June Monthly Review

2017 Mid-Year Muni Market Review:

We are half way through 2017, and the muni market appears to be living a charmed life. Total returns are near the top of US fixed income markets (without adjusting for taxes), tax reform seems to be a mute issue, and credit concerns a non-factor.

We figured this would be a good time to sit back, reflect on the first six months, and then look ahead to the final six. Join us for a short summer break and let us see what is in the muni picnic basket.
Muni Market Review:

By month-end, the municipal market slightly outperformed the taxable market. The overseas fixed income market reacted to the announcement that the ECB would be transitioning from a loose money policy to a tight one in the coming years. Muni supply/demand technicals help keep muni rates from rising as much as the taxable rates. Highlights from June are as follows:

Muni rates changed from 13 to 5 bps, with the curve flattening 8 bps.
Taxable rates changed 13 to 11 bps, with a 2 bps flattening.
To date, 2017 issuance is lagging 2016’s record levels by 15% and continues to lose pace. Refunding volume is down 26% (due to the rise in interest rates), causing overall issuance to be down; new money deals are on par with 2016. We anticipate a pick-up in issuance late third quarter and discuss this more in the monthly credit review.
Relative value can be found 15 years and longer on the muni curve, with 10 years and shorter being rich.

Total returns for US fixed income markets show munis at near the top of the class. Year-to-date returns for the various Barclays indices are as follows:

Barclays Index	YTD–Total Return
Municipal	3.57%
US Treasuries	1.87%
US Agencies	2.07%
US Corporates	3.79%

Puerto Rico continues to wreak havoc with year-to-year default comparisons for the muni market. MMD default statistics for 2017 show the following:

In 2017, 20 issuers defaulted for a total par amount of $18.56 billion. On a rough count basis, $16.5 billion of the 2017 total is from defaulted Puerto Rico issuers. That leaves $2 billion in non-PR related defaults year-to-date.
Year-to-date in 2016, 34 issuers defaulted for a total par amount of $5.97 billion. Total amount defaulted in 2016 that is non-PR related was roughly $3.9 billion in par.
It appears the pace of non-related PR defaults is on pace with 2016 & 2015 levels.

Market News & Credit Update:

Illinois was not alone, there are 15 other states trying to complete their budgets before the July 1 deadline. States such as Alaska, Connecticut, New Jersey, and Pennsylvania, are all trying to bridge large budget gaps. Delaware, Maine, Minnesota, New Hampshire, North Carolina, Ohio, Oregon, Rhode Island, Washington, and Wisconsin are also trying to get agreements done.
Ok, maybe we were a little early last month blaming California for the upcoming recession. After a drop of revenues of 6.2% in April, May’s revenues exceeded forecasts by 2%. After eleven months, year-to-date revenues remain marginally higher than last year. So much for an upcoming US recession.
Has climate change risk finally become a credit factor in the municipal market? There have been recent publications citing concerns with the credit outlook on some coastal towns, due to potential flooding from rising seas. The market has always viewed coastal issuers with caution, as they are prone to storms and hurricanes. This recent climate change concern has some investors looking to avoid some AAA rated New Jersey coastal towns.

June 2017 Monthly Credit Review – 2017 Mid-Year Review

The first 6 months has been a wonderful sunny stroll through the muni countryside. It has almost been as if the muni market dialed up the investment weather. So let’s take a short break and review the last six months and look ahead to the next six. We will take our picnic basket, roll out a blanket and see what we find inside.

Is the Market Overcooked?
The fixed income markets have rallied since year-end, and as we reach the hot summer months. Is the market getting overheated?

MUNI TOTAL RETURN PERFORMANCE

It was at this time in 2016 that the seasonal technicals helped munis reached their lowest yields of the year.

Change in Yields bps	10 Yr Muni		25 Yr Muni	10 Yr Treas	30 Yr Treas
12/14/15-6/27/16	-0.66	-0.82		-0.78	-0.68
12/16/16-6/23/17	-0.62	-0.53		-0.44	-0.46

BUT… we do feel that political risks are growing as some states continue to disappoint on credit news and this, at some point, will impact prices. We anticipated that munis would perform well in 2017, and still feel that will be the case by year-end. We just don’t see the technicals and credit news to remain consistently positive all year long. We feel there could be a good buying opportunity before year-end.

Is the Muni Yield Curve Toast?

The callable nature of the muni curve keeps it from inverting and historically has been challenged to keep pace with a flattening US Treasury curve. At this time, the muni curve is flatter than average, but its recent performance is a little baffling. Over the last year, even with the Fed tightening three times for 75 bps, the muni curve has performed counter to the US Treasury curve. The Treasury curve flattened roughly 25 to 33 bps, the muni curve has steepened 17 to 20 bps.

Muni Yield Curve	10 Yr Avg	6/30/16	Current	1 Yr Change
2-5 Years	.67	0.31	0.28	-0.03
2-25 Years	2.74	1.50	1.67	0.17
5-25 Years	2.07	1.19	1.39	0.20
10-25 Years	1.09	0.65	0.77	0.12
US Treas Yield Curve		6/30/16	Current	1 Yr Change
2-5 Years	.85	0.42	0.42	0.00
2-30 Years	2.28	1.71	1.38	-0.33
5-30 Years	1.42	1.29	0.96	-0.33
10-30 Years	.77	0.82	0.57	-0.25

This is a roughly 50 bps underperformance of the long-end of the muni curve. This places the long-end of the muni curve as the best relative value, but at historically low rates.

BUT… do we think the curve has flattening in the near future? Possibly a little bit more, but with prospect of the Fed not moving for a while, or never, and a possible pick-up in issuance during the second half of the year, further muni flattening appears to be “toast”.

Illinois Fried Chicken:

The State seemed poised to have its bond rating cut to junk bond status then, at the final hour, the Illinois Legislature overrode the Governor’s vetoes and enacted a $36 billion fiscal 2018 budget and a $5 billion income tax increase. The action ended an unprecedented two-year budget impasse. The details are still to follow and there are many questions that still need to be answered. The ratings could still be cut if the budget is not sound and realisitic. The municipal market has already priced the downgrade in (bonds trading +200 to 250 bps higher than high rated states), and it appears conservative investors have sold out of their positions. If a budget is not sound and the ratings are cut, we do not expect much of a market reaction nor any issues with debt service payments being made.

BUT… this does not mean we do not feel there is pending muni market risk at some point from the state. We feel the state is still playing a game of chicken politics. It has $14.6 billion of unpaid bills and that total is growing. This means there are state agencies and municipalities that are having budget problems because the state owes them money. Neither political party is willing to compromise, as they continue to wait for the other to blink. At what point does this game cause legislation or actions that compromises an issuer’s ability to meet its obligations? If this happens the muni market could reprice “political risk” throughout the industry.

The Puerto Rico Pickle:

Yes, there are still Puerto Rico bonds in the muni market and yes, they are still going through bankruptcy. Puerto Rico has defaulted on General Obligation payments in 2016 and again in 2017, saying they need the money for day to day government services on the island. Most recently, even the sales-tax bonds debt service payment was suspended.

BUT… since we first forecasted the default of Puerto Rico in May 2015, no one has a clue what is going to happen. The PREPA Restructuring Support Agreement (RSA) has been extended numerous times since initiated in February 2016 and was to be a blueprint for restructuring the debt for Puerto Rico issuers. It now appears to have expired and negotiations are over. Most recently the Federal Government has set up a committee of five judges whose job is to mediate settlements with creditors. Those who do not take part in the settlements, most likely will give PR the authority to impose losses unilaterally. We called this the wild west of municipal bankruptcy when we first reviewed in June 2015. It has not let us down, and we still don’t know what to expect.

Where’s the Beef? – Muni Issuance is down:

Issuance is down, but we feel may be on the edge of picking back up. Year-to-date issuance is down 15%, due mainly to low advance refunding. The lower issuance has helped munis perform much better than expected. The decrease in issuance is due to rates being higher and refunding math not working. Another factor that has hurt refunding is that the Fed shut the SLGS window in March until September. This is the primary means for municipalities to comply with Federal tax laws against arbitraging when investing cash proceeds from the issuance of bonds. The window was shut because it had met its debt limit.

BUT… rates are now lower, helping the refunding math and, when the window opens in September (if rates are still lower) we could see a big pick up in refunding and therefore issuance. Analyst are cutting their estimates for 2017 by roughly 10%. This does not seem big, but it’s all about the timing and fund flows.

Conclusion:

It looks like a mixed basket of goods year-to-date, with good muni performance, but some items that don’t look very appealing that still need to be digested. MainLine is approaching the third quarter with caution, and we do not mind recommending investors stay in cash and earn 85 to 95 bps tax-exempt. This is 25% of the 3% being paid on long-term 5% coupon bonds, but with no price risk. Time to sit back, put on the sunscreen and wait for the storm, or the ants to ruin the picnic. BUT, why worry about that now and ruin the muni glow?