Municipal Market Review October 2017 – Credit & Coupons:
The muni outperformance music is still playing, and seems to have pick up a new beat. The market has become more comfortable with what we see as building credit concerns. Credit default swaps for the “bad boy” states have tightened significantly year-to-date, and along with them bond performance has been good. This just adds to our list of concerns for the market, and our continued advice to stay in 7 day floaters earning 80 to 90 bps.
This month in our credit review, we look at round three of our “which coupon is best for you” study. We present a time-series analysis on OAS (Option Adjusted Spread) and total return results for 5%, 4%, and 3% coupon bonds over six-month and life-to-date time frames. The data is starting to help us reach some conclusions that we feel fits with our general understanding of bond performance in the muni market. How does a coupon help determine the performance of a bond? We will share a few ideas with you this month.
Muni Market Review:
The muni market was virtually unchanged during the month of October. Once again munis outperformed taxables, and once again issuance continues to lag expectations and 2016 levels. Highlights of October are as follows:
- Muni yields were up 7 bps (5 year) to 0 bps (25 year) with the curve flattening.
- Taxable yields were up roughly 9 to 6 bps.
- Year-to-date, muni issuance is still lower than expected and our forecast for a quick pick-up has not been realized. Issuance remains down 17% from year-to-date 2016 levels.
- Credit default spreads for the “bad boy” states are showing what we feel is a blind obedience to muni credit quality. In or opinion, the credit outlook for each of these has not changed, but the spreads would tell you different. More specifically credit default spreads have decreased year to date by the following:
|
New Jersey |
40% |
|
Illinois |
16% |
|
Pennsylvania |
28% |
|
Connecticut |
33% |
We are getting worried that the muni market is looking at any news as good news from a credit perspective. It is losing sight of some bigger more concerning trends that are not changing. Pension problems, rising costs of healthcare, the need for infrastructure, and slow to flat tax revenue growth are not good trends. This miss pricing of credit risk, and what we feel could still be a pick-up in issuance between now and year-end, is keeping us defensive. We continue to recommend 7 day variable rate obligations earning 80 to 90 bps.
Market News & Credit Update:
- The city of Hartford Connecticut, the state capital with an aging population, essentially no commercial tax base, and already dependent on state aid, looks as though it will be saved from defaulting on its debt by the state. Connecticut will provide additional tax revenues, eliminate transfers from the city to the state, and provide credit support for $20 million in bonds which will be used to pay off current bills. This should provide Hartford time to try and make changes to reverse the fiscal deterioration of the “insurance capital of the world”.
- The state of Illinois in October issued $4.5 billion in bonds from 5 to 15 years, with maximum yields of +185 bps higher than AAA rated issuers, but it was “warmly” received by the market. The state is rated BBB+/Baa3 and needed the funds to pay off over $16 billion in overdue bills. We still do not feel there are any real signs of credit trend improvement that makes these bonds a great bargain and did not place any customers in them.
- The Commonwealth of Pennsylvania has finalized its budget and it is getting mixed reviews. The budget uses money from the 1998 tobacco master settlement, transfers dedicated funds to the general fund, and relies on revenue from the expansion of gambling in the state. Although the budget appears to be balanced, it’s use of one-time reserves and lack of natural revenue growth remains a long-term credit concern for the Commonwealth.
What’s Your Coupon of Choice?
This is round three of our “which coupon is the best for you” study. We first published this analysis in our monthly review for October 2015, and then updated it September 2016. We review it again and continue to look at the trend of the performance of the various coupons as time goes by. Our objectives for this study remain the same:
- Which coupon prices cheaper using OAS (Option Adjusted Spread) analyses, and how does this affect the bond’s returns?
- Which coupon shows the best return in the short-run (6 months) as it gets acclimated to the market, and which coupon preforms the best over the long-term (life of bond)?
Refreshing the Background Data:
We understand investors have different investment objectives and, for some of them, this includes coupon preference. For this study, assuming the investors does not have a coupon preference, we step back to look at how the coupon impacts the bonds return. From there, we identify which coupon fits which type of investor.
We continue to age the same bonds from the first study, as I believe a time series analysis comparing the total returns and OAS’s (see appendix for description of this analysis) on different coupon bonds from the same issuer with roughly the same maturities is the only way to see the performance characteristics of a coupon. Currently, the database we are following and in this review include the following:
- 25 bonds with 5% or greater coupons
- 19 bonds with 4% coupons
- 6 bonds with 3% to 3 5/8% coupons
Data Review:
Below is a chart with the findings for bonds we started tracking in the spring of 2015 thru September 2017. There are 50 bonds: 25 of the 5% cpn or greater, 19 of the 4% cpn, and 6 of them have coupons ranging from 3% to 3.625%. Chart #1 shows the change in OAS and total return for the life of the bond. This shows the long-term performance of the coupon. Chart #2 shows the same bonds, but the change in OAS and total returns for just the first six months after issuance.
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Chart #1 –Life of Bond |
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||||
|
Cpn |
Purch Yield |
Beginning OAS |
Current OAS |
OAS Change |
Total Return as of 9/29/17 |
|
5% or greater Cpn |
3.29% |
112 |
97 |
-15 |
4.53% |
|
4% Cpn |
3.51% |
104 |
88 |
-16 |
4.40% |
|
3% to 3 5/8% Coupon |
3.61% |
89 |
88 |
-1 |
1.10% |
|
Chart #2 – First 6 Month Horizon |
|
|||
|
Coupon |
Beginning OAS |
Current OAS |
OAS Change |
Total Return |
|
5% or greater Coupon |
112 |
111 |
-1 |
5.23% |
|
4% Cpn |
104 |
97 |
-7 |
6.59% |
|
3% to 3 5/8% Coupon |
86 |
105 |
16 |
-2.23% |
Observations/Conclusions:
5% coupons consistently priced cheaper on an OAS basis than 4% or 3% coupons, and it appears over time are outperforming. Looks like it may be the best coupon for a buy and hold strategy.
4% coupons show strong 6-month performance, as it gets acclimated and marked-up in the market but as time goes by it appears it may be impacting its total return versus the 5% coupon. The 4% bond does provide a higher yield at issuance, but over time this is not enough to offset the additional coupon of the 5% and its pricing performance. 4% coupons look like the classic buy and mark-up bond for a short-term total return trading strategy.
3% coupons prices the richest on an OAS basis, and now looks like the clear underperformer. This coupon looks like it may be best to trade as it falls in and out of favor. Total return dynamics don’t look good, and first 6 month of issuance doesn’t show well as the market acclimates the bond.
We will continue to follow this coupon study and see how the results look in another year. We understand that this study is not all inclusive and there are a lot of factors that can influence a bond’s return. It is intended to be more of a point of discussion and generality than our way of telling you our investor “what is your best coupon”.
Appendix:
Option Adjusted Spread Analysis (OAS):
OAS is a common analysis that allows fixed income managers to price the value of a bond after adjusting for the probability it being called. It uses an option-based pricing model to calculate the value of the call risk in basis points. More specifically, it identifies the basis point spread a bond is earning above and beyond an AAA non?callable bond (with the same maturity) after taking out the cost of call. Another way to look at it is to view it as the credit spread of the bond versus an AAA?rated bond. The higher the OAS, the more yield being earned by the investor that can be associated with credit risk and not call risk. Therefore, in analyzing two bonds from the same issuer, the OAS (credit risk) should theoretically be the same. If the OAS is di?erent between bonds, then an investor can assume the value of the call risk between the two bonds has been priced incorrectly. When comparing two bonds, the bond with the higher OAS is considered the cheaper bond (more basis points of income for the same credit risk).