September Monthly Review

September 2017, Muni Market Review – Hurricane Muni

No, a tropical storm is not raging in muniland, but we do see dark clouds growing.  The strength of the underperformance we expect is still out to sea and gaining strength.  Munis performed well versus taxables in September, but we are now in the seasonally weak time of year, and the conversation of tax reform is in the air.

How has the muni market handled natural disasters in the past – more specifically, hurricanes? In light of the recent devastating hurricanes to hit the mainland, we thought we should look back on how the muni market has dealt with natural disasters.  We will look at what the impact could be on the market, issuers, Puerto Rico, and how to better prepare you portfolio for future natural disasters.

 

Muni Market Review:

The municipal market as now made it five months in a row of outperforming its taxable equivalents, but only slightly. This market review is starting to get rather repetitive, but we think that is about to change. Once again, highlights of muni performance for the month are as follows:

  • Tax-exempt yield curve flattened, with yields rising from 23 to 13 bps. Taxable yield curve has changed from 24 to 10 bps.
  • Year-to-date date, 2017 issuance is lagging 2016’s record levels by 16% with refunding off 28%.
  • Credit default spreads have declined a bit, as New Jersey & Illinois spreads have lowered after having put forth a budget that made investors more comfortable with their credit quality.
  • 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, 53 issuers defaulted, for a total par amount of $33.33 billion. Year-to-date in 2016, 44 issuers defaulted, for a total par amount of $23.17 billion

We continue to be bearish over the next 30 to 60 days for numerous reasons, as we discussed last month, as the trends have not changed:

  • Issuance is increasing and refunding deals should pick up. This is at a time when supply/demand technicals are now seasonally negative for the market.
  • Tax reform looks to be muni neutral, but we are only at the beginning of the process. We are one late night tweet away from muni concern.

 Market News & Credit Update:

 Munis and Tax Reform? Everyone in muniland feels that the exempt status on muni income is safe, and any of the potential changes in tax rates will not have an impact on valuations. The bill states that most deductions will be eliminated, but specifics are not provided. That sounds like too much confidence in an administration and Congress that has yet to earn it. Watch your twitter account!

  • Joy in Illinois? – After finally passing a weak budget, the State has enjoyed a sharp drop in its bond yields. There has been roughly 150 to 200 bps drop in the spread between the Commonwealth’s bonds and the AAA muni index. Plans to issue $6 billion in bonds to help repay over $15 billion in unpaid bills are on track for the next 60 days.
  • The Commonwealth of Pennsylvania was downgraded from AA- to A+ by S&P. The chronic structural imbalance for over a decade continues to weaken the State’s financials. It remains stubborn to make the cuts it needs to make, or raise taxes increase revenue. Outlook is now stable, but not so sure it will still be that way is they do not change how they do business.

 Hurricane Muni:

After the recent damage done by two of the largest hurricanes in recent history, Harvey and Irma, we decided it may a good time to review the potential impact of natural disasters on the municipal market, the issuers, and review what an investor can do to help minimize their impact on their portfolio.

History would suggest that the impact would be minimal, with some issuers more affected than others. Moody’s has recently announced that a natural disaster has never led to a municipal default over at least the last 75 years.

Impact on Issuers:

Ultimately, most issuers will receive aid from FEMA (Federal Emergency Management Agency).  The timing of this aid is what is important.  If it is delayed, the municipalities may need to find monies to meet immediate concerns. If the US Government can act quickly, then this helps ease any liquidity concerns. In fact, an S&P study looking at the impact of the three previous largest storms to hit the US showed that issuers that were already under review for downgrade usually were downgraded after the storm.  Those that were stable or improving, the storm had no impact on their credit ratings.

Impact on P&C Muni Holdings:

Property and Causality Insurance firms invest in municipal bonds.  If they need to pay out insurance claims, would the act of selling munis to raise cash hurt the market? Historical holdings by P&C companies of munis does not show a drop in assets the year after a major storm.

 Impact on Puerto Rico?

Already in bankruptcy process, Hurricane Irma caused severe damage to the infrastructure of the island.  If aid is delayed, a complicated settlement with creditors will get a lot worse.  If the aid is provided quickly, we think this could help the long-term prospect of Puerto Rico bonds.  The island will be able to rebuild and improve is service infrastructure (water, power, sewer). It will also provide funds for construction, which should boost the local economy.  We are not recommending our clients buy Puerto Rico bonds at this time, as they are highly speculative, but we are a bit intrigued with the possibility of their performance going forward.

Impact on Revenue versus General Obligation bonds:

Revenue bonds can be a bit more of a concern regarding short-term liquidity problems due to a natural disaster. If the issuer’s operation is hit hard and there are no other options available (for example a single source small town electric utility provider) short-term liquidity could become a concern. The issuer’s ability to assess the damage, analyze cashflow needs and the time it will take to get back on line, could determine the ability to meet debt service requirements. 

General Obligation bonds impacted by a natural disaster, the concern is more focused on the impact to the local economy and there is a lower probability for short-term liquidity concerns as revenue sources are usually from numerous sources. If the damage keeps people from visiting, working, or making purchases, then the issuer could have a short-term liquidity concern.  If the threat of further disasters causes the population to decline, then you have a long-term credit concern that needs to be evaluated.

Increase in Issuance:

The tax code has recently reinforced that tax-exempt bonds can be issued to finance rebuilding of infrastructure due to natural disasters. We can expect an increase in issuance at some point due to hurricane damage.

What can you do to further protect your portfolio from hurricanes?

  • Stay diversified by Issuer and Geography
    • We recommend issuer diversification of 5% to 10%. It may be good idea to keep prime hurricane targets to 5%.
    • Do not own all your bonds in states that have a history of hurricanes. Look to own bonds around the USA and not just in Florida, Louisiana, Texas or other potential targets.
  • Review all small issuer’s revenue bonds credit quality if they are in hurricane territory. What would be the impact on meeting debt service requirements if operations were delayed for a length of time?  There are so many different issuers that sell revenue bonds that an investor can be meticulous about location and size.
  • Don’t worry, unless you have booked a vacation to the islands. Municipal finance remains strong enough to beat a category 5 hurricane! This has been proven and will, once again, be verified.