January Monthly Review

January 2018 Muni Market Monthly Report – The Need for Infrastructure:

Munis suffered their first loss in the month of January since 2011, and their biggest since 1981.  Not a good start to a year that we believe will show muni outperformance.  We still remain positive and feel the lack of issuance hurt the bid for bonds, but we see demand piling up and it’s only a matter of time before the bid returns.

That being said, there is one potential “wild card” looming on the horizon. It could be months or years away –or- never make it to the present.  The need for an infrastructure plan has been talked about for the last decade and, once again, it is a political hot button.  The Trump administration has a plan – and it relies heavily on munis.  This month, we will take a look at this program and give you our expert muni opinion.

Muni Market Review:

Contrary to our expectations, the muni market did not start the year with a bang. It has been more like a thud, as trading activity and new issuance has been stagnant.  This, in combination with the US Treasury market selling off due to economic growth concerns and increasing overseas rates, pulled munis along quite easily.  Lowlights of January are as follows:

  • Muni yields increased from 15 to 38 bps, steepening and underperforming taxables.
  • Taxable yields increased 29 to 34 bps, with no change in curve steepness.
  • Issuance was down 48% versus 2017, which we had expected. We think this will continue to be the theme and, at some point, lead to muni outperformance.
  • Munis continue to receive inflows of cash, having done so five weeks in a row. We estimate that muni funds have received $3.8 to $4.0 billion year-to-date.
  • The larger than expected drop in the 7-day VRDN rate, now at 98 bps (or 62% of 1 month Libor), shows that muni managers are taking the recent inflows of funds and investing in cash instead of bonds.
    • Year-to-date money market assets have grown by $7 billion, after being flat throughout 2017.

We remain bullish on munis in 2018.  The only warning sign we see is the Trump Infrastructure plan that appears to rely heavily on munis.  We look at this plan in this month’s credit review section and feel it is too flawed to pass or actually be successful as it is currently presented. 

Market News & Credit Update:

The selloff in munis during the month of January and decline of the general index of .81% is the largest since 1981. It is also the first time there has been a loss during the month of January since 2011.

I don’t think weed is legal in Illinois yet, but those state lawmakers discussing the possibility of issuing $107 billion in debt to firm up its unfunded pension and then invest in in the stock market have to be out of touch with reality.  They plan to have a follow up meeting to discuss it more in the future. Really?

Good news for Hartford, Connecticut.  The State’s capital was on the brink of bankruptcy until the state bailed it out at the end of 2017.  Now under an oversight board, it appears the city may be getting its fiscal house in order. Moody’s is considering raising its credit rating from the current Caa3 level.

The Need for an Infrastructure Plan: Why all the fuss?

The ASCE (American Society of Civil Engineers) has identified an infrastructure gap of $1.5 trillion today, a need for $4.6 trillion by 2025. This includes maintenance of current projects, and the demand for new ones. A quick review of the issues looks like this:

  • One in four bridges is structurally deficient.
  • Water and energy systems require $632 billion for safety and usage needs.
  • One out of every five miles of highway pavement is in poor condition.
  • A broadband gap: believe it or not, the USA trails a lot of other countries in providing internet service. Roughly 25% of Americans live in “low subscription” neighborhoods.

 There are numerous reports that show investing in new and current infrastructure has a positive influence on the economy.  Roughly 11% of the workforce currently is employed in infrastructure-related jobs, but this would increase and provide the following benefits:

  • Lower transportation costs by increasing reliability and efficiency.
  • A University of Maryland study showed for every $1 spent on infrastructure, $3 was added to GDP.
  • The increase in employment reflects that for every 1% increase in GDP, 1.5 million jobs are added.

Once a nation known for its good infrastructure, the USA has lost pace with the rest of the world and now needs to change its ways.  The USA spends much too little on infrastructure.

  • European countries spend roughly 5% of GDP, USA spends 2.4%.
  • Most states have been concerned with cutting taxes and offering corporate subsidies to promote economic growth, and have not invested in their infrastructure.
    • State and local spending on infrastructure is now at a 30-year low.
    • Most states are in solid fiscal shape and could afford an increase in spending or taxes.

The Issues the Plan needs to address: What it needs to do to be successful!

  • The Plan needs to identify a source of funds and a means to help fund and promote infrastructure projects:
    • Needs to help meet maintenance on current projects (estimated at $65.3 bln a year) and to build new projects.
    • Needs to provide a “national” revenue source to combine with local sources to help pay for the costs. We cannot rely on all private money and/or state revenues to successfully fund the plan.
    • The Funds must be enough and available in a way that encourages municipalities to take on more projects.
  • The Plan needs to find a way to direct more investable money to infrastructure projects:
    • Identify an investor base that would have interest in investing in infrastructure projects and create an investment vehicle that encourages it without increasing the costs.
  • Maintain accountability and responsibility by the state and local municipalities and find a way to help them prioritize projects.
    • This will lead to the most efficient way to implement the program.

 The Current “Proposed” Trump Plan: Let’s hope it’s just a first draft!

After numerous leaks, and now an official release, the program looks as follows:

  • Spend $1 trillion (also has been referred as being $1.5 trillion) over the next 10 years on infrastructure. The Federal aid portion would be $200 billion.
  • 50% of the aid is to encourage state, local and private investments into core projects by providing grants. The grant can be no more than 20% of the projects cost. So rough math says that for $100 billion in grants, municipal issuers would have to issue 1/2 trillion in bonds. The entire muni market is roughly $3.4 trillion in size.
  • 25% of the aid would be used on the “rural infrastructure program”. These are aimed at electric power, water/sewer, and broadband projects.
  • 10% of the aid will be spent on “transformative projects”. These are technical assisted innovated and transformative projects that are commercially viable and able to secure private sector financing.
  • 7% on federal lending program that receives federal tax credits.
  • 5% for a federal capital financing fund to finance purchases of federally owned real property.
  • 3% roughly private activity bonds (PAB).

The American Trucking Association (ATA) has released a plan they feel would help solve the infrastructure funding problem. They are proposing a 20 cent increase on per gallon user fee, phased in over the next 10 years.  They estimate it will provide an additional $340 billion over the next 10 years, targeted to the highway trust fund which is estimated to be insolvent by 2021. The Federal gas tax has not been raised or adjusted for inflation since 1993.

Another idea to raise revenue is to charge user fees, things like tolls on roads, express lane fees, and some sort of usage fees on federally funded roads.

The Potential Impact on the Muni Market: Increased supply and decreased credit quality?

The plan appears to lean heavy on municipal issuance and credit quality.  Already the primary source for infrastructure funding, it appears this plan wants to grow it.

  • Impact of PABs is going to be minimal (3% of plan) even though they can be advance refunded and AMT would be removed. In fact they are such a small part of the market now, any increase would not be noticed.
  • For the plan to be successful, States will need to find a way and be willing to fund 80% of the project costs. They would most likely do this by issuing tax-exempt bonds. This would increase the supply and could put pressure on rates going up, unless a new source of demand is found. If the plan was fully implemented and accepted, it would mean roughly 1/2 trillion in additional muni debt.
  • How are these additional bonds going to be paid for? Do the issuers increase taxes or fees? And/or increase their debt and leverage ratios, hurting credit quality?

What we think will happen: No way Jose!

We doubt the plan will get passed as is, and if it does, it will fail to reach its $1 trillion goal. We believe there are several fundamentally flawed issues with the plan:

  • Plan doesn’t provide a source of funds to help with the affordability of projects.
  • Does not do much to encourage states, localities, or private investors to get involved.
  • It relies on municipalities taking on a lot more debt.
    • It’s hard to see municipalities issuing roughly ½ trillion in debt; if they did they would need to really raise taxes and/or fees. It is highly unlikely that residents will approve the needed increases.
    • Where are the investors of the bonds going to come from without increasing borrowing rates?

The plan is too unorganized, has too many loose ends and relies on municipalities to carry the weight. It sounds nice, but not sure where the incentive to participate, or to invest is going to come from?  Add to that the politics involved and the budget issues created, we think this plan is a long-shot as it stands. If it does find its way out of DC, the States will be hesitant to get involved, due to the costs. Plus, there may not be enough interested investors to provide enough money to make the program a success.

How about a solution? Glad you asked!

  • The Federal Government needs to provide an ongoing source of funds/grants that municipalities can rely on to help pay the cost. I like the ATA gas tax proposal to provide grants for roads and bridges. This is estimated to provide roughly 1/3 of the $1 trillion needed. This is much more than the 20% or $200 bln in grants the current proposal appears to set aside from where we don’t know yet. From there the States can find local ways to further back the bonds.
  • I like the municipal bond market to provide accountability, and responsibility. Yet, the tax-exempt market has a limited investment audience and, for this plan to be successful, it needs to be big and done as quickly as possible. There is a program, with some historical success, that may work: Build America Bonds.
  • I like the rebirth of the Build America Bonds (BAB’s: taxable munis where the issuer receives a subsidy from US Government) to attract pension funds, overseas investors, retirement funds and others looking for a secure source of fixed income. Let’s not put any more stress on the tax-exempt market to fund a major project for the nation. There will need to be a few changes from the original program.