Inspiration for quarterly commentary topics can often come from the most unlikely of places. As I sat racking my brain for a fresh perspective on the municipal market, I received a call from a reporter. He mentioned that the people he speaks with regularly seem to have concerns about the municipal bond market. It seems they have all coalesced around everything from credit risk to interest rate risk. Despite those concerns, a record amount of money has poured into the asset class year to date. His question was simple: How do you reconcile overwhelming demand for municipal bonds with the concerns of municipal bond investors?
Interesting question, worthy of a quarterly commentary. Rather than droning on about how interest rates have changed over the quarter, it might be more helpful to take a look at some of those common concerns and determine which are overblown and which investors should be mindful of.
Municipal Bond Supply and Demand
Municipal investors tend to be overly sensitive to supply trends. The common refrain being that a big supply year is bearish for bond prices and vice versa. While that is generally true, it negates the other half of the equation. Demand, not supply, can be a large driver of total return, and that is exactly what the market has experienced thus far in 2019. A record $45 billion has poured into the municipal market since the beginning of the year.
Forty-five billion dollars is a lot of money. So much so, it represents roughly 6% of all assets in municipal bond mutual funds. So much so, that demand, not fundamentals, has been the driver of asset appreciation throughout the year. That should be troubling. As investors, we like fundamentals to move asset prices. If you were to invest in Apple, and Apple sells more iPhones and the stock appreciates, we would consider the stock appreciation to be for the right reasons. When price is driven by factors other than fundamental value, the potential for a reversal tends to be high. We would recommend caution when investing in a market where fundamental improvement isn’t the reason for price appreciation.
SALT and the California Conundrum
At least part of the increase in demand for municipal paper was driven by fears over the SALT deduction cap. Faced with an ever-increasing tax bill, investors in high-tax states flocked to the municipal bond market. In no place is that truer than California. For many investors in the state, investments in the California municipal bond market no longer make economic sense. In some cases, it hasn’t for quite some time. The table below shows the yield for a recent California municipal issuance for Berkeley Unified School District (USD) vs. U.S. Treasury securities in similar years (remember treasuries are tax-exempt at the state and local level but are still subject to federal income taxes).
Bond Yield (%)
|Berkeley USD Tax Adjusted* Bond Yield (%)||U.S. Treasury
Security Yield (%)
*Assumes top Federal tax bracket of 37%
In every instance, the California investor would be better off investing in the U.S. Treasury on an after-tax basis, which assumes the highest Federal tax rate of 37%. Yet, money continues to flow into the California municipal bond market as investors make non-economic decisions. More troubling is the fact that non-economic decision making is not isolated to the California market. Therefore, we would recommend analyzing purchases based on after-tax yields and putting extra consideration in the risks and rewards being taking for each marginal dollar.
Macroeconomics and the Fed
Can you imagine anyone more terrified of a mean tweet than Jerome Powell?
As recently as December 2018, the Federal Reserve seemed bound and determined to push interest rates higher. It took only a few angry tweets and some stock market volatility for a complete reversal of course. Now the world is convinced that not only is the Fed done raising rates, the market is placing a 100% probability that the Fed cuts rates by the end of the year.
Investors may be tempted to take more duration risk based on the prospect of a Fed cut. We would caution against that strategy. If 100% of the market believes an interest rate cut is coming, then it’s likely the information is being priced into the market and any upside associated with that trade has already been exhausted. The real risk is that the Fed does an about face again and rates remain stable. In our minds the duration trade has minimal upside and quite a bit of downside.
The reality is that the macroeconomic situation, at least from a data perspective, doesn’t seem markedly different from December 2018. The U.S. economy just added another 224,000 jobs and unemployment is 3.7%. Not long ago “full-employment” was thought to be around 5.5%.
Assuming the market is correct and the Fed cuts rates, what does that say about the economy? Essentially the Fed is making a statement that the U.S. cannot sustain itself at a 2% 10-year treasury yield. If the economy cannot function at a 2% 10-year, then assets prices are almost certainly inflated and credit spreads in fixed-income markets are way too tight.
Much has been said surrounding the covenant- lite status of recent corporate debt issuance. Less has been said about the phenomenon in the municipal bond market. Credit security packages are getting weaker. Net revenue covenants, liquidity covenants, additional bonds tests and other protections granted to municipal investors are weakening. Anecdotally, we recently looked at a deal for Charleston Area Medical Center. The official statement contained this line:
“By the purchase of the series 2019A bonds […], each holder of the series 2019A bonds will be deemed to have consented to the release of the mortgage in accordance with the terms of the master indenture.”
By buying the bonds, investors were consenting to the release of their mortgage interest in the property. In addition, the official statement clearly dictates that an Event of Default does not occur until Charleston Area Medical Center fails to cover debt service for two years in a row. Essentially, the hospital has to stop paying for two consecutive years before bondholders are able to enforce any remedies.
From a legal perspective this is clearly a weaker credit than it used to be, yet Charleston Area Medical Center was able to issue debt at significantly lower yields than in the past. Much like the Berkeley USD example, this phenomenon isn’t unique to Charleston Area Medical Center. Investors are being asked to take more and more risk for less and less yield.
The municipal bond market is changing. Investors just haven’t realized it yet. Credit is weakening at a time when spreads are tightening. Markets such as California have dislocated from not just other better alternatives, but from reality. The Fed is at best schizophrenic and at worst reacting to the whims of 140 characters. And all the while, money continues to flow into municipal bonds.
At Thornburg we believe strongly in transparency and employ a “know what you own” philosophy. The overwhelming demand for municipal products has made it difficult to find value on a day-to-day basis. In our minds it has led to a mispricing of risk broadly. As such, we are running our portfolios more conservatively. Mindful of the fact that when price and fundamental value diverge there tends to be a reckoning. We are paying attention to all the above, deploying dollars where risk and return are aligned.
More than anything, demand will determine the prospect for total return through the rest of the year. If demand stays strong and valuation high, we will continue to do the prudent thing. Should demand fall off, we are well positioned to take advantage in each of the municipal portfolios.
Thank you for your continued trust.