Is There An Echo In Here?

For much of 2018, we have bemoaned the rock-solid stability of the municipal market. In the face of tax reform-induced uncertainties, declining creditor protections, and a Federal Reserve (Fed) marching towards policy normalization, market valuations reflected nary a concern. In fact, from February through August, municipal market volatility reached its lowest point in the 30+ years for which we have data. As the fourth quarter commenced, however, overall financial market conditions changed so dramatically that we even thought we heard echoes of the Financial Crisis.

  • S&P 500 down 14%
  • NASDAQ down 17%
  • Oil down 38%
  • High Yield spreads 200 basis points1 (bps) wider
  • TIPS market-implied inflation down 45 bps
  • U.S. Treasury Secretary Mnuchin provides public assurances that the largest U.S. banks are fine

During periods of turmoil, we are often asked, “What is the market saying?” While we can usually derive a narrative consistent with the price movements, there is no way to know for certain. However, our experience has taught us that market prices are far more volatile than underlying fundamentals. When broad classes of securities swing wildly, the moves tend to be exaggerated. Short-term market volatility generates opportunities to find long-term values for our clients. In our evaluation of individual investments, we are mindful of the broader environment, even if it is not of primary importance. The combination of declining equity and commodity prices, widening credit spreads, and declining inflation expectations paint a gloomy economic picture – or worse. Our challenge is to ensure every credit we own can withstand tough times and still offer attractive yields.

U.S. Treasuries benefited the most from the fourth quarter’s investor angst, generating a return of 2.6%. The municipal market returned 1.7%, after nine months of near-zero returns. During the middle of the fourth quarter, the muni market generated positive returns for a record 21 consecutive business days – not exactly a random walk down Wall Street. For the quarter, triple-A rated 5-, 10-, and 30-year maturity yields fell 15 to 30 basis points, ending the year at 1.94%, 2.28%, and 3.02%, respectively. The fourth quarter rally offset almost half of the sell-off prior to October 2018. For the year, municipal returns beat those of all other major fixed income sectors.

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We are happy to report that our managed portfolios generally kept pace with the market in the late-year rally and beat their benchmarks for the year. During the quarter, our last major Auction Rate Security position, backed by Westar Energy, was refunded at par. When we started purchasing these securities in 2011, we did not know when their value would materialize. We did know that they offered meaningful return potential, particularly as the Fed normalized monetary policy. This return potential consisted of two parts: first from higher income as their coupons reset at a multiple of a short-term index; and second, from price appreciation as the probability of par-priced redemptions increased as coupon rates went up. This is just what happened. Our auction rate holdings have generated significant value for our fully discretionary clients over the past few years.

Our portfolio’s zero-coupon school district debt also performed very well. Most of these schools are located in California and Oregon. Municipal investors continue to underappreciate zero-coupon bonds, preferring semi-annual cash coupon payments instead. When paired with our floating-rate bonds, our zero’s form an effective bridge over expensive one- to three-year debt. For the quarter, this yield curve positioning benefited performance as short maturities lagged relative to 5- to 10-year debt.

Lastly, over the past several quarters we have written about our portfolios’ rising reserves. As certain credit-sensitive sectors such as tobacco, prepaid natural gas, and airports underperformed during the quarter, our relative results benefited. More importantly, we went shopping. We added to our position in 8-year Railsplitter Tobacco Settlement Authority at spreads of 80 bps, over 20 bps wider than bonds were trading throughout the summer. Our Railsplitters are strong credits, backed by master settlement agreement payments made by any entities selling cigarettes and other tobacco products within the U.S. Our bonds can withstand 15% to 20% annual declines in cigarette shipments, the primary factor behind our pledged revenues. Earlier in the year, New Jersey and California issued billions of tobacco bonds with less than half of the protection of our bonds. We viewed the voracious appetite of the market for these deals with concern. Weak structures and inadequate compensation often lead to poor ownership experiences.

The prepaid natural gas sector (“Prepaids”) also struggled during the quarter, creating several opportunities for us. With only $80 billion outstanding, Prepaids occupy an interesting niche in the municipal market. In these transactions, the gas supplier contracts to deliver a fixed amount of natural gas for a specified amount of time at a discount to prevailing spot prices. The buyers are typically municipal electric utilities or gas distribution systems. These bonds help fund the gas purchases, which are often facilitated by a commodity subsidiary of a major bank, which can also provide guarantees around the overall structure. As a result, it is common for the ultimate obligor in these structures to be a bank, such as Bank of America or JP Morgan.

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Prepaids allow banks to borrow tax-free in the muni market as long as they pass along some of their financing savings in the form of discounted gas prices. We collaborate with our colleagues on our taxable team to underwrite both the underlying credits and bond structures. Years ago, when we first researched these instruments, we were skeptical. However, we were comforted that the IRS opined and issued final regulations for Prepaids back in 2003. It is important to remember that these deals must support a valid municipal use for the natural gas and ensure that the participants abide by these rules, for the bonds to remain tax-exempt. Given the complexity of these bonds, clear initial and continuing disclosures are important to our understanding of the credit’s performance, the flow of money, and the responsibilities of the involved parties.

Late in the year, as taxable bank spreads widened significantly, so did Prepaids. We purchased a couple of new deals backed by Goldman Sachs and Morgan Stanley, as well as a seasoned issue backed by Bank of America. These bonds offered approximately 100 bps of spread for 5- to 7-year average lives, roughly 30 bps wider than during the summer.

Looking forward, we have doubts whether the late-year rally will be sustained. First, flight-to-quality episodes are short-lived. Second, negative municipal mutual fund flows cast a pall on the fourth quarter’s strong performance. Over $5 billion of capital exited industry funds, with outflows in all but two weeks of the quarter. Approximately 60% of the capital left from “high yield” funds. These funds had been strong consumers of credit-sensitive bonds. Beyond mutual funds, banks continue to sell actively. The Fed recently reported that banks had liquidated 5% of their municipal holdings through the third quarter, or about $40 billion. The Fed data is subject to a timing lag, but we witnessed additional selling in the fourth quarter. Typically, industry outflows of this magnitude are associated with poorly performing markets, not strong ones.

The Fed presents another hurdle. Amid the chaotic fourth quarter, the Fed tightened for the fourth time this year, bringing this cycle’s rate hike count to nine for a total of 225 bps. The Fed’s current dot plot projects two rate increases in 2019, less than the three rate hikes it had previously projected in September. The new dot plot was well above that of market consensus, which sees the next move by the Fed as an ease in 2020.

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The market’s Fed expectations appear heavily influenced by the performance of equities. The stock market can generate important wealth effects and influence consumer sentiment. Since the leadership of Chairman Greenspan, the Fed has displayed an asymmetric attitude toward the stock market. The “Greenspan Put” entailed running to the rescue with policy accommodation during big market declines and letting markets run in good times. Thus far, Chairman Powell has acted in a more balanced fashion – a welcome development. Overall, we view both the Fed’s assessment of the domestic economy and its policy stance as reasonable.

Despite all the financial news banter, the domestic economy remains healthy and it continues to be pumped up with fiscal stimulus from Washington. The consensus forecast for this year’s federal fiscal deficit is over $1 trillion – more than 5% of gross domestic product (GDP). We would be alarmed even if we did not invest bond portfolios for a living. Between the debt needed to finance Washington’s prodigious spending and the expected $600 billion contraction in the Fed’s balance sheet, the market will need to absorb a significant amount of government paper. This will likely place upward pressure on today’s low rates.

Mutual fund redemptions, bank selling, continued Fed normalization, and rising deficit financing needs present serious pressure to today’s still-low tax-exempt yields. The late-year municipal market strength surprised us and makes us question the sustainability of the recent rally. In contrast, what remained true to form was our ability to identify credit opportunities amidst all the redemption activity. After staying resilient all year while taxable credit sectors gyrated, municipal credit weakened and provided opportunities for which we had been patiently waiting.

With some markets in freefall, it is difficult not to experience flashbacks to the crisis 10 years ago. Today’s heightened volatility has created loud reverberations throughout markets. These echoes of the financial crisis have probably caused more than a few headaches. For us, the best remedy is to stick to our criteria, stay patient, and keep the financial news TV on mute.

Best wishes for a healthy, happy, and prosperous 2019, and we thank you for your trust and support.

 

Sincerely,

 

Gregory S. Steier
Portfolio Manager

 

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IM-05974-2019-01-22        Exp. Date 04/30/2019

1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.