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Fixed-Income Insights

How might supply/demand dynamics, credit quality, challenges for Puerto Rico and Illinois, and other developments, affect the market in the coming year?

 

In Brief

  • What are some of the important trends that could influence the municipal bond market in the year ahead?

    1) Supply—The muni market is likely to see another year of relatively high new-issue supply.

    2) Demand—Continued price stability of muni securities could help keep demand positive into 2016.

    3) Credit quality—The factors that have supported the muni market’s overall strong credit quality should continue into the new year.

    4) Illinois and Puerto Rico—These issuers likely will continue to face challenges in resolving their respective fiscal situations in 2016.

    5) Other trends—Emerging developments in municipal bond-ownership patterns, credit-rating activity, and pension funding also bear watching in 2016.

  • The key takeaway—We believe 2016 likely will look similar to 2015 for important market characteristics, such as supply, demand, and credit quality.

 

(First of two parts)

The municipal bond market had a relatively strong year in 2015 compared to other fixed-income markets. Despite having elevated new-issue supply and some large troubled issuers in the headlines, the market had positive returns and low volatility. Where does this leave us as we start 2016? In the first of a two-part Muni Matters, we’ll offer some thoughts on key muni market topics for the year ahead. In part two, we’ll assess key muni bond sectors and offer a view on prospects for the broader market in 2016.

Supply
In 2016, the municipal bond market likely will see another year of relatively high new-issue supply. Similar to 2015, there likely will be a large volume of refunding of bond issues. Refunding bonds refinance older bonds that were issued at higher interest rates, but are now approaching their call dates. Issuers can lower their annual interest expenses by issuing new bonds at lower rates. During 2015, about two-thirds of new bonds were refundings. 

Low interest rates should have a positive impact upon the volume of borrowing again next year.  Strangely, an increase in short-term interest rates by the Federal Reserve (Fed) could actually lead to further increases in refunding supply. This is because if call dates for existing bonds that are being refinanced are more than a year away, issuers have to deposit the proceeds of the new bond issue into an escrow account until the outstanding bonds are called on the first call date. Currently, with short-term rates low, the interest earned on the escrow is well below a longer-term borrowing rate, so any increase in short rates might lower the spread between the interest being earned on the escrow and the interest being paid on new bonds if longer rates do not rise as much. This, in turn, could actually reduce the interest cost to issuers of a refunding bond issue, making such deals even more attractive.

Another factor that could boost supply even more would be the pace of new money issuance—that is, bonds sold for purposes other than refunding. During the first half of 2015, for example, new-money issuance was lower than the comparable period in 2014, and by the end of the year, it was only slightly ahead. Many states are still focusing on austerity, so their governments have not been willing to borrow for infrastructure needs; they eventually will, however, need to make those investments. If the overall U.S. economy continues to be steady, issuers could become more comfortable selling new bonds because they will have more tax revenue to support their needs. While this is not a certainty, we think there is a strong probability that it will happen.

Demand
More supply could put pressure on the market, but in recent months, demand has been increasing. Total returns for municipal bond funds have been positive, and yields are attractive compared to other markets, especially when adjusted higher on a tax-equivalent basis. Investors appear comfortable with the outlook for municipal bonds and have been appreciating the lower volatility compared to other markets. Issues that whipsawed other markets—China, the eurozone, and oil prices—have not significantly affected the muni market. As a result, municipal bonds did not fluctuate in price as much as equities or taxable fixed income during 2015. This price stability helped increase muni fund flows over the second half of the year; should this trend continue, it likely would keep the demand positive as we enter 2016. Relatively strong demand would be able to offset the higher supply and provide market stability.

Credit Quality
The financial media have focused on the issues in the few trouble spots of the municipal bond market, such as Illinois and Puerto Rico, but overall credit quality has been strong. Tax revenues have been increasing across the country with the stable, slowly growing U.S. economy, and defaults have remained infrequent. Credit rating agencies have released more upgrades than downgrades of municipal bond issuers, and trends in most sectors are stable to positive. This should continue into 2016. If the Fed is contemplating tightening policy, as seems likely, policymakers must be forecasting that the economy is strong enough to handle a rate hike, which is another positive signal for tax revenues next year.

Illinois and Puerto Rico
A municipal bond market outlook for 2016 would not be complete without discussing Illinois and Puerto Rico. Both Illinois and its largest city, Chicago, are facing issues with underfunded pensions. Both need to increase annual payments in order to catch up on their funding, but they do not currently appear to have the revenue necessary to do so, and recent court decisions have complicated their efforts to alter pension agreements. As we head into 2016, there do not appear to be any short-term solutions. It is likely that Governor Bruce Rauner will continue to hold firm his stance on not raising taxes, and the state legislature will not be willing to make material cuts to the budget or be able to change pension agreements. The standoff likely will continue, and without a budget agreement, the state may fall further behind on its bills. Eventually, the parties will need to come to a solution, but it is not likely to occur until well into 2016, at best.

Puerto Rico’s liquidity and funding issues continue as we enter 2016. Officials are claiming that the commonwealth will run out of money by the middle of 2016, but they have only provided unaudited financial information, so it is tough to analyze the island’s actual finances. During 2016, Puerto Rico will need to reach agreements with at least some of its creditors, and the government will have to decide how it wants to handle its debt while trying to generate enough revenue to cover expenses. The commonwealth also will be going through a gubernatorial election, making it difficult to reach political agreements. This situation has been ongoing for a couple years, but the government will need to make some tough decisions before 2016 is over. Since Lord Abbett holds modest allocations to certain Puerto Rico bonds in some of our mutual funds, where it is appropriate for the targeted investment strategy, we hope that the commonwealth will not challenge its current constitution by diverting funds from bondholders. Such actions would exacerbate an already complex situation, and create additional uncertainty for all involved, given the legal issues. The best outcome would be for Puerto Rico to negotiate with creditors and work out fair debt agreements, but the future is unclear.

Market Trends
Some recent trends are likely to continue for the municipal bond market. Fed data have shown that individual investors have been decreasing their holdings of individual municipal bonds and increasing their holdings of muni securities through managed products. Investors appear to be seeking the benefits of diversification and professional surveillance of their credit exposure. This likely will continue, because many brokerage firms are encouraging their advisors to make these recommendations to their clients. Banks have been reducing their municipal bond holdings due to regulatory pressure and efforts to reduce risk. This too likely will continue into the future, as more regulation comes online and management responds to volatility in other markets. This means that the municipal bond market will become even more dependent upon demand from total-return buyers who can invest in a range of markets when mutual fund flows are not positive.

Meanwhile, the major credit rating agencies have been making more, large rating changes, referred to as super upgrades or downgrades, and this is likely to continue. The agencies have opted to make larger rating changes than in the past in reaction to surprises from issuers who do not provide regular financial updates or due to significant changes in financial metrics, and they have been increasing the volume of their credit surveillance. 

A third trend that also bears watching is pension funding will continue to receive a lot of attention from the ratings agencies and the media. While most states and municipalities have their pension finances under control, there are some, including the issuers mentioned earlier, that have fallen behind. Any worsening of pension-funding shortfalls for state and local issuers is likely to raise more concerns and potentially lead to more downgrades, even though for most of them, any cash flows issues due to pension obligations will not occur for many years.

Next: The outlook for key revenue bond sectors—and the broader municipal market.

 

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