As we close out an extremely eventful year in the municipal market, let’s indulge in a little crystal ball exercise and try to see what the New Year has in store for us. For muni investors, 2014 should bring a fresh mix of risks and opportunities.
It’s fair to say most risks and opportunities will come from the interaction of the following key trends, which we expect will converge in 2014: (1) rising interest rates; (2) rising muni credit concerns; (3) shrinking volume; (4) increased regulatory pressure; (5) increased participation from non-traditional buyers and (6) new technological applications in the areas of disclosure, research and trading. Other market observers have also mentioned a potential “disintermediation” trend away from traditional vehicles (such as mutual funds) toward direct retail, ETFs and separately managed accounts, but the evidence for that remains inconclusive at this time.
Let’s start with the risk side of the equation. From our vantage point, it looks like many of the market risk factors that first reared their ugly heads in 2013 will carry into the coming year.
First and foremost, interest rate risk is back with a vengeance. The secular bull market in bonds came to a crashing end this past May and its fate was further sealed by the Fed’s decision to taper earlier this month. Whether or not a new bear market has started, however, is still a matter of debate. We believe any spike in rates is likely to be short-lived, as rising economic strength here at home may be offset to some extent by weaker economic performance overseas, most notably in Europe. Proclamations about the Great Rotation notwithstanding, the demand for fixed-income investments is not going away any time soon, given our aging demographics, and the new capital rules for global banks are certainly stacked in favor of Treasury bond ownership. All these factors, in our view, will combine to limit any potential rate breakout. Thus, the best case scenario for bond investors going forward should be a gradual and orderly rise in rates, with the 10-year Treasury yield topping out at around 4.00%.
That said, away from the plain-vanilla government market, liquidity risk is very much a rising concern with spread sectors such as corporates and municipals, for reasons we’ve discussed in past articles. Thus, the occurrence of periodic bouts of illiquidity, similar to this summer’s tax-exempt selloff, may become a regular feature of our market going forward.
Arguably, muni credit risk has been back on the forefront for a while, given the market’s “de-commoditization” following the 2008 crisis, but its impact has been muted by the benign rate environment we’ve experienced over the last few years. Indeed, the rising tide of low rates did lift all boats and the smattering of muni bankruptcy filings in 2011 and 2012 were easily dismissed as “one-off” occurrences.
Until this past summer, that is. Since June, the topic of municipal distress and bankruptcy (actual or potential) has captured the media’s attention as never before. The relentless negative press coverage on Detroit and Puerto Rico has scared away muni fund shareholders and, in the process, created a vicious feedback loop on mutual fund redemptions, with selling begetting even more selling.
On the positive side, it appears likely that headline-making Chapter 9 cases such as Detroit and Stockton will reach some kind of resolution over the next few months, hopefully providing much-needed clarity on critical issues regarding G.O. bondholder security and public pension liabilities. On the negative side, the “systemic” issues posed by Puerto Rico will probably come to a head in some fashion or another in the first half of 2014, barring a miraculous resurgence of the island’s economy over the next few months.
Tobacco bonds are another widely-held sector with potential market-wide impact in 2014, should cigarette shipment trends re-accelerate on the downside. This year, the sector has benefited from the positive resolution of the so-called NPM Statute arbitration in favor of the tobacco companies. However, this year also saw a worldwide surge in e-cigarette sales, potentially at the detriment of traditional cigarette consumption (we will examine the e-cig phenomenon in an upcoming article). Our readers will recall that the last major muni selloff back in 2010 was triggered by Standard & Poor’s selective downgrade of the tobacco sector, even before Meredith Whitney gave her now-infamous 60 Minutes interview.
Although the credit outlook for US States has brightened considerably, local governments will continue to struggle with legacy pension and OPEB cost issues and reduced State aid. Although the recent housing recovery will help stabilize property tax revenues, many of the municipalities’ problems can be self-inflicted: for example, many have saddled themselves with some ill-conceived economic development projects such as stadiums or convention centers.
Credit issues aside, it’s likely that the industry will also spend the better part of the new year dealing with regulatory risk, as the broker-dealer community comes to grips with new rules of conduct, particularly with regard to its role as municipal advisors. Street trading desks will also have to learn to live with the recently implemented Volcker Rule.
On the flip side of “risk”, one usually finds “opportunity”. As we’ve said before, 2014 should be “The Year of The Credit Investor”. Without the pressure of putting cash inflows to work, asset managers can finally afford to be discerning in their bond selection and ensure that they are adequately compensated for all perceived risks.
Since we can no longer rely on a favorable rate environment to bail us out of ill-conceived trades, good credit selection will be a critical ingredient to investment success (It always has been, of course, but perhaps more so now than ever). Investors will also have to balance the need for “yield” against the need for “liquidity”. That choice may get easier as absolute yield levels rise, as one does not need to reach down the quality spectrum as much to achieve one’s income objectives. A sound relative value framework, however, will always be required.
We also note that, going forward, “relative value” in munis may also mean “relative value versus other asset classes”, as the appeal of the municipal asset class starts to extend beyond our own shores.
In terms of target sectors, we’d keep an eye on Health Care (still struggling to cope with the State-by-State effects of Obamacare), Transportation (watch those struggling Managed Lanes projects) and, as mentioned above, Tobacco. Puerto Rico paper, of course, could go through another round of volatility before some kind of resolution is achieved.
Distressed investors, particularly those new to the tax-exempt market, should have plenty of interesting situations to look at, although probably not at the scale of a Puerto Rico, as long as they’re willing to roll up their sleeves and learn all the idiosyncrasies of the tax-exempt market. Local government issues will be a prime hunting ground for stressed or distressed opportunities.
Given the constraints of a shrinking new issue market, many market participants will probably look toward technology as a tool to achieve productivity gains while still being able to reduce overhead. We expect new technology to affect all aspects of the muni market’s structure, from improved disclosure to the development of new credit scoring systems. This environment should be more conducive to tech entrepreneurship than at any time over the last five years, particularly if one’s product addresses a critical industry need, such as liquidity or credit research. Again, this is not necessarily a new development, but we see evidence that it may accelerate in the next year.
At the risk of stating the obvious, a muni investor’s success this coming year will hinge on his or her ability to successfully manage many of the risks mentioned above while taking advantage of any potential opportunity. This is never an easy feat. At a minimum, it will require a combination of risk management discipline, an opportunistic mindset and the judicious use of new technology in research and trading.
Until then, here’s to a very successful 2014.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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