Greg Kaplan, CFA
Director of Fixed Income, City National Rochdale
Michael Korzenko, CFA
Senior Fixed Income Analyst, City National Rochdale
The impressive returns posted by the municipal bond market in 2014 surprised even the most sophisticated investors. Strong technical forces (supply/demand imbalance) and appetite for tax-adjusted income overshadowed expectations for higher rates and below average returns. While we believe 2015 will present attractive opportunities, total return will likely trail advances achieved in 2014.
U.S. economic performance has distanced itself from global counterparts, and weakness among other developed nations poses a risk. Depressed oil prices will undoubtedly have disparate effects on world economies. In the U.S., the Federal Reserve will be closely watched as changes to monetary policy create uncertainty. The momentum in the U.S. economy has supported improvement in municipal credit quality, albeit to varying levels. While many issuers are in a better position today to honor their commitments than in previous years, those still struggling to recover will find it difficult to repair their fiscal standing and may experience further deterioration.
As we begin our journey into 2015, there are several themes to keep a watchful eye on. Tax reform efforts seem to be a perennial issue, Federal transportation funding will surface in the spring, and we also expect the new GASB pension accounting standards to elevate the importance of pension funding. The U.S. Supreme Court is scheduled to rule on an Affordable Care Act (ACA) case by summer and credit headlines out of Puerto Rico, Illinois, and New Jersey could lead to volatility and create attractive entry points.
Year of the Muni Bull
Municipals outperformed taxable fixed income in 2014 by a healthy margin, especially in the non-investment grade space. The Barclays Aggregate Municipal Bond Index posted 9.05% returns in 2014, versus 5.97% earned by the Barclays Aggregate Bond Index. The Barclays Municipal High Yield Index returned a stunning 13.84%. The solid performance for municipals is a sharp rebound from the -2.55% earned by the broad index in 2013, the first negative returns since 2008. If we recall, the second half of 2013 was a very volatile period for the municipal bond market. Puerto Rico and Detroit headlines, negative mutual fund flows, and the great “taper tantrum” talk created a perfect storm for municipal underperformance.
Market participants prepared themselves for a year of higher interest rates and muted performance. While we kept our duration target neutral relative to the benchmark, our investment grade strategies outperformed on security selection and curve positioning. Considerable spread compression across all credit grades also contributed to performance, particularly lower rated bonds (see figure 1). Our strategy for the year tilted credit quality to A-rated revenue bonds, and de-emphasized AAA and pre-refunded bonds. Sector exposure also played a key role, as cyclical sectors that benefit from broadly improving economics, such as transportation, outperformed.
Municipal high yield also experienced an exceptional year reflecting a reversal of 2013 weakness, a flattening yield curve, and the continued global search for yield. City National Rochdale’s own Municipal High Income Fund, launched at the end of 2013, benefited from the supportive environment growing to almost $500 million AUM.
U.S. on a Delicate Path
The U.S. economy continues to outpace the growth of the global economy, placing considerable distance between itself and other developed nations. Advances in employment, productivity, and consumer confidence suggest the U.S. has the momentum to expand further, but recent global macro events could impede the trajectory. We expect volatility to escalate in the months ahead, with financial market activity vulnerable to price swings. The City National Rochdale forecast for 2015 GDP is 2.5% to 3%, and our year-end rate forecast for U.S. 10-year Treasuries is 2% to 2.5%.
Fed policy will be a focal point in 2015 as the market gears up for a tightening cycle, the first since 2004. Consensus estimates call for a mid-2015 rate hike. In our view, we expect Fed action further into 2015. At the December 2014 FOMC committee meeting, policy makers indicated they would be noncommittal in their stance on tightening. The Fed now has more flexibility on the timing of a rate hike and, together with data dependency, will likely consider global market conditions in subsequent policy. In addition to Fed actions, low inflation expectations and sovereign debt yields well below those of U.S. government bonds should keep interest rates suppressed as domestic securities offer a quality alternative with higher yields. The yield curve should remain relatively flat as a result.
Municipals in 2015
In the year ahead, security selection should continue to be a key contributor to performance. Technical indicators remain supportive in the near term with positive fund flows and supply dynamics. Due to the retail orientation of the municipal market we view mutual fund flows as indicative of investor sentiment and will be watching this closely as we near a possible Fed rate hike.
Market supply stabilized in 2014 at $335 billion, but new money issuance has declined appreciably since 2010. Low rates have boosted refunding activity. Post-recession austerity and anti-tax sentiment have diminished issuer appetite for new public debt – in effect reducing interest costs and debt burden – but deferral or cancellation of needed projects could pressure future budgets. Positively, bond authorizations placed on the ballots in November 2014 indicate more economic capacity and community support for new debt. Therefore, we expect a gradual increase in new money issuance during 2015.
Despite low nominal rates, municipal taxable equivalent yields still remain attractive among fixed income asset classes. An important relative value indicator frequently used is the municipal-to-Treasury yield ratio, which is effectively a gauge of municipal bond attractiveness. The higher the ratio, the more attractive tax-exempt municipal bonds should be compared to taxable securities. At the close of 2014 longer maturity ratios were relatively cheap while shorter maturity ratios remained fairly rich. At that time, the 30-year ratio was 105% versus 96% historically, the 10-year ratio was 95% versus 90% historically, and the 5-year ratio was 82% versus 85% historically. With the sharp fall in treasury yields year-to-date, municipals have become increasingly attractive.
The yield curve flattened during 2014 with the spread between 2- and 30-year bonds declining by 146 bps (see figure 2). We forecast a modest rise in rates but not enough to offset the cushion provided from rolling down the yield curve. With respect to curve positioning, we are maintaining our duration neutral approach and view a barbell structure as an appropriate theme for 2015.
We believe credit trends continue to be positive and credit spreads have room to compress but the upside is more limited. Nevertheless, we will diligently be looking for credit opportunities to help drive returns. We also expect the municipal high yield space to continue to perform well, especially on a tax-adjusted basis.
Events to Watch
Economic expansion in the U.S. has been accretive to state and municipal finances. States primarily rely on income and sales taxes, so the ebb and flow of a state’s revenue performance will correlate with broader activity (see figure 3). Housing trends are improving in many regions, and with gains in employment the public finance sector as a whole has generally benefited, but with exceptions.
Post-recession, many governmental entities improved their budget structure with more realistic revenue assumptions and reduced spending plans to counter a more challenged operating environment. The vast majority of issuers have managed well, but there are laggards that have struggled to take advantage of the economic recovery and will find it more difficult to stabilize their finances.
Pent up demand for services and other municipal activities will compete with rising employee benefit costs and infrastructure requirements. In our view, strong governance and management skills will be necessary to balance community needs and tax base resources.
Recent declines in oil prices should provide a boost to many states with consumers benefiting from lower energy costs. Consumption of goods and services could lead to greater tax collections for state coffers. On the other hand, resource-rich states that rely on oil-related revenues may be challenged. The impact on affected states will vary and must be considered individually. We also view the impact of lower oil prices on transportation sectors to be positive, particularly toll roads and airport systems, since traffic volume and enplanement activity should rise.
Tax reform will likely be a renewed theme in 2015. While we recognize the ongoing threat to the municipal tax exemption, we place a very low probability on comprehensive tax reforms this year. The most likely case is that the right-wing Congress reaches a middle ground with the president on corporate tax reform.
The need for state and local governments to invest in infrastructure has been gaining importance in recent years. The condition of the nation’s infrastructure is poor, and the funding of critical public projects is a central debate among policymakers. While deferring or eliminating projects could provide near term budgetary benefits, over the long term it could create fiscal drag.
Federal transportation funding will come up in May when the current Highway Trust Fund (HTF) extension expires. Congress must continue to work toward a longer-term funding solution for the nation’s comprehensive transportation network. The short-term reauthorizations leave little visibility, which affects transportation budget planning by state governments. Congress has routinely passed short-term stop-gap solutions, and states have grown accustomed to these practices. As a result, states have begun to develop their own funding paradigm to help fill the void but a gap exists nonetheless.
The U.S. Supreme Court is expected to rule on King vs. Burwell by June. The ruling will determine whether federal subsidies are legally available to those who procured health care coverage on federally sponsored exchanges. The ruling could have negative ramifications for both states and the health care industry more broadly.
GASB 68 is effective in FY 2015 and these accounting standards will change the presentation of pension liabilities on financial statements. We expect ratings to be minimally affected since rating agencies already incorporate similar adjustments. More transparency adds to heightened scrutiny for pension burdens which may be reflected in bond pricing for certain issuers, but the “repeat offenders” are widely known. In any event, pension analysis has increasingly become a credit differentiator and GASB 68 could have the effect of forcing pension funding changes upon governmental entities.
Municipal defaults have declined for four consecutive years per Municipal Market Analytics (MMA), and there has not been a general purpose government bankruptcy filing since Detroit in 2013, according to Chapman Strategic Advisors. Recent chapter 9 outcomes give the impression political and social considerations place bondholder interests below those of pension beneficiaries. San Bernardino’s expected emergence from bankruptcy will add another reference point in the court’s treatment of pension benefits. However, we continue to view chapter 9 municipal bankruptcy as a rare event, and the outcomes of which are very unique, often achieved through negotiations. Any subsequent market dislocation could present a buying opportunity if market spreads widen out.
The strong relative performance earned by the municipal bond market in 2014 was largely a reversal from prior year weakness. In 2015 we expect the U.S. economy to continue on its path of modest growth but anticipate more volatility in the global financial markets. Developments in Europe and Asia will serve to mute rate movements and expected Fed rate hikes will likely flatten the yield curve further. We remain constructive on credit but are taking a more cautious tone as budgets remain challenging for some issuers this far into the expansion. Security selection and curve positioning should continue to drive performance this year. In 2015, we expect total return to be positive for investment grade municipals and closer to historical norms for non-investment grade bonds.
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• May Lose Value
The Barclays Aggregate Bond Index is comprised of U.S. government, mortgage-backed, asset-backed, and corporate fixed income securities with maturities of one year or more.
The Barclays Aggregate Municipal Bond Index is comprised of tax-exempt municipal bonds of investment grade quality with maturities of one year or more.
The Barclays Municipal High Yield Index is comprised of non-investment grade municipal bonds with remaining maturities of one year or more.
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. Bonds and bond funds are subject to interest rate risks and will decline in value as interest rates rise.
High yield bonds offer a higher yield and carry a greater risk of loss of principal and interest and an increased risk of default or downgrade than investment grade securities.
The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible.
Events affecting states and municipalities may adversely affect municipal bonds and their performance. These events may include severe financial difficulties and continued budget deficits, economic or political policy changes, tax base erosion, state constitutional limits on tax increases, and changes in the credit ratings.
City National Rochdale Funds are distributed by SEI Investments Distribution Co., which is not affiliated with City National Bank or any of its affiliates.
Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.
Investing involves risk, including the loss of principal.
As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money.
Past performance is no guarantee of future performance.