Invesco Municipal Bond Market Recap and Outlook

Transcription

1 Invesco Municipal Bond Market Recap and Outlook By William Black, CFA, Mark Paris, Robert Wimmel and Stephanie Larosiliere May 12, 2015 Highlights Investment grade and high yield municipal bonds posted positive price returns for the fifth consecutive quarter. three-month period, the investment grade municipal market returned 1.01% (1.78% tax-adjusted), while the high yield municipal market returned 1.11% (1.96% tax-adjusted) 1. The long end of the yield curve outperformed over the quarter, as rates on long-term municipal bonds followed Treasuries lower and the yield curve marginally flattened (Figure 1). Moderate revenue recovery in 2014 benefited certain US public finance credits, and for the first time since 2008, annual upgrades exceeded downgrades. Although municipal bond issuance in the first quarter totaled $103 billion, up 63% from 2014, stand-alone new money issuance was down almost 4% while refunding volume was up 178%. Municipal mutual funds continued to see positive net flows, accounting for a larger portion of flows into bond funds. After robust returns in 2014, the municipal bond market posted positive, albeit lackluster, returns in the first quarter of Coming off of 13 consecutive months of positive returns, the municipal bond market turned negative in February. In March, the investment grade segment of the asset class posted a decline in yields (with the exception of the 20-year tenor) after the Federal Open Market Committee (FOMC) meeting that month, allowing total returns to stay in positive territory for the quarter. For the Source: Municipal Market Data, US Treasury, as of March 31, bps = basis points. Past performance cannot guarantee future results. Market environment: All eyes on the Fed The first quarter also marked the sixth anniversary of the bottom in US equities, where the S&P 500 Index reached an intra-day low of 666 on March 9, The US economy has since recovered with the S&P 500 rising 218%, unemployment trending lower, state and local governments displaying stronger credit profiles and the Fed now appearing to be ready to adjust its monetary policy. A major theme that we believe will play out this year is the shift in monetary policy, and for the first time since 2006, we may see a rate 1

2 hike in the second part of the year that moves us away from the near zero percent Federal Funds rate that we have been at since At the March FOMC meeting, Federal Reserve (the Fed) removed the word patience from its forward guidance, increasing the probability of a rate increase in the near term. In other words, they are prepared to raise interest rates at any subsequent meeting if the data warrants. Our expectation is that once rate hikes begin, we are likely to see a flattening of the Treasury yield curve, with short-term Treasury rates getting higher, while the long end remains anchored to current levels. Long-term Treasury rates, which are typically more affected by economic growth rather than Fed policy, can also drift higher, but typically lag short-term rates. Yields in the municipal market tend to follow Treasury yields, and hence, we expect to see a flatter yield curve in our market as well. We expect municipal yields in the intermediate to longer-term maturities to see modest gains going forward, and we advocate that investors consider coupon payments rather than price appreciation. Given the dovish tone of the Fed s recent comments, we believe that they will be very careful to ensure that the economy is capable of withstanding a rate hike before it decides to pull the trigger. We also believe that the pace of these hikes will be very gradual once they begin. This is a positive for all risk markets, including high yield municipals, as it indicates that the Fed will do its best to ensure that the economy continues to expand. The latest Fed move should also spur some volatility, as well as opportunity, in the municipal market. Expectations of a tighter monetary policy continue to drive volatility in the US Treasury market, with the municipal market following suit. The spike in refundings seen over the first quarter also played a role in contributing to volatility as it boosted issuance, leading to an imbalance between supply and demand. We believe that volatility can be seen as an opportunity to establish attractive trade entry points across the yield curve. Crossover investors, who may have duration constraints, may find opportunity in the intermediate portion of the curve, and in general, municipals are now cheap relative to US Treasuries at most points along the curve following the spike in volatility over the quarter. For investors with a higher risk tolerance, we feel an allocation to high yield municipals may be warranted. Municipal fundamentals: States continue to benefit from economic expansion Most state tax revenue sources are heavily influenced by the economy. Income tax receipts rise when income rises; the sales tax generates more revenue when consumers increase their purchases of taxable items, and so on. When the economy booms, tax revenue tends to rise rapidly, with the inverse also being true when the economy declines, tax revenue tends to decline. During the first quarter, the US economy continued to benefit from lower energy costs, low interest rates, and an improving labor market, and despite some outliers (such as Puerto Rico, Chicago and Illinois), state and local economies continue to strengthen. State tax revenues grew by 4.4% in the third quarter of 2014 (latest available data), according to the Rockefeller Institute and Census Bureau data. All regions of the country reported growth, with the Southwest and Rocky Mountain regions showing the strongest growth at 8.7 % each, and the New England region showing the weakest growth at 2.6 %. All major sources of tax revenues showed solid growth in the third quarter of For example, personal income tax collections reported growth at 4.1%, corporate income taxes grew 9.2%, and sales taxes rose 6.1%. Overall, state tax collections for the fiscal year 2014 grew by 2% compared to fiscal year Preliminary figures for the fourth quarter of 2014 indicate continued and strong growth in overall state tax collections at 6.4%. The outlook for the remainder of fiscal year 2015 remains positive in most states. However, oil-rich states are facing heightened fiscal challenges due to drops in oil prices. In 2014, US public finance upgrades outnumbered downgrades, reversing a five-year trend. The number of downgrades has been decreasing for the past three years and was at its lowest level since Upgrades were at their highest level since 2009 and the number of se- 2

3 curities with a negative outlook at the end of the year was at its lowest level since the end of The year-end ratio of negative to positive rating outlooks at the end of 2014 was also at its lowest level since year-end Technicals: Supply / Demand imbalance continued to drive performance In line with 2014, municipal bond fund flows remained strong during the first quarter, totaling $10.5 billion, the largest Q1 net in-flow since 2012 (Figure 2). Inflows into tax-exempt funds have started accounting for a larger portion of the total inflows in all bond funds. We expect to see continued demand for the asset class given that we believe relative value remains attractive versus other areas of the fixed income market, especially on a tax-adjusted basis. Source: Morningstar. As of March 31, Past performance cannot guarantee future results. First quarter municipal bond issuance was the busiest on record since 2010, when issuance was inflated by the Build America Bonds program. During the first quarter of 2015, municipal bond issuance totaled $103 billion, up 63% from 2014, due in large part to a substantial increase in refunding activity as issuers took advantage of falling interest rates (Figure 3). Refunding volume in the first quarter of 2015 was 178% higher than it was in the first quarter of 2014, while stand-alone new money issuance was down almost 4%. In fact, new money issuance as a percent of total issuance came in at 28% in the first quarter of 2015, compared to the average of 60%. 2 Source: The Bond Buyer. As of March 31, Past performance cannot guarantee future results. It is worth noting that this year s refunding activity has been highly correlated with interest rate movements. In the weeks in which the Municipal Market Data 10-yr AAA rate 3 averaged less than 2%, refundings as a percent of total issuance hovered around 60%. But when the weekly average 10-year rate printed greater than 2%, this percentage dropped to an average of 43% of total issuance. As a result, we expect refunding volume to decline if rates rise as expected later this year, resulting in a market where municipal bonds would seem to be poised to benefit from another year of limited supply. Lower oil prices: Is the municipal market immune? The decline in oil prices since the summer of 2014 continued throughout the first quarter, as oil supply surpassed demand and we saw substantial price declines. This is of particular 3

4 interest to municipal bond investors, as many US state and local budgets have a substantial dependence on oil production and exploration revenue. In addition lower oil prices can influence economic growth and inflation, which can affect Treasury and municipal yields. Falling oil prices typically signal that the global economy isn t growing fast enough to absorb oil production and can also produce investor anxiety over the credit quality of municipalities whose economies depend on the energy sector. Source: Bloomberg L.P. Municipalities may potentially see a decline in employment and revenues due to falling oil prices, but its impact can differ between state and local governments. Conversely, some state and local governments can benefit as lower oil prices and related gasoline prices increase consumer spending, and in turn, increase taxes and boost the economy. Within the municipal market, lower oil prices are a potential downside risk to state and local government general obligation issues, possibly putting state budgets at risk, although these risks will be localized to a small group of states that rely on the energy industry. Outsized exposure to oil-related industries vary, depending on location, and become significant in areas where oil-related employment has been a key driver of overall employment growth. In these locations oil-related revenues may be a sizeable portion of total revenues collected by the state. To put this in perspective, oil and gas extraction accounts for more than 8% of gross state product (GSP) for only five states (Alaska, Wyoming, Texas, Oklahoma and Louisiana). Three states (New Mexico, North Dakota, and Colorado) have between 3% and 8% GSP exposure through oil and gas extraction. By contrast, oil and gas accounts for about 1.6% of the overall US economy. 4 Typically, states will receive revenues from various sources tied to the energy sector, such as a severance tax on the extraction, production and sale of oil and gas. States with a higher reliance on these taxes will likely feel the impact of falling oil prices more than states that have a more diversified revenue streams. Historically, resource-rich municipalities were generally perceived as superior credits. Of the states that have a Source: Morgan Stanley, Municipal Strategy - Municipal Macro Report Oil Spillover February 6, higher economic exposure to oil-related industries, many of them have sufficiently high credit ratings and debt levels, although a sharp drop in revenues would warrant the attention of credit agencies and investors. However, the total size of debt from risky areas is small, making this an idiosyncratic risk as opposed to a 4

5 broad fundamental risk in the municipal market. Risks to states appear manageable, and risks to locals appear to be a little less manageable, but still, more idiosyncratic in nature. While states with high levels of oil production are at risk for potential weakening of their overall credit quality, state reliance on oil is diverse. Examples can be seen in states such as Texas, Alaska and Oklahoma, which are vulnerable due to their exposure to oil, but also employ various levels of reliance on the industry. Alaska: The Last Frontier State is unique among the states, as it levies no income or sales tax on residents, but relies primarily on oil and gas revenue to fund operations. While lower oil revenues are beginning to result in fiscal pressure, the state has a considerable amount of reserves sufficient enough to provide a buffer from its structural imbalance. Although these reserves won t last too long in the face of long-term oil price declines, they provide for a cushion in times of extended low oil prices, allowing legislators to address fiscal pressures. In contrast, Texas and Oklahoma largely restrict the use of oil and gas revenues funding general operations and are less depended on the industry than Alaska. Texas: The oil and gas industry in the Lone Star State has been the primary driver of growth in recent years, but it is important to note that the Texas economy is large and diverse. The diversity of its economy and sound financial profile have been able to protect the state from fluctuations in oil. While the state produces more than 6.5 times more crude than the State of Alaska, oil and gas taxes represent a much smaller share (9.4%) of its tax base and an even less significant component of its total budget (4.5%). 5 Proceeds from these more volatile taxes have been diverted to the state s economic stabilization fund and for non-recurring capital programs. Oklahoma: The Sooner State lies between Alaska and Texas on the spectrum of reliance on oil. Its economy is more concentrated and dependent on oil than that of Texas, bringing it closer to Alaska in this factor. Similar to Texas, Oklahoma tends to use its gross production revenues to feed its reserves and to fund capital projects, reducing the general fund reliance on oil revenues, while seeking to provide a cushion during times of economic downturns. While the states can face revenue shortfalls due to a decrease in oil prices, these shortfalls appear to be manageable. Louisiana: For some states, lower energy prices compound current financial challenges. Standard & Poor s recently revised its outlook on the Pelican State s AA rating to negative after revenue growth slowed in the wake of falling energy prices. A persistent structural deficit, which represented an amount equal to an estimated 17% of the budget, was the principal driver of the rating action. Absent the decline in oil prices, the rating agency may have been more willing to retain a stable outlook on the credit. Moody s also decided to retain its own Aa2 rating of the Pelican State but acknowledged the adverse impact of falling energy prices on the state budget and revised its outlook to negative as well. According to the state legislature s chief economist, the state loses $11 million in revenue each time the price of a barrel of crude drops by $1.40. As a result, the state s Revenue Estimating Conference (REC) lowered its estimate of state tax revenues by $126 million in fiscal year 2015 and $203 million in fiscal With the drop in crude prices, Louisiana has a lot less room to maneuver and further rating revisions could be likely. Wyoming:The National Association of State Budget Officers (NASBO) estimates that the Cowboy State receives 39.7% of its total state tax collections from oil severance taxes, the third-highest percentage among states. According to the state, a $5 decline in oil prices results in a $35 million decline in state annual revenue collections. For perspective, total general fund revenues for fiscal 2013 totaled $2.4 billion. A $25 million decline in oil revenues would result in a 1% decline in revenues. The potential benefits for less oil-reliant states Offsetting this decline is the increased consumer spending that is typically associated with a decline in oil prices. In many ways, falling oil prices can mimic tax cuts by transferring cash to the consumers due to an increase in dis- 5

6 cretionary spending, which occurs when less of their income is used on oil-related items, such as gasoline. Declining gas prices combined with low interest rates may result in boosting the spending power of the US consumer. We believe that for states with less reliance on the energy industry, this could mean a boost to tax revenues and financial flexibility. For municipal bond funds that primarily invest in revenue bonds, the drop in oil prices could result in a significant tail-wind, particularly for bonds backed by revenues from toll roads, airports, electric utilities, airlines and sales tax bonds in cold weather states where gas/oil consumption is a large part of consumer expenditures. Putting it all together Attractive yields may make municipal bonds a compelling standalone opportunity or addition to a broader investment portfolio. Their tax-exempt status certainly enhances their relative appeal, but even before taxes, municipal bonds have the potential to offer attractive opportunities for income and capital appreciation. Municipal bonds may also serve as diversifiers in an overall investment portfolio because of their low correlation to other major asset classes. Three reasons to consider municipal bonds 1. Tax advantage: New laws, as well as tax provisions that expired at the end of 2013, have led to larger tax bills for many high-income earners. Some of the significant changes to tax law include: a top marginal rate of 39.6%, up from 35%; a 20% tax on long-term capital gains and dividends, up from 15% and a new 3.8% tax on investment income, which municipal income is exempt from. We believe that these higher tax rates increase the incentive for taxpayers to seek tax-exempt income via municipal bonds. Municipals have the potential to offer a broad range of investment options that are exempt from federal income tax and can be exempt from state and local income taxes. However, income may be subject to the alternative minimum tax (AMT). Source: Barclays and Bloomberg L.P. as of March 31, High-yield corporate bonds are represented by the Barclays U.S. Corporate High Yield Index; high-yield municipal bonds by the Barclays High Yield Municipal Bond Index; investmentgrade municipal bonds by the Barclays Municipal Bond Index; investment-grade corporate bonds by the Barclays U.S. Corporate Investment Grade Index. Past performance is not a guarantee of future results. An investment cannot be made directly in an index. The tax-adjusted calculation uses a tax rate of 43.4%, which is the top federal tax bracket of 39.6% + the net investment income tax of 3.8%. 2. Diversification potential: We believe diversification can potentially increase opportunities for growth and reduce overall portfolio risk. Because municipal bonds historically have had very low correlation to other asset classes, including equities and Treasuries, they can be effective portfolio diversifiers. Over the last 10-year period ending March 31, 2015, the Barclays Municipal Bond and Barclays High Yield Municipal Bond indices have exhibited low correlations of 10% and 27%, respectively, to the S&P 500 Index. This is in contrast to the Barclays U.S. Corporate High Yield Index, which has had a much higher 73% correlation with the S&P 500 Index over the same time period. This lower correlation illustrates that investment grade and high yield municipal bonds have not moved in the same direction or to the same degree as their corporate counter- 6

7 parts when the equity market rises or falls. We believe that this low correlation can potentially enhance a portfolio s diversification benefits. Source: Morningstar, as of March 31, Data from March 2005-March Relatively lower default risk: Contrary to popular belief, the vast majority of municipal bond issuers remain creditworthy, and municipal default rates have remained relatively low, especially when compared with US corporate bonds. As shown in the chart below, when the credit structure decreases, the odds of a default rise. However, the percentages are much higher for investment grade corporates compared with municipals. Since 1970, there has never been an Aaa-rated municipal bond default. Similarly, in the same time frame, only 0.01% has defaulted with an Aa-rating. By contrast, Aa-rated -corporate issuances have had a nearly 1% default rate since Source: Moody s Investor Services, as of May 2014, 10-year average cumulative default rates (CDR) for municipal and corporate issuers over the entire period of study ( ). CDRs are calculated by averaging the default experience of cohorts made up of Moody s-rated credits formed at monthly frequencies throughtout the study period. The 10-year average CDR tells us the average of the historically-observed defaults for ten year periods from 1970 to A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. For more information on Moody s rating methodology, please visit and select Rating Methodologies under Research and Ratings on the homepage. Outlook The stars aligned for the municipal bond market in 2014: Low supply amid solid demand, improving fiscal conditions among state and local issuers, and a broad drop in interest rates (and rise in bond prices) helped make municipals one of the top-performing fixed income asset classes of the year. As we enter the second quarter of in 2015, many of the favorable dynamics that boosted the municipal market in 2014 remain, although at much more muted levels. Positive flows into municipal bond funds, while volatile at times, are likely to continue throughout the year, particularly as new tax proposals are unveiled, and overall new issue is expected to be at modest levels due to an increase in bond maturities and redemptions in Unlike 2014, when prices of municipal bonds recovered significantly from their 2013 lows, there is less opportunity for price appreciation this year. That being said, we believe that 2015 will be a year when municipal 7

8 bonds serve their intended purpose: competitive tax-exempt income with relatively low volatility. A major theme that we expect to see play out later this year is the shift in monetary policy. Our expectation is that rates will likely begin to rise at a measured pace beginning in September (although June remains a valid possibility), and that once rates rise, we will see a flattening of the yield curve, with the front end doing the bulk of the movement and the long end remaining anchored to current levels. We do believe that once the various dislocations in the global economy are factored in, we ll continue to see Europe and Asia buying long Treasuries, which will help to keep long US Treasury rates low. Invesco Municipal Bond Team The Invesco Municipal Bond team s management philosophy is based on the belief that creating long-term value through comprehensive forward-looking research is the key to providing clients with highly diversified portfolios that aim to maximize risk-adjusted returns. Proprietary credit research and risk management are the foundations of our investment process, supported by a deep and experienced team of investment professionals with expertise that spans the entire municipal investment universe. We maintain an integrated, team-based investment process that combines the strength of our fundamental credit research staff with the market knowledge and investment experience of our portfolio managers. Our position among the top 10 municipal managers allows us the ability to access preferred market opportunities and gain valuable market insight. 6 Our team has established relationships with more than 120 national and regional tax-exempt debt dealers. These established relationships, as well as our size, allow us to achieve superior execution in daily transactions. Our ability to aggregate trades across multiple funds enables us to obtain lower, institutional pricing, which can contribute to fund performance. 1 Source: Barclays Municipal Bond Index, Barclays Municipal Bond High Yield Index, as of March 31, The tax-adjusted calculation uses a tax rate of 43.4%, which is the top federal tax bracket of 39.6% plus the net investment income tax of 3.8%. 2 RBC Capital Markets 2015 First Quarter Volume These Are The Good Ole Days April 1, Thomas Reuters, as of March 31, Morgan Stanley Municipal Macro Report Oil Spillover February 6, Comparison of Alaska and Texas crude production is based on US Energy Information Administration monthly data through November Oil and gas tax revenue data is based on fiscal year 2013 financial results. 6 Source: Strategic Insight Simfund/MF Desktop, based on assets under management as of Sept. 30,