treasuries is both surprising and likely temporary.
Favorable technicals provide opportunity
The new tax reform law prohibits the use of tax-exempt bonds for advance refundings. As a result, refunding volume dropped 68% in the first quarter. New money raised for new projects increased at a 5% rate, in line with recent historical trends. This drove a 32% decrease in new issue supply.
Annualizing first quarter supply indicates 2018 new issuance would fall well below $300 billion, after averaging $440 billion in the last two years. Given the bonds that are maturing and being called this year, this would translate into approximately -$120 billion in net new issue supply. Importantly for U.S. infrastructure goals, new projects are still being funded even as the total amount of municipal bonds outstanding is scheduled to decline.
Net flows have been fairly steady in 2018, with nearly all weeks showing inflows.
Individual investors added a net $10.7 billion of municipal bond funds in the first quarter. Net flows have been fairly steady so far in 2018, with nearly all weeks showing inflows. It is unusual for ratios to rise while supply declines and inflows are positive. This ratio increase has been due to short-lived factors such as heavy dealer inventories after record supply in December 2017.
As this temporary situation works itself out, we believe the cheaper valuations and growing scarcity value of tax-exempt bonds bodes well for municipal bond outperformance going forward.
Credit spreads have been narrowing as investors seek income while the strong broader economy pushes default rates lower, increases governmental revenues and improves investor comfort with credit exposure.
The cushion of higher income and narrowing credit spreads helped offset the small total return losses from higher interest rates during the quarter. The average spread between AAA and high yield municipals started the year at +272 basis points and fell to end the quarter at +243 basis points. We expect this trend to continue, as the factors driving the narrowing remain. Nevertheless, we anticipate that current trends will compress credit spreads below the long-term average of +254 basis points.
Credit conditions are benefiting from economic expansion
State and local governments
Credit conditions in the state and local government sectors continue to benefit from the improving economy. State personal income tax collections rose 14.4% in the fourth quarter of 2017, and income tax collections were up 5.8% for the year as a whole. Corporate income tax collections were up 8.8% in the fourth quarter 2017, bringing them to flat for the calendar year. Sales tax collections were up 6.4% in the fourth quarter 2017 and 2.4% for the calendar year. Local property taxes were up 9.2% the fourth quarter 2017 and 6.2% for the year. In combination, all state and local government revenues increased by 4.7% in 2017, one of the best performances in recent years.
The market has become less sensitive to the drama unfolding in Puerto Rico’s Title III process. Outside of Puerto Rico, defaults have remained low and upgrades exceeded downgrades. Moody’s upgraded 774 issues in 2017, while downgrading only 461. Defaults for 2017 were below $1 billion in par value, and Puerto Rico has accounted for approximately 95% of defaults for the last two years.
Pension funding will likely remain an ongoing concern in selected areas. In the near term, lack of progress or backsliding in pension funding may result in downgrades, but would not likely be the catalyst for significant defaults. Given the above conditions, credit spreads are logically narrowing. We expect these trends to continue this year, which would argue for further spread narrowing.
Puerto Rico bond prices rallied in the first quarter, though the price improvement has not necessarily been supported by improving credit fundamentals or any emerging clarity regarding how creditors will be treated in territory’s ongoing debt restructuring process. The benchmark GO credit (the 8%s of 2035) improved from a low of $21 in mid-December 2017 to $42 as of 23 Apr 2018. Price movement suggests some bondholders may be encouraged by recent iterations of the fiscal plan that show a near-term operating surplus, in comparison to the stark deficits projected last year.
In mid-April, Puerto Rico’s Financial Oversight and Management Board (FOMB) certified new fiscal plans for the commonwealth and other entities currently working through a Title III restructuring. The revised fiscal plan, which covers fiscal years 2018 through 2023, incorporates the impact of approximately $62 million in disaster relief funding and numerous reforms, projects the commonwealth will generate a $6.7 billion operating surplus over the plan period. Importantly, the $6.7 billion estimate assumes full implementation of a series of labor, pension, business, tax and governmental reforms aimed at driving economic growth.
The estimate falls far short of meeting the nearly $16 billion in debt service due between now and FY 2023, but is the largest operating surplus estimated since the commencement of the Title III cases. Labor reforms and pensions cuts called for in the plan are strongly opposed by the Puerto Rican government, making plan implementation very difficult. Additionally, even if implemented, the projected surplus is unlikely to be directed to debt service in the near term given the status of ongoing creditor negotiations and anticipated court appeals.
The plan’s debt sustainability analysis does not offer a concrete estimate on how much Puerto Rico can afford to allocate to debt service, but does provide some insight into how the board might approach debt restructuring. Specifically, once Puerto Rico’s debt capacity is determined, aggregate debt service could be capped at a maximum level. The plan indicates the maximum debt service cap will be structured to include a margin to support new debt and new capital projects, rather than just legacy restructured debt. Cash flows generated over cap, could then be dedicated to a number of debt costs including, a contingent “growth bond” or hope note for legacy bondholders.
It is still not yet clear if the Title III court will issue a ruling on the relative legal priority of general obligation (GO) and COFINA sales tax bonds. A ruling could have a material impact on how creditors are eventually treated in the Plan of Adjustment eventually submitted to the court, which will propose specific treatment for unsecured and secured creditors. Creditor negotiations and the Title III court process are ongoing. Both are expected to be lengthy and all initial court rulings are likely to be appealed.
The credit picture for the state of California continues to strengthen, benefiting from a strong, expanding economy and governance improvement that has allowed the state to achieve structural balance. The fiscal improvement has allowed the state to repay budgetary debt and deferrals used to balance the budget during the Great Recession; rebuild rainy day reserves; and begin to address its pension and retiree obligations.
Growth in high technology has led the economic expansion. California’s real GDP experienced a 3.3% increase in 2016 to $2.6 trillion, making the state of California’s economy the sixth largest in the world and 14% of the nation’s GDP. Employment has grown every year since 2010 at a rate faster than the nation as a whole, resulting in unemployment improving from 12.2% in December 2010 to 4.5% as of December 2017 (lowest level since 1976) yet still remains higher than the nation’s 4.1% during the same period.
A challenge to state’s full employment position includes escalating labor costs to attract and retain employees that could also restrain in-migration and reinvestment. This growth combined with strong stock market performance has fueled the state’s fiscal recovery, since personal income taxes account for approximately 67% of the state’s general fund (its primary operating fund) for FY ended 30 Jun 2017. This has resulted in a $5.4 billion net surplus.
Since 2016, as a required by Proposition 2, the state has deposited excess revenues into its budget stabilization fund (the state’s rainy day fund) and repaid state budgetary debt and liabilities. As a result, the state’s rainy day fund has grown from unfunded from FY 2009 to FY 2014 to $6.7 billion as of FYE 2017.
California’s unfunded pension and retiree health liabilities are large. The state has enacted various pension reform measures to reduce these liabilities such as reducing the assumed rate of return and the amortization period from 30 years to 20 years. While reducing the discount rate and amortization period is a long-term positive, in the short term it can add financial strain to the state and local governments.
Growth in high technology has led California’s economic expansion.
The 2018-19 governor’s budget totaled $131.7 billion. This equates to 4.1% higher than the revised estimate for FY 2018 and 37% higher than FY 2013’s budget. The proposal includes a $5.1 billion transfer to the rainy day fund of which $3.5 billion is an additional optional transfer to reach its maximum constitutional goal of $13.5 billion (or 10% of general fund tax revenues) by FY 2019. The budget proposal projects budgets to be balanced through FY 2022 and growing the rainy day fund to $14.7 billion by then.
However, the governor’s budget was finalized prior to the enactment of the federal tax reform legislation. The May revision to the budget is expected in the next month and will include a preliminary analysis of the projected effects of recent federal tax reform on the state’s general fund.
The state of Connecticut is currently on track to post a $198.5 million deficit for FY 2018, according to the State Comptroller. Part of the deficit is explained by the diversion of higher-than-expected capital gains tax revenue in December into the state’s rainy day fund. Under the newly enacted revenue volatility cap, capital gains taxes above a certain threshold must be deposited into the rainy day fund. As a result of this diversion, the rainy day fund increased from $212 million to $890 million.
If that December surge was tied to avoiding provisions of the new federal tax laws, tax collections may be lower in April than expected, further aggravating the deficit. However, the State will have the extra cash in the rainy day fund to offset the deficit at year end.
As part of the FY 2018-19 budget negotiations, Connecticut enacted various financial reforms, which if adhered to, will likely put the State on firmer financial footing. Among these are a constitutional cap on annual spending increases, automatically diverting money to the rainy day fund if capital gains tax revenues come in ahead of plan, and limiting annual appropriations to 98% of estimated revenues.
In order to further cement these reforms into place, these provisions are currently on track to be written into the GO bond indenture for issues that come between 15 May 2018 and 1 Jul 2020. This is being referred to as the “bond lock” because it would contractually tie the legislature’s hands (similar to what the state did on its pension payments). The bond lock would be in place for the life of the bonds or 1 Jul 2028, whichever is earlier.
In March, the state of Connecticut announced it had agreed to assume payment of Hartford’s GO debt as a way to assist that city. Under this plan, the state would pay the debt off over time, rather than all at once. Hartford had $600 million of GO debt as of 30 Jun 2017. Assuming that debt increases the state’s debt ($23.6 billion) by approximately 2.5%. This agreement has generated some controversy in the state legislature, with some legislators vowing to repeal it.
First Energy Solutions
First Energy Solutions recently filed for bankruptcy protection, a move that was not a surprise to most bond holders. FirstEnergy Solutions (FES) is the FirstEnergy (FE) subsidiary that owns all of the unregulated power plants within the FirstEnergy (FE) corporate structure. FirstEnergy specializes in coal, nuclear and natural gas energy production. It is the main energy producer in the state of Ohio and a major energy provider in Pennsylvania.
Because of the challenging market environment for nuclear and coal power in the face of rising availability of inexpensive natural gas, FirstEnergy (FE) announced in late 2016 that it would begin a strategic review of its generation assets (primarily coal and nuclear) and would potentially seek to move away from coal and nuclear energy generating in the absence of some form of regulatory relief.
FES is a unique corporate issuer in that the majority of its debt (about 75% or $2.2 billion) was issued in the municipal market to finance pollution control and waste disposal for its coal and nuclear plants.
All Aboard Florida
All Aboard Florida introduced Brightline, an express train that serves Florida’s east coast, connecting Fort Lauderdale, West Palm Beach and Miami. It is the nation’s only high speed rail service that is entirely financed by private investment. Operations began in January, so it is too soon to tell if it will meet objectives. This area of Florida was only accessible by a heavily traveled I95 highway, and this alternate travel route will benefit the region. The project recently received a municipal bond issue.
All of the 2018 municipal market yield increases occurred between January 1 and February 21, with rates stabilizing and retracing slightly since the February peak. Rates have increased much more than inflation, and municipal performance has been uncorrelated to the recent upsurge in equity market volatility.
As 2018 began, we believed high quality municipals would outperform Treasuries due to favorable municipal supply and demand dynamics. We expected high yield municipals to outperform high quality due to extra income generation and credit spread narrowing.
Municipal high quality has underperformed Treasuries slightly so far, but we believe this trend will likely reverse during the second quarter and beyond. High yield is outperforming investment grade, based on stable fundamentals, improving technicals and scarcity value. We expect this outperformance to continue.
Tax reform is finalized with no retroactivity to existing municipal bonds. The tax exemption itself is generally as valuable, or more valuable, than before the legislation was passed. After surviving intense scrutiny from Congress, municipal bonds will have a central role in the White House infrastructure proposal as a tool to help rebuild our infrastructure.
Supply should remain relatively low due to the lack of refunding deals, while existing municipal bonds are called and mature. As that happens, the technical glut and overhang should be alleviated.
Gross Domestic Product: U.S. Department of Commerce
Treasury Yields and Ratios: Bloomberg (subscription required)
Municipal Bond Yields: Municipal Market Data
ICI Fund Flows: http://www.ici.org/research/stats
Municipal Issuance: Seibert Research
Defaults: Municipals Weekly, Bank of America/Merrill Lynch Research, July 7, 2017.
State Revenues: The Nelson A. Rockefeller Institute of Government, State Revenue Report, June 2017.
State Budget Reserves: Pew Charitable Trust.
Global Growth: International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD)
Standard & Poor’s and Investortools: http://www.invtools.com/
Flow of Funds, The Federal Reserve Board: http://www.federalreserve.gov/releases/Z1/Current/z1.pdf
Payroll Data: Bureau of Labor Statistics
Bond Ratings: Standard & Poor’s, Moody’s, Fitch
New Money Project Financing: The Bond Buyer
Consumer Price Index: http://www.bls.gov/cpi/ http://research.stlouisfed.org/fred2/series/CPIAUCNS
State of Connecticut Fiscal Year 2017 Comprehensive Annual Financial Report
State of Connecticut Annual Information Statement
State of California Official Statement dated March 6, 2018
Moody’s Analytics, California, April 2, 2018
State of California, Comprehensive Annual Financial Report, FYE June 30, 2017
New Fiscal Plan for Puerto Rico, Restoring Growth and Prosperity, April 2018
Puerto Rico’s Financial Oversight and Management Board hearing on April 19, 2018
The Bond Buyer, Governor’s opposition to Puerto Rico fiscal plan could end up in court, April 20, 2018
The Municipal Market Data AAA scales are compilations of the previous day’s actual trades for AAA-rated insured bonds.
The personal consumption expenditures (PCE) deflator indicates the average increase in prices for all domestic personal consumption.
One basis point equals .01%, or 100 basis points equal 1%.
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The
information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions
should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
A word on risk
This report provides general information only. The analysis contained herein is based on the data available at the time of publication. This information represents the opinion of Nuveen Asset Management, LLC and is not intended to be a forecast of future events and this is no guarantee of any future result. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. Information is current or relevant as of the date indicated and such information may
become outdated or otherwise superseded at any time without notice. This analysis is based on numerous assumptions. Different assumptions could result in materially different outcomes. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment.
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated
municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.
This information should not replace an investor’s consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based
on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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