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FIRST QUARTER MUNICIPAL BONDS UPDATE

Recap

During the first quarter of the year, Treasury rates moved aggressively higher amid improving economic growth and higher inflations expectations. Based on data from Bloomberg, 10 and 30yr rates moved higher by 83 and 77 basis points (bps), respectively, with the overall yield curve from 2 to 30yrs steepening by 73bps. Tax-exempt yields reported by Refinitiv Municipal Market Data (MMD) also moved higher by 29bps, but relative valuations to taxables improved dramatically. Very favorable demand technicals from heavy seasonal reinvestment flows, combined with a very manageable new issue calendar, provided the impetus for substantial outperformance. Ratios of municipal-to-Treasury yields in 10yrs reached a record low of 53.95% in Mid-February, before ending the quarter at a still very expensive 64.3%.

Taxable municipals also performed well during the quarter. In reviewing data compiled by AAM, ‘AAA’ muni spreads to Treasuries moved tighter by 5 to 14bps, with the 30yr part of the curve exhibiting the strongest performance. Improving supply technicals, along with persistent demand, were likely the primary catalysts for the spread tightening. New issuance has been down significantly from the peak of issuance that occurred during the June-to-October 2020 period. Based on data from the Bond Buyer, issuance of municipal-only cusips during that period averaged $16.6 billion per month as issuers rushed to execute deals before the November general elections. Since that time, taxable muni issuance has only averaged $7.8 billion per month. The overall higher rate environment has likely reduced the present value savings of taxable refinancings, which we expect was the primary driver of taxable municipal supply. Additionally, with the Democrats in control of both the executive and legislative branches, there is strong speculation that tax reform will be implemented this year, which is expected to include a restoration of tax-exempt advance refundings. As reported by the Bond Buyer, a bipartisan bill called Investing in Our Communities Act has already been introduced by Reps. Steve Stivers, R-Ohio, and Dutch Ruppersberger, D-Md., and the bill has 21 Democrat and Republican cosponsors. Ruppersberger and Stivers are co-chairs of the House Municipal Finance Caucus. With tax-exempt relative valuations near record levels, we believe the cost savings for executing tax-exempt advance refundings is substantial enough that issuers are expected to wait until this technique is restored to the tax-exempt market before resuming large scale refinancings. 

Credit Tailwinds from Fiscal Stimulus

Policy initiatives are generally expected to be constructive for the municipal market. The first major initiative enacted by the Biden administration was the passing of the $1.9 trillion America Rescue Plan Act (ARP). The legislation provided $350 billion in direct aid to state and local governments. The stimulus was designed to help replace COVID-induced lost revenue, stabilize budgets and restore liquidity. The aid has been viewed as a major credit positive, with Standard and Poor’s subsequently revising their outlooks on the state and local government sectors to stable from negative. Moody’s also revised their outlook to stable from negative, citing the strong fiscal support and stronger-than-expected tax collections. 

Outlook: Heavier Supply Expected During the Second Half of the Year

The next major agenda item for the Biden administration will be the American Jobs Plan, which was introduced at the end of the first quarter. The $2.2 trillion infrastructure package, along with tax-reform within the Made in America Tax Plan, are expected to contain provisions that will affect municipal supply technicals over the balance of the year. Although details are still forthcoming as to the financing structure of the infrastructure plan, news sources reported that the Chairman of the House Ways and Means Committee, Richard Neal, indicated that federally subsidized Build America Bonds will be part of the legislation. The direct-pay bonds, which were used as part of the infrastructure spending initiative under the Obama/Biden administration, were introduced with a federal subsidy of 35%. It is unclear at this time what the overall size of this program will be under Biden’s plan, but the original issuance totaled ~$182 billion of taxable municipal debt over two years, before the program expired in 2010. 

The source of funding for the infrastructure is expected to come from tax-reform measures incorporated within the Made in America Tax Plan. The plan is expected to incorporate an increase in the corporate tax rate to 28% from 21%. The Biden administration estimates that the provisions within the legislation will generate a total of $2 trillion in tax revenue over 15yrs. 

As mentioned earlier in this writing, this tax-reform legislation is also likely to include the restoration of tax-exempt refinancings. Unless we see a substantial weakening in relative valuations for tax-exempts before this legislation can be passed, we expect to see much higher issuance of tax-exempt debt during the second half of the year. 

Another potential tax-reform measure that could be included in the legislation is the repeal of the $10,000 cap on state and local tax deductions (SALT). The cap has been largely felt in high-tax states and many of the representatives from these jurisdictions are making their support of the infrastructure package contingent on the inclusion of the SALT repeal in the infrastructure plan. With thin majorities in both the House and Senate, the Biden administration will have to strongly consider the repeal, even though the reported costs of its inclusion is estimated to be more than $600 billion, based on data from the Tax Policy Center. If the cap is removed, that would reduce the tax burden on wealthier investors and soften the retail demand for tax-exempts at a time when supply could dramatically accelerate due to the potential restoration of tax-exempt advance refundings. 

In terms of demand from institutional investors like insurance companies, the effects of the increase in corporate rates is not expected to materially increase their demand for tax-exempts, in our opinion. In the graph below (Exhibit 1), we highlight the yield curves between taxable municipals, Treasuries and tax-exempts, with yields tax-adjusted using corporate rates of 21% and 28%. We also included the tax-exempt yields tax-adjusted at a 25% corporate rate. At least one senator, Joe Manchin of West Virginia, has expressed a desire to cap the corporate tax increase to a rate of 25%. Under either event in the current yield environment, the additional yield carry of 10yr taxable munis to same-tenor tax-exempts stands at a very compelling 67 and 73bps at a 25% and 28% corporate rate, respectively. Consequently, we expect demand for taxable munis from institutional investors should remain firmly entrenched. 

Exhibit 1: Market Yields as of 3/31/2021

Source: Refinitiv Municipal Market Data, Bloomberg, AAM. *21% Corp Rate Tax-Adjusted at a Factor of 1.1994. *25% Corp Rate Tax-Adjusted at a Factor of 1.2633. *28% Corp Rate Tax-Adjusted at a Factor of 1.316.

While we expect taxable muni supply to move higher over the second half of the year, we continue to expect global and domestic demand for taxable munis will remain intact throughout the year. We also view current valuations for taxable municipals to be at fair value relative to historical spread relationships to the corporate market. Given the substantial yield advantage of taxable munis to tax-exempts, along with the potential for sizable technical imbalances to develop in the tax-exempt market, we continue to advocate a significant underweight to the tax-exempt sector in favor of taxable alternatives across the yield curve.

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Recap

During the first half of the year, the municipal market has weathered a substantial amount of volatility in the wake of the COVID-19 pandemic and the resulting shut-in orders across the country. For tax-exempts, in reviewing data published by Municipal Market Data (MMD), 10yr AAA muni-to-Treasury ratios reached a record 354% at the most severe point of the market dislocation on March 10th. On a tax-adjusted basis using the 21% corporate tax rate, that high point in ratios resulted in muni spreads to Treasuries to hit 256 basis points (bps). These relative value metrics started the year at 75% and -19bps, respectively. Taxable munis, however, were far more resilient, with 10yr AAA spreads to Treasuries widening by 114bps to 168bps on April 10th, using market data compiled by AAM. 

Market Recovery 

Since the worst of the market dislocations, both muni sectors have improved substantially during the 2nd quarter due to policy responses to the pandemic. State and local governments received federal stimulus of ~$235 billion from the CARES Act, with $150 billion of that aid narrowly focused towards COVID-related expenses. Additionally, the CARES Act provided funding for the Municipal Liquidity Facility (MLF) through the Federal Reserve, which provides loans to eligible municipalities. Although this support is not deemed sufficient to mitigate the budget stress from the projected estimates of $500 billion in revenues losses for state and local governments for fiscal 2020 and 2021, the support seemed to be enough to assuage the concerns that massive defaults could develop during the recession.

The more constructive, albeit cautious, tone in the market resulted in stronger demand, which helped drive relative valuations to stronger levels to end the 2nd quarter. As shown in Exhibit 1, for tax-exempts, AAA muni-to-Treasury ratios in 10yrs would end the quarter at 137%. On a tax-adjusted basis (21% corporate rate), yield spreads in 10yrs would tighten by 213bps from their wide point to end the quarter at 42bps. 

Taxable munis also saw very strong performance. From their widest points during the quarter, spreads for AAA’s have contracted by 80bps. Per the graph in Exhibit 1, spreads to end the quarter were at 88bps (i.e., 46bps wider than tax-exempts on a tax-adjusted basis). For insurance companies taxed at 21%, we view this level as attractive and a compelling entry point to add exposure to the basis. 

Exhibit 1: Market Yield as of 7/1/2020

Source: Bloomberg, AAM, Thomson Municipal Market Data. *Tax-exempt rates are tax-adjusted using a factor of 1.19968

Compelling Spread Tightening Potential for Taxable Munis

Although the taxable muni sector has generally exhibited extraordinarily strong demand over the last quarter, spread levels still appear to be a long way off from their pre-COVID trading levels. In the following table (Exhibit 2), we compiled and reviewed the market evaluation levels for representative, liquid issuers across the AAA and AA ratings categories. The listed examples compare issuer yield spreads (i.e., to the interpolated Treasury yield curve) from the end of February to the spread levels for those issuers at the end of the 2nd quarter. For the AAA category, there appears to be an additional 33 to 38bps of additional spread tightening before we capture a full normalization towards pre-COVID trading levels. For the AA category, potential tightening is an even more compelling 44 to 55bps. We find that because of the expected heavy supply of taxable munis this year and its heavy concentration of issuance in the 10 to 20yr maturity range, that this area of the yield curve provides the best value proposition. 

Exhibit 2: Potential Spread Normalization to Pre-COVID Levels

Source: Bloomberg; AAM; ICE Data Pricing and Reference, LLC; Refinitiv

Outlook: Supply Surge Should Provide Ample Opportunities to Add Exposure

As states have come to terms with the new realities of their fiscal condition and as they move aggressively to correct structural imbalances, every tool available to issuers is expected to be utilized. Municipalities have already started laying off employees, reducing services, postponing or cancelling capital spending plans and engaging in deficit financing. With the dramatic drop in Treasury yield levels this year from the Federal Reserve’s substantial easing in monetary policy, state and local governments are also expected to take full advantage of refinancing their debt to achieve substantial savings in debt service costs. 

One of the primary tools towards that end will be to continue to utilize the issuance of taxable debt to refinance tax-exempt debt. At the end of 2017, tax reform under the Tax Cut and Jobs Act (TCJA) eliminated the use of tax-exempt advance refundings. Prior to the TCJA, this process allowed for the refinancing of tax-exempt debt more than 90 days before its call date, but under the new rules, the refinancing can now only be executed in the taxable municipal market. It was not until August of 2019 that Treasury rates were low enough to generate a substantial level of debt service savings to compel municipalities to aggressively utilize this refinancing technique. Based on data published by the Bond Buyer, taxable muni issuance between August 2019 to the end of the year was $50.5 billion, which was an increase of 209% versus the same period in 2018. 

At the start of the year, Treasury yields remained low enough that the broker/dealer community estimated a total of between $95 to $120 billion of taxable muni issuance for 2020, most of which would be tied to taxable advance refundings. To put that number into perspective, according to published data from the Bond Buyer, average annual taxable municipal issuance over the last 8yrs has only been $36 billion per year. The pandemic-driven recession has helped push Treasury rates lower by another 126bps year-to-date, and combined with the recovery in taxable muni spreads during the 2nd quarter, interest savings under taxable advance refundings are even more compelling than they were at the beginning of the year. Consequently, we expect very heavy issuance of taxable municipals over the balance of the year, unless we see a dramatic turn in Treasury rates to higher levels. 

While we view taxable municipals as an attractive sector and we are actively looking at adding exposure to the sector, we are aware that we could see the recent surge in COVID-19 cases lead to more downward pressure on state and local government revenues in the future. Consequently, we remain very cautious in our approach and plan to be very selective in the issuers that we target for investment, with an up-in-quality bias towards those issuers which have exhibited strong liquidity and budget flexibility metrics. 

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Recap

During the third quarter, yields on fixed income assets continued to plunge. The move by the Federal Reserve to cut interest rates twice during the quarter on concerns related to a tariff-driven economic slowdown and volatile swings in the stock market created extremely strong risk-off demand for Treasury assets. Treasury rates fell by 34 and 42 basis points in 10 yr and 30 yr maturities, respectively, during the quarter. Tax-exempt yields followed suit, but as has been the case since mid-May, the municipal market underperformed. Municipal Market Data (MMD) ‘AAA’ nominal yield spread relationships to Treasuries widened out by 13 bps and 12 bps in 10 yrs and 30 yrs, respectively. 

The principal reasons for the underperformance during the quarter have generally been tied to the unattractive relative valuation levels for the sector and a softening of technicals during August and September. As we highlighted in the prior quarter’s commentary, new issue supply during the first half of the year and into July has largely been underwhelming, while the demand for tax-exempts has been incredibly strong. The record level of refundings/refinancings that occurred between 2015 and  2017 created a healthy stream of calls and maturities related to that refinancing activity, and retail investors remain firmly entrenched in reinvesting these flows in the tax-exempt market. That’s been especially true for wealthy investors in high tax states. The tax-reform related cap on state and local taxes or SALT deductions has resulted in increased federal liabilities for these investors, making the after-tax yield profile of tax-exempt assets look very compelling relative to taxable investments. This robust demand profile resulted in relative valuation metrics like 10 yr muni-to-Treasury yield ratios to move to over a 25 yr low of 70.9% during May. The average for this metric is 92% over the last 10 yrs. 

Advance Refundings are Attractive Again

On the supply side, 2019’s new issuance, as reported by the Bond Buyer, has been running at anemic levels for most of the year. Monthly supply exceeded $30 billion only once during the first 7 months, with an average of $27.7 billion per month. The most significant factor driving the low supply  is the dramatic slowdown of refinancings since the passage of the Tax Cut and Jobs Act (TCJA) that eliminated the use of tax-exempt advance refundings. Prior to tax reform, this process allowed for the issuance of tax-exempt debt to refinance outstanding tax-exempt debt more than 90 days before its call date. However, under the new rules, the refinancing can now only be executed in the taxable municipal market. For 2019, the net result of the tax-reform over the first 7 months was a 59% decline in refinancings relative to the same time period in 2017, the last year that the pre-tax reform rules were in effect. 

In general, with taxable rates at much higher levels than nominal tax-exempt levels, pushing advance refundings to the taxable municipal market created a significant impediment to the execution of refinancings utilizing taxable debt. Based on data compiled by AAM and MMD, over the last 15 yrs, 10 yr ‘AAA’ taxable muni yields were higher by an average of 113 bps relative to ‘AAA’ tax-exempt nominal yields, and at the beginning of 2019, this spread relationship stood at 111 bps. However, as rates have plummeted and tax-exempts have underperformed taxables during the third quarter, there’s been a significant shift in this spread relationship during 2019. From the beginning of the year through the beginning of September, 10 yr Treasury rates have fallen by 123 bps, and taxable muni spreads to tax-exempts in 10 yrs have tightened by 32 bps to a spread of 79 bps. The combination of these moves has produced taxable muni yields that are now low enough to prod issuers to become actively engaged in taxable advance refundings. Over the last two months of the third quarter, average monthly refinancing activity has increased by 178% relative to the average monthly issuance over the first 7 months of the year. Similarly, over the same time period comparison, average monthly taxable muni issuance has increased by 232%. 

Outlook

Looking forward, broker/dealer estimates call for an additional $5 to $10 billion per month of increased new issuance supply over the balance of the year, with a large proportion expected to be taxable issuance from advance refundings. With this expected increase, overall taxable muni supply for 2019 is expected to come in at between $50 and $60 billion, which would be the highest level of issuance since the expiration of the Build America Bond program in 2010. The last year of that program helped produce $152 billion in taxable muni issuance, as reported by the Bond Buyer. 

In our opinion, we do not expect this supply surge to have a meaningful impact on taxable muni spreads versus Treasuries. The demand for taxable munis has been healthy all year, with foreign investors finding the yields available in the sector attractive relative to the negative yield environment overseas. Additionally, institutional investors taxed at 21% still find that taxable munis provide a compelling yield advantage relative to similarly rated tax-exempt bonds. As of this writing, ‘AAA’ taxable municipals out-yield tax-adjusted tax-exempt bonds by 59 bps and 55 bps in 10 yr and 30 yr maturities, respectively.

Market Yield as of 10/21/2019

*Municipal Tax-Exempt Yields are Tax-Adjusted using a factor of 1.199367. Source: AAM, Bloomberg, Thomson Reuters Municipal Market Data

Consequently, we are maintaining our negative bias towards the tax-exempt market and continue to advocate a sector rotation trade out of the sector and into taxable alternatives with a more compelling after-tax return outlook. We view one of the favorable sectors to be taxable municipals, and as long as rates remain low, there should be ample opportunities to add to the basis over the balance of the current year and into 2020.

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Are insurance companies missing an opportunity to reduce exposure?

The municipal tax-exempt market has enjoyed particularly strong performance on a year-to-date basis. Through the end of the 2nd quarter, Municipal Market Data (MMD) ‘AAA’ yields have fallen by 65 and 72 basis points (bps) in 10 and 20yr maturities, respectively. Most of this performance can be traced to the strong demand exhibited by the household or retail segment of the market. However, what we have failed to see materialize so far in 2019 is any dramatic shift in institutional demand from insurance companies to take advantage of the increased buying focus across the curve from retail investors. 

Sector rotation trade

As we have noted in prior AAM Insight write-ups, the Tax Cut and Jobs Act (TCJA) that passed at the end of 2017 reduced corporate tax rates from 35% to 21%, and in the process reduced tax-adjusted ‘AAA’ yield levels for insurance companies. Our view at AAM since the law was passed has been to target an increase in after-tax portfolio yields by gradually sector rotating out of tax-exempts and into taxable sectors like corporates and taxable municipals during periods of significant relative outperformance by the tax-exempt market. 

During 2018, we did this by selling into very strong demand inside of 10yrs. At the time, tax-exempt investors were very concerned about the hawkish tone of the Federal Reserve and the course of rate hikes to the federal funds rate. To mitigate that interest rate risk, there was a significant shift toward reducing duration, with demand heavily focused on moving to the front end of the yield curve. The net results of this demand to the short and intermediate areas of the yield curve were exceptional downward pressure on yields, relative valuation metrics moving to extremely expensive levels and a dramatically steep yield curve on both an absolute and relative basis versus the Treasury yield curve. 

Although we reduced a significant amount of our tax-exempt exposure throughout 2018 in maturities inside of 10yrs, the exceptional steepness in the yield curve from 2 to 20yrs provided us with a compelling strategy of maintaining an overweight to maturities 10yrs and longer. Our belief was that investors would eventually identify that the absolute yield levels on the front end of the curve were unattractive and that the compelling steepness in the yield curve would entice investors to move out the curve. 

Market rallies on dovish tone from the federal reserve

During 2019, we continued to reduce exposure as technical imbalances developed on the longer end of the yield curve. Very strong demand extended further out the curve into the 15 to 30yr area on the heels of disappointing economic data and FOMC commentary that they would likely halt further rate hikes for the balance of 2019. 

Additionally, reduced supply was also a major contributor to the rally. Another casualty of the TCJA tax reform was the elimination of tax-exempt advance refundings. This process allowed for the refinancing of debt more than 90 days before its call date. According to data reported by the Bond Buyer, the repeal of this technique reduced overall municipal supply by over $100 billion in 2018 relative to 2017, and 2019 is running at a similar pace to 2018. 

The resulting supply/demand imbalances led to tax-exempt rates falling dramatically across the yield curve. Additionally, the slope of the muni curve from 2 to 20yrs flattened by as much as 35bps on 5/13/19, which also coincided with municipal-to-Treasury ratios in 10yrs falling to an over 25yr low of 70.9%. 

Insurance companies added muni exposure during the 1st quarter of 2019

For our insurance company portfolios, we reduced most of our tax-exempt exposure leading into the heart of these technical imbalances and resulting relative outperformance. However, we have noticed that so far in 2019, both property and casualty (P&C) and life companies have been adding exposure. The Federal Reserve’s Flow of Funds Data reported for the 1st Quarter of 2019 shows that municipal bond exposure increased by $5.3 billion and $3.7 billion for P&C and life companies, respectively. By contrast, U.S. banks, which also saw a drastic reduction in their tax-adjusted yields at the new 21% corporate rate, reduced exposure by $7.7 billion during the quarter.

Federal Reserve Flow of Funds

Source: Federal Reserve

What’s also notable from the flow of funds data is that the retail segment, both households and mutual funds, were drastically increasing exposure during the quarter. With rates falling across the curve, mutual funds and households added $45 billion and $33 billion, respectively. Additionally, it appears that solid retail demand extended into the 2nd quarter. Lipper data shows mutual funds that report on a weekly basis reported inflows that averaged $1.1 billion per week during the quarter. 

Based on the flow of funds data, It appears that insurance companies are missing an opportunity to reduce exposure and to feed the strong demand that‘s currently in the market, especially on the long end of the curve. Historically, mutual funds have exhibited a negative correlation with Treasury yield movements. Treasury rates have fallen over 100bps since October of 2018. If we see a reversal of that rate movement, it’s likely that you could see a slowing in momentum of inflows or outflows develop in the 2nd half of 2019. That could potentially remove a very essential source of demand from the market. 

Additionally, with the strong rally in tax-exempts, the sector continues to look over-valued relative to taxable alternatives. Based on MMD data and data compiled by AAM as of 6/30/19, ‘AAA’ tax-adjusted muni yield levels remains well-through that of ‘AA/A’-rated industrial corporates, with yield spreads in 5 and 10yrs at negative 77 and 85bps, respectively. Relative valuation metrics like muni-to-Treasury ratios in 10yrs have moved higher by 10.3 ratios to 81.2%, since they hit their 2019 low point of 70.9% on 5/13/19. However, that ratio level still appears rather expensive compared to the 5yr average of 90%.

Market Yield as of 6/30/2019

Source: AAM, Bloomberg, Thomson Reuters Municipal Market Data

On the supply side, there’s also the risk that the tax-exempt market could see a much higher supply cycle, if we see a return of tax-exempt advance refundings. A bipartisan sponsored bill to restore this refinancing technique, H.R. 2772–Investing in our Communities Act, was referred to the House Committee on Ways and Means on 5/15/19. There are 9 Democrats and 6 Republicans listed as co-sponsors on this bill. If it were to pass, given the low rate environment and the flattening in the yield curve, we could see a dramatic increase in supply levels that could result in a substantial weakening in relative valuations for tax-exempts. Given the amount of dysfunction between Congress and the White House, it would appear that there’s a low probability of this bill passing on its own this year, but could find firmer footing if there is a change in the makeup of Congress and the Executive Branch in 2021. 

Conclusion

In reviewing the flow of funds data over the last 5 quarters, insurance companies have reduced their exposure to tax-exempts by $43.5 billion to a total of $493.2 billion, which still makes up 12.25% of the overall market. There appears to be a number of persuasive arguments for insurance companies to look at a continuation of reducing exposure further to tax-exempts in the near term. However, given that insurance companies increased their exposure in the 1st quarter of 2019, we are wondering when the actual trading activity and asset repositioning will begin to reflect the compelling sector rotation trade that exists for these investors. 

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Favorable market technicals lead to strong performance and curve flattening bias

Following a strong performance in the fourth quarter of 2018, municipals once again experienced exceptional strength throughout the first quarter of 2019. A combination of weaker than expected economic data and dovish commentary from the Federal Reserve prompted 10yr Treasuries to rally by 28 basis points (bps) during the quarter.  However, most of the positive performance in Treasuries was concentrated in March, with rates in 10yrs falling by 31bps.

Strong and even performance

For the municipal sector, strong performance in the sector was more evenly distributed throughout the quarter as supply/demand imbalances pressured yields lower across the yield curve. Heavier demand was expected as a result of the exceptional levels of reinvestment flows from coupons/calls/maturities, which are at the second highest level of the year during January and February. However, subdued supply levels, both in the secondary and the new issue market, have exacerbated the imbalances that are typically in place during the first quarter.

Secondary supply

In looking at secondary supply, broker/dealer inventory levels to start the year were at very low levels. According to data provided by the Federal Reserve, fixed-rate bonds with maturities 10yrs and shorter were reported 30% below the 1-year average at ~$4.5 Billion. As retail investors early in the quarter were still concerned about the volatility in interest rate levels, demand from these investors remained concentrated inside of 10yrs. That demand helped push inventory levels to a 2-year low of $3.75B on March 6th, and pressured yields lower in 5yr and 10yr maturities by 27 and 18bps, respectively, through the end of February. 

Demand would extend further out the curve into the 15 to 30yr area on the heels of disappointing economic data and FOMC commentary that they would likely halt further rate hikes for the balance of 2019. The resulting Treasury rally and reduced investor concerns about rising rates compelled investor to take advantage of the steepness in the muni curve. Additionally, supply technicals continued to provide support as new issuance levels during March came in at 27% below expectations. Per data reported by Thomson Reuter’s Municipal Market Data, these positive developments lead to 20 and 30yr muni rates to fall by 37 and 38bps, respectively. The rally also resulted in the muni yield curve from 2 to 20yrs to flatten by 25bps during March.

Looking ahead

With the strong performance for the sector, relative valuation levels across the curve now look expensive, especially 7yrs and longer. In both the 10yr and 20yr areas of the yield curve, municipal-to-Treasury ratios ended the quarter at or near 5-year lows of 77% and 93%, respectively. Current supply levels could provide near-term support for these relative valuations levels. Broker/dealer Inventories remain light, with levels for maturities 10yrs and longer ending the quarter down 25% from January 1stand 26% below the 1-year average. Additionally, demand looks very solid. Mutual fund inflows, as reported by Lipper, were running at a record pace during the first quarter, with an average of almost $2 Billion per week. However, with 10yr and longer rates falling by over 40bps during the quarter, we could see a pickup in issuance from refinancing supply during an April-to-June period that historically is the highest issuance period of the year. Our outlook for the sector over the next quarter is to expect some weakness from current expensive relative valuations and we are advocating selling into the current market strength and sector-rotating into the taxable sectors.

Exhibit 1: Yield Curve Slope Analysis

Source: Thomson Reuters, Federal Reserve Bank of New York, Bloomberg, Lipper US Fund Flows

Exhibit 2: 10 Year Municipal/Treasury Yield Ratio


Source: Thomson Reuters, Federal Reserve Bank of New York, Bloomberg, Lipper US Fund Flows

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Economic Outlook

Following two strong quarters of economic activity, U.S. real GDP growth for Q4 2018 and for all of 2019 appears to be slowing towards the economy’s long-term trend rate. On a year-over-year basis (q4/q4), real GDP growth is forecasted to slow from a 3.1% pace for 2018 to 2.2% for 2019. Reduced impact from the tax cuts and fiscal stimulus are reasons for the forecasted slowdown. Consumer spending, which increased around 2.8% in 2018, is projected to moderate to 2.4% for 2019. A strong labor market and rising wages should continue to support spending. Also driving the slower growth projection for 2019 is weaker business spending/investment. Recent declines in business sentiment suggest manufacturers and service-sector businesses are becoming less confident with the economic outlook. Additional downside risks to growth include a Fed policy mistake, slowing global growth, trade tensions, and geopolitical risks. We are calling for below-consensus GDP growth in 2019 as we view the risks to growth as skewed to the downside. We do not expect the U.S. economy to fall into a recession in 2019.

The Federal Reserve seems to have become more dovish as downside risks to economic growth have increased. Recent comments from Fed officials suggest they will be more “patient” with future rate hikes, with Fed policy becoming more data dependent. We believe the Fed will be closely monitoring incoming data for signs of increasing inflation (CPI, core PCE), strengthening labor markets (unemployment rate, wages), increases in market based inflation expectations (forward breakeven rates), and increases in survey based measures of inflation (ISM prices paid, consumer inflation expectations). With economic growth slowing and inflation expected to remain near the Fed’s target of 2%, we expect them to increase the Fed Funds target range one time this year, or 25 basis points.

Treasury yields, according to consensus forecasts, are expected to move modestly higher from current levels. The benchmark 10-year Treasury yield is forecasted to end 2019 at 3.15% based on the median forecast among economists. The yield spread between the 10 year and 2 year Treasury notes is expected to remain in a tight range of 20bps. We are calling for the 10 year Treasury yield to end the year modestly higher but below 3%. Exhibit 1 lists our risks to U.S. GDP Growth, Inflation, and Treasury Yields.

Exhibit 1: GDP Growth, Inflation, and Treasury Yield Risks

Source: AAM

Fixed Income

2018 – Going into 2018 we anticipated the Fed to raise the Funds rate, causing the economy to slow and the yield curve to flatten. The Fed raised the Funds rate by 1.0% with the final nail in the coffin coming in December. We saw the economy slowing in Q4 which, when coupled with apparent Fed indifference to the current state of the economy and the market’s gyrations, caused a significant selloff. In December, equities fell, credit spreads widened, and we finished the year with losses and uncertainty across a number of sectors.

2019 – We expect that the Fed will have significantly less impact on the markets in 2019. Recently, they have indicated more of a “wait and see” approach while the market is pricing in zero rate hikes for 2019. Just as investors could only see bad news after the December 19th Fed meeting, it seems that there is nothing but roses since the new year.

Our expectation for interest rates is that the yield curve will not invert, and 10 year Treasury yields will stay below 3.0%. There are number of risks to this benign forecast that include but are not limited to: failed Chinese tariff negotiations, stalling economic growth in Europe, a hard Brexit, or a spike in wage driven inflation.

AAM expects that 2019 will be a positive environment for spread product and equities. However, given the potential impediments to growth, risk assets are NOT attractive enough to aggressively overweight. We recommend that risk allocations be maintained at a conservative level in order to allow flexibility to add should the markets stumble. Once again, we anticipate individual security selection and a focus on risk will prove to be the right call in 2019.

Exhibit 2: 2018 Returns by Asset Class

Source: Bloomberg Barclays Index Series, S&P 500, Barclays Global High Yield Index, VOA0 (Merrill Lynch Convertibles Ex-Mandatory)

Corporate Credit

2018 was a disappointing year for the markets despite record revenue and profit growth. After a period of credit creation in 2016-2017, the unwind of QE programs and higher rates caused a sharp slowdown in credit creation from both the private sector and central banks in 2018. The Investment Grade (IG) market also suffered from idiosyncratic events related to GE, Goldman Sachs, Comcast, PCG and the tobacco companies. The spread to Treasuries for the IG market (OAS) closed the year 60 basis points wider with BBBs and longer maturities underperforming.

Exhibit 3: Global central bank securities purchases, rolling 12 months ($T)

Source: National Central Banks, Citi Research

We expect revenue and EBITDA growth rates to decelerate in 2019 to approximately 5% and 8% respectively on average. Capital spending is also expected to decelerate to 2-3%. Debt leverage for IG companies on aggregate changed very little in 2018, but given the focus on debt by the equity community and rating agencies today, we expect companies with over-leveraged balance sheets to work more proactively to reduce debt leverage in 2019. However we do not expect this to be widespread since: (1) lower growth rates make it more difficult to reduce leverage organically, as the equity market has become accustomed to companies using the majority of their excess cash to repurchase stock, and (2) historically, the C-suite does not get more aggressive with credit improvement unless the cost of debt approaches the cost of equity, which has not yet occurred. Therefore, we believe material fundamental credit improvement will be challenging in 2019, with companies facing uncertain growth outlooks and higher costs (labor, transport, interest, trade).

From a technical or supply/demand perspective, we expect net supply of IG bonds to be down materially in 2019 due to the high level of debt maturing, and gross debt supply to be down modestly. This environment of uncertainty/volatility does not support increased M&A activity, and despite improved economics from year-end 2017 (i.e., the spread between earnings yield and the after tax cost of debt), we would not expect an acceleration of debt financed share repurchase activity. Therefore, net supply should be related to refinancing upcoming maturities and tendering others. We believe the demand for IG debt could be lackluster again in 2019 due to higher short term rates and the shape of the Treasury curve. Therefore, we expect another year of less supportive technicals.  

Valuations have improved with the IG OAS widening to a point at year end 2018 that reflects an approximate 25% probability of a recession, and the spread premium for BBBs vs. A/higher rated securities widening towards its historic average of 88 bps. Our credit cycle signals related to the shape of the Treasury curve and access to funding have weakened but do not flag the end of the credit cycle. However, given our economic outlook which has risks skewed to the downside, we do not consider current spreads to be “attractive.” Therefore, we would recommend maintaining a neutral position vs. a benchmark in the IG credit sector, investing cautiously in the asset class, preferring shorter duration bonds, sectors with stable cash flows through the economic cycle, and credits we consider to be higher quality from a balance sheet perspective. We have a constructive view on the following sectors: Banks, Pharmaceuticals, Midstream, Capital Goods, Food/Beverage, and Insurance. On the contrary, we are concerned with the fundamental performance of: Chemicals, Cable, Autos, Tobacco, Consumer Products, and lower quality Media credits. It is important to stress that security selection is critical at this late stage of the credit cycle.  

Our market and sector outlooks are supported by expectations of: (1) positive albeit lackluster economic growth in the US and EU (2) geopolitical events (i.e., trade talks with China, a hard Brexit, and Italy leaving the EU) remaining at a simmer point (3) Federal Reserve pausing its rate hike cycle.  If growth disappoints, the biggest upside surprise for all markets would be a reversal in the unwind of various QE programs to support and stimulate growth. We are not assigning a material probability to that in the US in 2019, since the labor market is far tighter than it was three years ago with unemployment below the natural rate.        

Structured Products

With the exception of shorter duration Asset Backed Securities (ABS), structured products performed relatively poorly in 2018.  The prospect of slowing domestic growth and dislocations in global trade caused risk assets to underperform less risky Agency and Treasury securities.  We’re cautiously optimistic that structured securities will perform better in 2019, although we do anticipate a fair amount of volatility over the course of the year.  We expect non-agency mortgage backed securities, Commercial Mortgage Backed Securities (CMBS), and consumer backed ABS securities to outperform lower risk assets.

Agency Residential Mortgage Backed Securities (RMBS) experienced their worst yearly performance relative to Treasuries since 2011 as spreads widened 25bps. Unlike in prior years when Federal Reserve asset purchases materially reduced the available supply of RMBS, balance sheet normalization which began in the second half of 2018, will provide an incremental $170b to $180B of supply which the market will struggle to absorb. Traditionally, domestic banks have been big purchasers of agency RMBS, but with the relaxation of liquidity rules for small and mid-sized banks and since money managers have generally been avoiding the sector, we don’t see the market being able to absorb the supply without some spread concession. In the most recent release of the FOMC minutes there was some discussion of selling securities from the mortgage portfolio, but we do not believe the Fed will follow through with any sales. Given the poor technical environment, we favor allocating investments elsewhere within structured products and to other spread sectors.  

Non-agency RMBS still represents an attractive investment option.  Credit fundamentals in the sector still look very good and since underwriting continues to be very conservative, we anticipate the sector outperforming agency RMBS and to a lesser extent Treasuries this year.  Housing price appreciation should slow to roughly 3.5% as compared to levels of 5% and 6% in prior years; however, we don’t anticipate that it will negatively impact the market. With the consumer being in such excellent financial shape due to low unemployment of 3.9% and wage growth of 3.2%, delinquency and default rates should remain at very low levels.

Commercial real estate fundamentals remain in relatively good shape following multiple years of property price appreciation and domestic economic strength. Conduit CMBS supply is estimated to be $70B this year which should prove to be very manageable including only $7.5B of maturing conduit loans in need of refinancing. Ordinarily this type of environment would lead us to conclude that CMBS spreads should tighten in 2019, however, we see more risk to the CMBS market from global economic risks and trade dislocations rather than technical and fundamental factors. Spreads of senior conduit CMBS securities tend to track single A rated corporate bonds fairly closely and we’re anticipating heightened volatility within the corporate sector this year. We expect spread levels to closely track corporate bond spreads but with slightly less volatility which should allow them to modestly outperform Treasuries and single A corporate bonds. Our investment of choice within the sector continues to be conservatively underwritten single asset transactions with low leverage. As in prior years we remain concerned about the retail sector, particularly regional malls in less populated areas, which must be carefully analyzed in any conduit securitization.

ABS was the only structured products sector to outperform Treasuries last year, and we believe they will outperform again in 2019. Healthy consumer balance sheets due to strong job growth and healthy wage gains will support credit performance. We’ll continue to maintain significant portfolio weightings in the asset class particularly in structures backed by consumer receivables. High credit quality and stable cash flows make ABS an attractive alternative to short Corporate Credit, Taxable municipals and Treasuries. Our favorite sub-sectors continue to be prime and some select subprime auto, credit card, and equipment transactions.

Municipal Market

We are maintaining a constructive bias for the tax-exempt sector. During the tumultuous level of volatility that stressed the capital markets during the latter half of 2018, the municipal sector held its ground and performed very well due to very favorable technical conditions. As we enter 2019, we remain constructive on the sector due to similar themes that are expected to see municipal relative valuations continue to improve, especially in the near term.

Tax-reform will once again play a large role in providing a solid technical environment for the tax-exempt sector. The Tax Cut and Jobs Act (TCJA) that passed late in 2017, eliminated the use of tax-exempt advanced refundings, which is a process that allowed issuers to effectively refinance their debt more than 90 days before the actual call date. Its absence resulted in a year-over-year decline in issuance of approximately $100 Billion during 2018 to $339 Billion and, in 2019, its repealed status will continue to suppress supply conditions. We expect to see only a 10% increase in new issuance to $375 Billion, and that level would be 14% below the average annual issuance produced in the three years before tax reform was implemented.

On the demand side, reinvestment flows of coupons/calls/maturities are expected to remain sizable during the year and provide ample support. The record level of refundings that were executed from 2015 to 2017 is expected to result in a large number of maturities during the year that will lead to net supply levels of negative $69 Billion. Although that’s not as extreme as the negative $121 Billion in net supply during 2018, it should remain as a major underpinning to the sector’s solid relative performance during the year.

In looking at the different market segments of demand, we expect that the muted investment behavior from institutional investors (primarily banks and insurance companies) in 2018 will continue to be in play during 2019. Municipal tax-adjusted yield levels at the new 21% corporate rate remain below that of Treasuries inside of 10 years and are well below that of taxable spread product across the yield curve. The Federal Reserve’s Flow of Funds data reported that banks reduced their exposure to municipals by approximately $40 Billion during the first three quarters of 2018, and we expect to see more right-sizing of institutional portfolios during the course of 2019.

However, we are also expecting the retail segment to remain fully engaged in the market. These investors will be flush with cash from reinvestment flows, and tax-adjusted yield levels for investors in the highest tax bracket of 40.8% (37% plus 3.8% Medicare surtax) look very compelling versus taxable alternatives. At the start of the year, grossed-up yields of tax-exempts were 116 basis points north of Treasuries in the 10 year maturity and were at comparable levels to corporates in maturities 10 years and shorter.

Additionally, we do not expect any headline risk to create selling pressure in the space, as we expect credit fundamentals to remain solid during the year. Individual and corporate tax revenues have been growing at a robust rate during 2018 and are expected to continue going forward. That should bode well for solid fiscal performance for state and local governments.

For our insurance portfolios, we believe that tax-adjusted yield levels remain unattractive versus taxable alternatives. However, the relative slope of the municipal curve remains steep from 2 to 20 years and we view the 11 to 20 year relative curve steepness as attractive. We will continue to look at underweighting the sector into any relative outperformance in favor of taxable alternatives that provide a better after-tax yield profile.

The risks to the upside include:

  • Stronger than consensus economic growth that would lead to even stronger tax revenue growth.

The risks to the downside include:

  • A continued downward move in oil prices could pressure the fiscal performance of the heavy oil-producing states.
  • Sharply higher Treasury rates could lead to heavy mutual fund outflows.  
  • Potential passage of federally-sponsored infrastructure spending that leads to higher-than-expected new issuance.

High Yield

After credit spreads fell to a post financial crisis low in early October, the high yield market re-priced significantly in Q4 2018 with spreads widening 223 basis points (bps). This resulted in returns of -2.08% for that year. To put that in perspective, 2018 marks only the 7th time in 35 calendar years of index data the high yield asset class experienced negative total returns. Broad market yields ended the year at 7.95% with credit spreads at +526 bps, both metrics exceeding their 5 year average. Valuations for the sector have become more attractive given the underlying fundamentals as 2019 default rates are expected to remain below the long-term average.

Exhibit 4: High Yield Market Credit Spreads

Source: Bloomberg Barclays US Corporate High Yield Index

Unlike the investment grade market, high yield issuers have generally deleveraged their balance sheets since 2015, as evidenced by a continued positive upgrade/downgrade ratio and the percentage of CCC rated issuers in the market, which has declined to a decade low at 13% of the index. Further, interest coverage ratios remain high, and the level of future debt maturities to be refinanced is manageable.

Exhibit 5: Default Rates

Note: 2018 data is through November 30.
Source: J.P. Morgan

Technicals for the asset class are supportive as the high yield market debt outstanding has been shrinking since 2016. New issue supply for High Yield was $187 billion or -43% year-over-year which was the lowest volume since 2009. In contrast, the loan market has been a funding alternative for high yield corporates, as issuance of $697 billion ranked as the second highest annual total on record despite a 28% drop from 2017. It bears watching that acquisition-related issuance has drifted higher to 21% of volume, but that level remains below the long-term average of 24% which is well below the highs of over 50% in 2007. Additional headwinds for the sector will likely persist if macroeconomic declines exceed expectations. Increased hedging costs have weighed on foreign demand as US monetary policy has diverged from global central banks, and further rate hikes would likely extend this trend. A recession could also impact valuations as BBB issuers are downgraded to high yield, increasing supply. However, higher yields and spreads overall improve break-evens and provide more downside protection around interest rate risks and potential credit concerns. We continue to believe credit risk is best managed with an active approach that emphasizes credit quality and diversification to reduce risk in portfolios. Long-term investors with the ability to act as liquidity providers to the market during periods of volatility are likely to be rewarded.

Convertibles

While convertibles outperformed most asset classes in 2018, the year is best viewed as two distinct periods – the first nine months of the year, and the last three months of the year.

First quarter 2018 through the third quarter saw a continuation of the longest equity bull market on record, and many convertibles moved further “up the curve” becoming ever more equity-like. However, the market capitulation in the fourth quarter highlighted the lack of downside protection afforded by equity-like convertibles. As some individual stocks dropped by a magnitude of 50% or more, equity-like convertibles linked to those shares fell virtually in lockstep with the underlying stock price.

Balanced convertible portfolios, on the other hand, offered downside protection during the fourth quarter as bond floors held up and provided support.

In the aggregate, balanced convertibles did their job in 2018, providing upside participation as equities climbed during the first three quarters, and delivering downside protection as markets fell in the fourth quarter. Over a complete market cycle – which we have not seen in nearly ten years – we expect the “ratchet” effect provided by balanced convertibles will result in equity-like returns with less volatility.

U.S. primary market activity was strong with convertible issuance of $53 billion during 2018. That made 2018 the biggest year for convertible issuance since 2008 (when issuance was $59 billion). The Technology and Healthcare sectors represented 60% of new issuance at 43% and 17%, respectively.

Convertible issuance combined with the fourth quarter equity market decline allowed us to counteract two fundamental issues associated with the convertible market today: technology sector concentration and equity sensitivity.

The sector breakdowns below highlight the Technology concentration in the broader market (using the V0A0 index as a proxy) versus a balanced convertible composite (using the Zazove Associates Blend Strategy Composite as a proxy).

Exhibit 6: V0A0 Sector Breakdown as of 12/31/18

Source: ICE BofAML Convertible Index Data

Exhibit 7: Zazove Associates Blend Composite Sector Breakdown as of 12/31/18

Source: Zazove Associates

Further, the weighted average investment premium (a measure of downside risk exposure) of the V0A0 Convertible Index is 49.4% versus 20.5% for the Zazove Blend Composite. For investors in convertibles, active management of portfolio investment premium mitigates downside risk and leads to superior risk-adjusted returns over market cycles.

To the extent interest rates continue to increase in 2019, the low duration of convertibles (~2 years or less) will insulate our portfolios from the headwinds typically associated with a rising interest rate environment.

Further, if the fourth quarter of 2018 portends renewed 2019 market volatility that would be a positive development for investors in AAM/Zazove balanced convertible strategies.  As an active manager of balanced convertible portfolios, volatility provides abundant trading opportunities and allows us to rebalance, take advantage of attractive valuations, and continue to optimize portfolios. As an aside, volatility increases the value of the embedded option of convertibles.

The opportunity set and trading environment for convertibles is as strong as it has been in years, and we are excited about the prospects for 2019.

Contributions by:
Greg Bell, CFA, CPA | Director of Municipal Bonds
Marco Bravo, CFA | Senior Portfolio Manager
Scott Edwards, CFA, CPA | Director of Structured Products
Elizabeth Henderson, CFA | Director of Corporate Credit
Reed Nuttall, CFA | Chief Investment Officer
Scott Skowronski, CFA | Senior Portfolio Manager
Stephen Bard, CFA | Chief Operating Officer, Zazove Associates
Gene Pretti | Chief Executive Officer, Zazove Associates