Farewell and Good Riddance
The Municipal bull market finally ran out of steam during the third quarter, with September ending a record run of 14 consecutive months of positive returns. Streaks like this typically come at the expense of returns in the future. The math of low bond yields is tough, as is finding attractive opportunities in durable credits. While bull markets present significant headwinds to finding value, they also provide ample liquidity to sell fully-valued securities and raise reserves for future purchases when better values emerge. Count us in the camp that looks forward to saying good riddance to historically tight valuations, and for interest rates to normalize to more sustainable levels.
For the quarter, returns for the full Municipal market fell 0.30%, while intermediate maturities dropped 0.1%. Trailing 1-year returns remained strong at roughly 5.6% and 3.4% for the full market and intermediates, respectively. In general, the Municipal market had a difficult time maintaining the historic low yield levels reached after the post-Brexit (British exit from the European Union) rally in late June. For the quarter, intermediate and long-term maturity yields increased from 15 to 30 basis points1 (bps). Five-, 10-, and 30-year triple-A rated yields ended September at 1%, 1.5%, and 2.3%, respectively, yet they remain 25 to 50 bps lower year-to-date. We are happy to report that selection gains fueled positive absolute and relative performance for our managed portfolios.
We entered 2016 with the Fed forecasting four quarter-point interest rate hikes. Fast forward to September 30 and we have yet to experience a single increase, and the chances of a year-end rate hike now stand at roughly 60%. The Federal Reserve’s (Fed) forward projections have dropped precipitously as well, with their estimate for year-end 2018 down nearly 150 bps. Effectively, the Fed has acquiesced to the markets. We are disappointed that the Fed has not demonstrated more leadership in normalizing its lopsidedly accommodative policy stance. Together, the world’s major central banks are playing a dangerous game. Arguably, short of explicit debt monetization or “helicopter money”, we are experiencing the limits of monetary policy. We believe the Fed has no effective tools left in the tool kit should they need to support a weakening economy. Hence, they need to get rates up now while they can in order to be able to lower rates meaningfully during the next economic downturn.
The support for the Municipal sector remains strong. As of quarter-end, Municipal bond funds have now enjoyed net inflows for 52 consecutive weeks. This streak is the longest since 2010. In addition to mutual funds, bank demand has been supportive of the overall market. Seeking alternatives to the proliferation of negative government bond yields overseas, even international investors are giving Municipal bonds a serious look. This broadening demand, even in the face of historically low yields, has easily absorbed this year’s supply uptick. New issue volume is on pace to reach $425-$450 billion this year, up 5% to 10%. By itself, having more bonds from which to choose is a healthy development; however, the competition for new issues has been fierce.
Despite the absence of a Fed rate move this year, the behavior of short-term interest rates has been anything but stable, largely attributable to Money Market Fund reform. Back in 2008, the $65 billion Reserve Primary Money Fund “broke the buck” as a result of its Lehman Brothers exposure, triggering a run on the fund. Amid concerns that some of the Reserve’s institutional investors may have been tipped at the expense of retail shareholders, regulators began contemplating reform measures. The final reforms dictate that only Government and Retail Money Market Funds can continue to use the stable $1 net asset value (NAV) and all other funds must allow their NAVs to float. Moreover, potential gates and fees are required to be applied to Non-Government funds if certain liquidity thresholds are breached. These factors have driven a strong behavioral response from Money Market Fund investors.
Although the October 14 reform implementation deadline has been long telegraphed, in recent weeks there have been seismic shifts in the Money Market Fund landscape. Investors have been fleeing traditional “Prime” and “Tax-Exempt” Money Funds in favor of taxable Government funds. Assets in Prime and Tax-Exempt Money Funds have declined by more than half this year, while Government fund assets have more than doubled. These asset flows have driven a significant re-pricing in short-term London interbank offering rate (LIBOR) and Municipal rates.
So far this year, one- and three-month LIBOR rates have risen 10 to 25 bps. The move in short-term Municipal rates has been more dramatic, rising 40-50 bps since the summer. As opposed to the more commonly known LIBOR, the Tax-Exempt short rate is known as SIFMA — The Securities Industry and Financial Markets Association Municipal Swap index. SIFMA is calculated on a weekly basis and released to the public on Wednesdays. The rate is based on the average of Variable-Rate Demand Obligation (VRDO) yields subject to the following major inclusion criteria (outliers falling outside of +/- 1 standard deviation from the mean are excluded):
- Weekly reset
- Not subject to the Alternative Minimum Tax
- At least $10 million outstanding
- Highest short-term rating by Moody’s or S&P
VRDO rates ended the quarter at an attractive 0.84%. We expect the rate to remain elevated until the assets of Non-Government funds stabilize. Until then, we expect a proverbial “buyer’s market” in short Municipals to continue. As a reminder,5-year, triple-A rated securities now yield just over 1%. We cannot say for sure whether the Money Market dislocation has played a role in catalyzing Auction-Rate Security (ARS) refundings, but we are happy to earn the performance gains nonetheless.
We have seen an uptick of par-priced ARS redemptions. So far this year we bid a fond farewell to securities issued by the Transmission Authority of Northern California (TANC) and bonds backed by Kentucky Utilities and Nevada Energy. As the third quarter was poised to end, we received notification that our Metropolitan Transportation Authority (MTA) ARS were called at par with a late-October settlement. These securities have provided an effective low-duration anchor to our portfolio barbells for several years. We have long advocated the value in ARS and are pleased with the recent performance gains from them.
Despite increasingly tempestuous election politics, credit news was generally light for the quarter. Some highlights included a quiet end to State budget season, the naming of individuals on the PROMESA (Puerto Rico Oversight Management Economic Stability Act) oversight board, and modest pension reform in Chicago. For our managed portfolios, the big news originated from Pennsylvania. On August 15, Moody’s restored the ratings of the Pennsylvania School District Intercept Programs which it had downgraded in December. Last year’s prolonged budget impasse exposed a weakness in the programs. In the absence of a budget, State aid for schools could not be appropriated and therefore could not flow onward to the bond trustee in a timely manner. The lack of State aid also placed many districts under operating pressure and forced many to pursue a significant amount of short-term borrowing. In response, Moody’s amended their methodology for the credit, citing concerns about the reliability of State aid behind the State’s school district enhancement programs. This uncertainty resulted in the downgrade of our Philadelphia School District to non-investment grade.
As we have written in the past, Pennsylvania has a constitutional requirement to support public education. The establishment of this program was a result of this obligation. Without sufficiently high ratings, the enhancement programs could not fulfill their purpose of facilitating access to capital markets so that participating school districts could borrow directly. On July 13, the Pennsylvania Legislature and Governor passed legislation which enables up to one-half of the prior year’s State aid to be made available for school districts in the event of a budget impasse. The school enhancement State aid intercepts have first claim upon these funds with the remainder available for operations, thus alleviating the aforementioned uncertainty. We are pleased that Pennsylvania’s budget was resolved in relatively short order this year. We are more excited that the State passed the necessary legislation to strengthen their school enhancement programs and restore their ratings.
Our portfolio positioning was little changed for the quarter. We had two notable purchases including Massachusetts State Bay Transportation Authority (MBTA) Sales Tax-backed zero-coupon bonds and Grossmont California Healthcare District general obligation zero-coupon bonds. As we wrote last quarter, Municipal investors’ preference for cash flow has led to attractive valuations in zero coupon bonds. Both of these credits are supported by strong fundamentals. MBTA enjoys a senior lien on a portion of State sales tax, offers over 2.5x coverage, and protective bond-holder covenants. Grossmont is secured by an unlimited property tax pledge on its eastern San Diego County service area. The Grossmont district also benefits from a strong tax base, low leverage, and healthy reserves.
The technical strength of the Municipal market has persisted for longer than we would have expected and fueled a prolonged bull market. The last prolonged period of meaningful weakness was roughly three years ago when the market had to digest the taper-tantrum, Detroit’s bankruptcy, and Puerto Rico’s distress. Unlike many others, we are not optimistic about the Municipal market because of its firm foundation. Instead we are optimistic about the opportunities that will emerge when this period of ebullience ends. Although this bull market has lasted longer than we would have guessed, we look forward to a continued correction and the attractive valuations that may result.
Gregory S. Steier
1 a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument
2 The Federal Funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.