Muni market participants returning from the Labor Day weekend were greeted by two important market developments: one that could have important implications for future market liquidity, the other the culmination of a ground-breaking credit event.
First, even after intense lobbying efforts on the part of the industry, municipal securities failed to qualify as high-quality liquid assets under a new federal liquidity coverage ratio rule slated to take effect on January 1st. However, the Fed did take a rain check on this issue and promised to revisit it at a later date. In the meantime, this may create a problem for banks with significant muni holdings. While we don’t expect banks to retreat from owning munis, it certainly would behoove them to accurately assess the risk/reward equation from their muni exposure going forward.
Detroit’s historic bankruptcy proceeding is also entering its final stage, or at least we hope so. The City’s confirmation hearings started this week, thirteen months after its Chapter 9 filing. Although Emergency Manager Kevyn Orr has been able to work out settlement agreements with most of the City’s creditors, bond insurers Syncora and FGIC remain the most vocal opponents to the City’s bankruptcy exit plans, arguing, as we did a few months ago, that the whole thing amounts to nothing more than “GM Redux.”
Given current concerns about a “credit bubble” in the high yield (HY) corporate bond market, we’ve been asked to assess the outlook for their tax-exempt counterparts. To us, many of those concerns don’t really apply to high yield municipals, at least not at this time.
Don’t let favorable market technicals lure you into complacency …
First, in contrast to corporates, most of the major HY muni sectors are not particularly dependent on macro factors, such as the Fed’s easy money policy (senior housing may be the only exception, as the sector does depend on a stable housing market). Secondly, HY issuers in the tax-exempt space have simply not taken advantage of the current low rate and more “relaxed” credit environment, so talks of a ’bubble” seem hardly appropriate here. Thirdly, in our view, the appeal of the HY muni asset class is the very fact that it is comprised of disparate sectors, all marching to their own drumbeats, leading to pricing inefficiencies that can be captured through canny research.
In fact, Barclays reports that the ratio of its Muni HY Index currently stands at 125% of its Corporate HY Index. In other words, you’re actually getting the tax exemption for nothing, even after taking account differences in maturity structure and liquidity characteristics between the two sectors. Needless to say, the case for HY munis is even more compelling on a tax-adjusted basis.
Last but not least, if you buy the premise that the U.S. is the only developed economy in the world to display any kind of positive growth at this time, then the high yield muni asset class is the ideal vehicle to gain exposure to U.S. domestic credit.
Don’t let favorable market technicals lure you into complacency, however. In fact, we would argue just the opposite: this is the ideal time to “know what you own” and to get rid of all the dogs in your portfolio, while the market is still hungry for paper and the bid side is still strong. Many HY names display what we call high “premium risk” at current yield levels, as holders of PR paper have learned (quite painfully) over the past two years. At the first sign of serious credit problems, HY issues will go from trading on a yield basis to trading on a dollar price basis and the resulting price decline could be very significant.
Let’s take a look at the historical performance of HY munis as an asset class. Again, based on data compiled by our friends at Barclays Research, as of August 31, the tax-adjusted annualized return for high yield munis over the past 3 and 5 years came in at 13.1% and 14.6%, respectively, exceeding most other fixed-income asset classes (including corporate HY) and trailing only equity market indices. Needless to say, this is quite a remarkable feat given that all said equity indices have been hitting historical records in recent weeks. It’s even more remarkable when you consider that this period saw the entire Puerto Rico bond complex migrate into the high yield universe.
Impressively, HY muni returns have also shined on a risk-adjusted basis, i.e., with significantly less volatility than equity index returns. To wit, over the last 10 years, tax-adjusted HY muni returns only exhibited an annualized standard deviation of about 8%, compared to 11% and higher for most equity indices.
What about the individual sectors within the high yield space? Year-to-date, the four top-performing sectors include: water & sewer (+20.3%, perhaps reflecting the performance of Jefferson County bonds); HY Tobacco (+15.3%, a complete reversal from -11.6% in full year 2013); special tax (+14.4%); industrial revenue bonds (+13.9%) and hospitals (+11.8%). The worst-performing HY sector? Electric utilities at minus 11.8% (thank you very much, PREPA).
Going into the fall, we would expect the market’s credit spotlight to start shining more brightly on a couple of problem areas: the States of Illinois and New Jersey.
Speaking of which, the Puerto Rico sector is, for all practical purposes, the entire high yield muni market at this point. In light of this year’s drastically reduced new issue volume, the bond funds are very reluctant to trade any of their high yield holdings for fear of not being able to replace the income. Which leaves PR bonds as the only sector of the market with any trading flows and “liquidity”. Here too, the Barclays index return data is revealing. After suffering through extreme pressure in July, the PR bond complex rebounded strongly in August, posting a 9.50% positive return year-to-date after a dismal -20.8% last year. PREPA bonds also rallied in August, following the Authority’s successful forbearance negotiations with its creditors.
At this point, it’s probably unrealistic to expect further significant gains in PR bonds until the Island’s economy shows signs of turning around. On this front, we may have to wait a while longer. The GDB’s Economic Activity Index (EAI) for July was released on Friday and it showed yet another year-over-year (YOY) decline of 0.7%, a slight improvement from -1.0% for June. Three out of the four components of the Index showed YOY declines: electric power generation -0.2%; gasoline consumption -7.2% and cement sales -6.9%. Total non-farm employment was essentially flat with a small increase of +0.2%.
As you may recall, PREPA has agreed to name a Chief Restructuring Officer by next Monday, September 8. At this writing, we’re being told that the Authority’s board has already selected Lisa Donahue from AlixPartners, a utility turnaround expert, for this critical role. Ms Donahue’s credentials are certainly impressive and, as far as we can tell, this does look like an excellent appointment. We also think the PREPA board was smart not to pick from the ranks of its current restructuring advisers, such as FTI and Millco.
Looking ahead to the rest of the year, we would expect PREPA to recede somewhat from the headlines, if only on a temporary basis, as the utility works through its restructuring plan. Of course, the current forbearance agreement with all the creditors is a tenuous one at best, and it can certainly blow up at any point in time. And then there’s PRHTA, another credit time bomb that will need to be addressed soon.
Going into the fall, we would expect the market’s credit spotlight to start shining more brightly on a couple of problem areas: the States of Illinois and New Jersey.
These two beleaguered State credits are starting out from very different points in the credit spectrum. According to Municipal Market Data (MMD), spreads on 10-year Illinois GOs have steadily widened from +105 in early April to about +155 currently, after peaking at +172 in mid-August. At current spreads, the Prairie State is already trading as a BBB name, so the question is whether all the bad news is already priced in. We suspect it mostly is, although investor perception could certainly deteriorate further as campaign rhetoric ratchets up going into November. So far, the Illinois gubernatorial race looks like a dead heat and, if history is any indication, things can only get more intense as we come down the home stretch. For Illinois investors, the fate of the income tax surcharge and its potential effect on the State budget hangs in the balance.
New Jersey GOs, on the other hand, are still trading at fairly lofty levels (+40 to the 10-year AAA scale, the last time we checked) so they still have, in our view, a fair amount of downside. We do expect to spend much more time on the Garden State’s credit outlook over the next few months.
As we head into the home stretch for what has been another tumultuous year, the fall season promises to feature new credit challenges and of course, new opportunities.
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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