Municipals

Headline Risk Returns to the Municipal Market:

Puerto Rico Debt Likely to Face Restructuring

The second quarter ended with Puerto Rico once again making the headlines.  On June 29, 2015, the governor of the Commonwealth, Alejandro Garcia Padilla, disclosed publicly for the first time that the island’s debt was “not payable.”  The announcement immediately called into question whether the island would default on its July 1 debt service payments of $820 million and $416 million of Puerto Rico General Obligation (GO) and Puerto Rico Electric Power Authority (PREPA) debt, respectively.  However, the island was able to make both payments in full. The Commonwealth provided the necessary set-aside deposits to meet the obligations for the GO debt.  In the case of the PREPA payment, debt service reserves and financing from bond insurers provided the necessary funding.

Also on June 29th, through an executive order, the governor appointed the “Working Group for the Economic Recovery of Puerto Rico” to address Puerto Rico’s fiscal condition.  The group is tasked with producing a five-year economic adjustment plan by August 30th, that’s expected to include a moratorium on debt service and a debt exchange.  With over $72 billion in debt outstanding and no current framework in place to restructure its debt via Chapter 9 bankruptcy, negotiations between the creditors and the Working Group will take center stage over the coming months, starting on July 13th.

As these developments have unfolded over the last two weeks, the sector has remained resilient and has not priced in any contagion risks to the general market. While Puerto Rico GO debt issued in 2014 has fallen by approximately 10%, relative valuation levels for tax-exempt municipals have actually remained stable. Since June 26th, tax-exempt nominal yield spreads to Treasuries from 3 to 7years are actually tighter by 1 to 6 basis points (bps), while the balance of the yield curve was unchanged to wider in spread by 1 to 2bps.

Part of the explanation for municipals performing well into the headline risk, is that events in Puerto Rico and in other fiscally-challenged areas of the country (Illinois and New Jersey) have largely been viewed as isolated events.  The vast majority of municipal issuers in the market are seeing slow, but steady, revenue growth and have retained a very austere focus in developing their budgets. Consequently, as long as investors continue to believe that credit deterioration is not developing within the broader sector, in the near term, demand should remain firm.  We are currently in the strongest reinvestment cycle of the year for coupons/calls/maturities that are estimated to be $59 billion in July and another $48 billion in August.

Relative valuations are also seeing noteworthy support from the slowing in the refunding/refinancing cycle.  Average tax-exempt 10 year yield levels during May and June have risen by approximately 30 bps versus rate levels during the first four months of the year.  The higher rate environment was the primary catalyst in slowing monthly refinancings by 37% from April to May.  If rates remain range-bound around current levels or move higher, we should continue to see a deceleration in issuance patterns for rate sensitive supply.  With expectations for favorable supply/demand technicals to continue to develop during the third quarter, we are constructive on the sector and recommend an overweight position to tax-exempts in tax-advantaged accounts.

Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Headline Risk Returns to the Municipal Market:

Puerto Rico Debt Likely to Face Restructuring

The second quarter ended with Puerto Rico once again making the headlines.  On June 29, 2015, the governor of the Commonwealth, Alejandro Garcia Padilla, disclosed publicly for the first time that the island’s debt was “not payable.”  The announcement immediately called into question whether the island would default on its July 1 debt service payments of $820 million and $416 million of Puerto Rico General Obligation (GO) and Puerto Rico Electric Power Authority (PREPA) debt, respectively.  However, the island was able to make both payments in full. The Commonwealth provided the necessary set-aside deposits to meet the obligations for the GO debt.  In the case of the PREPA payment, debt service reserves and financing from bond insurers provided the necessary funding.

Also on July 29th, through an executive order, the governor appointed the “Working Group for the Economic Recovery of Puerto Rico” to address Puerto Rico’s fiscal condition.  The group is tasked with producing a five-year economic adjustment plan by August 30th, that’s expected to include a moratorium on debt service and a debt exchange.  With over $72 billion in debt outstanding and no current framework in place to restructure its debt via Chapter 9 bankruptcy, negotiations between the creditors and the Working Group will take center stage over the coming months, starting on July 13th.

As these developments have unfolded over the last two weeks, the sector has remained resilient and has not priced in any contagion risks to the general market. While Puerto Rico GO debt issued in 2014 has fallen by approximately 10%, relative valuation levels for tax-exempt municipals have actually remained stable. Since June 26th, tax-exempt nominal yield spreads to Treasuries from 3 to 7years are actually tighter by 1 to 6 basis points (bps), while the balance of the yield curve was unchanged to wider in spread by 1 to 2bps.

Part of the explanation for municipals performing well into the headline risk, is that events in Puerto Rico and in other fiscally-challenged areas of the country (Illinois and New Jersey) have largely been viewed as isolated events.  The vast majority of municipal issuers in the market are seeing slow, but steady, revenue growth and have retained a very austere focus in developing their budgets. Consequently, as long as investors continue to believe that credit deterioration is not developing within the broader sector, in the near term, demand should remain firm.  We are currently in the strongest reinvestment cycle of the year for coupons/calls/maturities that are estimated to be $59 billion in July and another $48 billion in August.

Relative valuations are also seeing noteworthy support from the slowing in the refunding/refinancing cycle.  Average tax-exempt 10 year yield levels during May and June have risen by approximately 30 bps versus rate levels during the first four months of the year.  The higher rate environment was the primary catalyst in slowing monthly refinancings by 37% from April to May.  If rates remain range-bound around current levels or move higher, we should continue to see a deceleration in issuance patterns for rate sensitive supply.  With expectations for favorable supply/demand technicals to continue to develop during the third quarter, we are constructive on the sector and recommend an overweight position to tax-exempts in tax-advantaged accounts.

Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.
This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Puerto Rico Related Headline Risk Slows Buying Momentum in Tax-Exempts

The tax-exempt market continued to extend the sector’s strong first quarter performance, with 10-year yields falling another 23 basis points (bps) for the quarter.  Very favorable supply/demand dynamics continue to be the driving force behind the sector’s performance.  New issue supply continues to run well-below 2013’s pace by 16% or approximately $29 billion.  Demand continues to grow as investors have gravitated to the after-tax attractiveness of the sector, given the 24% increase in the highest marginal tax bracket following the 2013 tax hikes and the addition of the 3.8% Medicare surtax on investment income.  The favorable technical backdrop resulted in 10-year tax-adjusted spreads tightening by 15 bps for the quarter.

However, headline risk returned to the market at the end quarter, led by the credit events surrounding Puerto Rico.  The credit rating agencies put through a series of credit downgrades for Puerto Rican debt following the Commonwealth’s passage of the Puerto Rico Public Corporations Debt Compliance and Recovery Act on June 25, 2014.  The law allows for the orderly restructuring of certain public corporation debt such as Puerto Rico Electric Power Authority (PREPA), the Puerto Rico Aqueduct and Sewer Authority (PRASA) and the Puerto Rico Highway and Transportation Authority (HTA).  The passage of this law, and the sweeping downgrades that followed, created a wave of selling of Puerto Rican debt out of mutual funds and hedge funds that created near-term volatility in non-Puerto Rican debt, as well.  Since June 26, tax-adjusted spreads for the 10-year maturity have widened by 14 bps, as the market absorbed approximately $790 million in mutual fund redemptions in the week following the Fourth of July holiday.

The market now expects that the PREPA credit will be the most likely issuer to utilize the Commonwealth’s restructuring law.  The issuer has had a history of liquidity concerns and the authority has two credit lines totaling $671 million that are due to expire on July 31 and August 14.  These deadlines are due to create a cloud over the market, as more mutual fund outflows are expected to continue until some resolution to this issue has been defined.

Outside of the headline-risk headwinds, technicals remain very favorable for the next quarter and for the balance of the year.  New issue supply is expected to remain well-below historical norms. The primary catalyst for the below-trend issuance will continue to come from the substantial drop-off in refinancing/refunding supply.  With current yields in 10-years 66 bps higher than at the start of 2013, year-to-date refinancings through the end of June have plunged by 31% versus 2013’s level.  Another component of supply that continues to run well-below historical norms is new money financing for infrastructure-related projects. Year to date, this supply has generated $72.7 billion in issuance, which is in line with 2013’s levels.  However, when comparing this level of issuance versus the average from 2002 to 2010, current supply remains approximately 40% below the norm for this category.  With state and local revenue growth expected to remain on a slow growth trajectory in line with the slow growth in GDP, there does not appear to be the budget flexibility to increase spending dramatically to support additional infrastructure spending. Consequently, we expect to see new issuance remain in a muted pattern over the balance of the year that should result in the second lowest issuance cycle over the last 13 years.

Current 10-year tax-adjusted spreads as of this writing stand at 91 bps, which is 32 bps higher than the one-year tightest spread of 59 bps achieved on April 18th. While we view this spread level as attractive going into the highest reinvestment period of the year for coupons/calls/maturities (July 1 through September 1), we will look to maintain a neutral positioning in tax-exempts until the market receives more clarity on the events surrounding Puerto Rico.  If the market continues to see more volatility and potential spread widening resulting from a continued increase in mutual fund outflows, we would view this widening as a potential entry point to overweight the sector.

Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

A Powerful First Quarter Rally – Will It Continue?

The tax-exempt market exhibited a powerful rally during the first quarter of 2014. Technicals were exceptionally strong during January and February, as heavy reinvestment flows of coupons/calls/maturities coincided with a very anemic new issuance cycle.  Municipal 10-year yields during these months collapsed by 37 basis points (bps), which was almost in line with the 38 bps drop in 10-year treasuries. However, performance in March was mixed.  The fixed income markets began accounting for an anticipation of earlier-than-expected tightening in monetary policy.  This pricing was driven by recent comments from Federal Reserve Chairman Janet Yellen.  The results were a flattening of the municipal yield curve, with 5-year yields rising by 31 bps, while 30-year yields fell by 7 bps.

Supply technicals should continue to be generally favorable for municipals.  Year-to-date supply of $62.5 billion is running well below 2013’s issuance by 26%.  The primary catalyst for the downward trend remains muted refinancing opportunities for municipalities.  After the second half of 2013 experienced refinancing declines of 48% versus the same period in 2012, the downtrend has continued in 2014 with declines of 52% versus the first three months of 2013.  With interest rates expected to gradually move higher over the course of the year, this trend is expected to remain in place.

In looking forward over the next quarter, demand should continue to improve.  After the market moves past potential cash-flow needs leading into the April 15 tax-filing deadline, demand flows should see gradual improvement as we move into the stronger technicals that develop around the summer months.  Net supply is expected to decline to a total of -$25 billion during July and August.  Additionally, net supply during April, May and June is expected to reach a total of only +$6 billion, which is expected to be very manageable for the quarter.  As of this writing, municipal 10-year tax-adjusted yield spread levels to Treasuries stand at 91 bps, which still remains modestly attractive, especially when compared to current 10-year taxable municipal spreads of 67 bps.  With a manageable new issuance cycle ahead for the market, we expect municipals to remain in a tight trading range around current levels, before a tightening bias develops as the market moves into stronger technicals starting in late June.

Gregory A. Bell, CFA, CPA
Director of Municipal Bonds

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

 

The municipal sector experienced a substantial amount of volatility over the course of the third quarter. During July and August, 10-year yields increased by 48 basis points (bps), culminating in a 2013 high of 3.04% on September 6, 2013. Most of this sell-off was attributed to increased investor anxiety over the higher interest rate environment, and headline risk resulting from both the bankruptcy filing of Detroit and reported deterioration in the fiscal condition of Puerto Rico. The confluence of all of these events led to a continuation of the heavy level of withdrawals out of mutual funds that the market experienced during the second quarter.

However, over the last three weeks of the quarter, tax-exempt municipals experienced a dramatic turnaround. The Federal Reserve’s decision to postpone “tapering” of its quantitative easing program, along with Larry Summers’ decision to drop out of consideration as the next chairman of the Federal Reserve, started the rally. Additionally, a significant drop in new issuance levels, combined with the extremely attractive relative valuations for tax-exempt municipals, produced significant crossover buying interest in the sector. The increase in demand resulted in 10-year yields falling by 50 bps from September 6 through the end of the quarter. Tax-adjusted yield spreads to Treasuries during this period tightened by 34 bps and stood at 109 bps as of October 1.

At current spread levels, we remain constructive on the market over the next quarter due primarily to an expectation that market technicals should continue to improve through the balance of the year. Although the market has continued to deal with mutual fund outflows that have totaled $41billion year-to-date, these flows have begun to moderate. Weekly-only reporting funds averaged outflows of $1.7 billion from June 5 through September 18; however, over the last two reporting sessions, these outflows have averaged only $424 million.

Supply should also continue to contract and provide support for the market going forward. Even with the recent rally, 10-year yield levels, now at 2.54%, are 74 bps higher than the average yield levels over the first five months of 2013. This higher rate environment should continue to make refinancings look unattractive. Elevated yield levels have already resulted in the June to September monthly average of straight-refinancings to decline by 58% versus the monthly averages during the January to May period. Unless we see a substantial decrease in rates, we expect that the supply cycle should continue to moderate to levels that are well below historical norms. With these positive supply developments, combined with strong seasonal reinvestment flows of coupons/call/maturities expected on December 1 and January 1, we expect to see a continued gradual improvement in relative valuations into 2014.

Written by Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

The municipal market saw a substantial selloff during the second quarter of 2013.  Stronger economic growth during the quarter and increased expectations for the “tapering” of the Federal Reserve’s quantitative easing program fed investors’ concerns over the prospects for higher interest rates. These concerns led to a dramatic Technical-driven selloff, led by a massive $10.5 billion liquidation of mutual fund holdings during the month of June.  Aggressive selling by mutual funds to meet the heavy redemption flow overwhelmed the market, forcing yields higher across the yield curve.  For the quarter, 10-year tax-exempt rates rose by 65 basis points (bps), with 47 bps of this rise occurring during June.

Even with the substantial amount of selling during the quarter, the municipal market began to see some stability during the last week in June.  The backup in municipal rates created substantial dislocations in relative valuations versus Treasuries, resulting in municipal-to-Treasury 10-year yield ratios reaching a 2013 high of 110% on June 25.  That ratio level created an attractive entry point for relative value investors to aggressively rotate into the municipal sector, which in turn helped push yield levels lower by 25 bps from June 26 to July 1.

The late-quarter buying surge should continue into the third quarter. July and August reinvestment flows of coupon/calls/maturities are expected to total approximately $90 billion.  With municipal-to-Treasury ratios sitting well above 100% in most maturities across the yield curve and 10-year municipal tax-adjusted yield spreads to Treasuries at 124 bps, investors should continue to find the sector attractive for further investment.

However, higher-than-expected supply conditions during July may temper expectations for any substantial outsized returns relative to Treasuries during the quarter. The higher rate environment during May and June resulted in a number of new deals being pulled from the market.  New issuance during June was expected to be as high as $40 billion, but because of the rise in rates, only $23 billion was priced. That was a drop of 46.5% relative to June 2012.  Additionally, refinancings/refundings, the largest component of new issuance over the last two years, was down 45%% during May and June versus the same time period in 2012.  To the extent that market conditions are conducive, some of the refinancing supply that was pulled in the second quarter is expected to re-enter the market during July, which would soften the expected net negative supply conditions for the quarter.

Our near term outlook for the sector is for the strong Technical backdrop to support the market for the next several months.  Although, we could see a heavier new issuance cycle develop in July relative to historical norms, demand resulting from high reinvestment flows and attractive relative valuations should lead to gradual improvements in relative performance during the quarter.  However, the positive Technicals that should exist during the third quarter should see a reversal as we enter the final weeks of September and into the fourth quarter.  If relative valuations move to unattractive levels, we will look to reducing exposure to the Municipal sector in tax-advantaged accounts.

Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.