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Fixed-Income Insights

Here is a look at prospects for key revenue-bond categories—and the broader muni-bond market—in the coming year.

 

In Brief

  • What are the prospects for key revenue-bond sectors in the year ahead?

    1) Health care—Solid credit performance is likely to continue, as the Affordable Care Act has prompted healthcare systems to cut expenses.

    2) Education—While smaller, lower-rated schools face some pressure, demand remains strong, and the education sector should continue to offer a number of appealing opportunities.

    3) Transportation—Given trends in energy prices, airline finances, road usage, and international trade, this sector should continue to present some attractive investments.

    4) Utilities—With energy costs being low, most utility systems are well positioned within the industry.

    5) Industrial development—Issuers outside commodity-based industries should continue to do well. Those with exposure to the energy market are likely to continue to underperform.
  • The key takeaway—Overall, the municipal bond market has a wider range of investment opportunities than many might expect, and most sectors have strong credit fundamentals as we head into the new year.

 

In part one of this column, we looked at trends that could influence the municipal bond market in 2016 from a macro perspective. Here, we will take a more granular review of the market by examining the outlooks for key sectors within the revenue-bond category. We then will conclude by returning to the macro level with our view of how the broader muni market might fare in the coming year.

Although many investors focus primarily on general obligations of states and municipalities when they analyze the municipal bond market, the majority of bonds are actually in revenue sectors, so analysis of the outlook for municipals needs to include sector views. Some of the larger sectors are health care, education, transportation, utilities, and industrial development. Each one is dependent upon different factors, and the relative performance of municipal-bond portfolios can be materially affected by sector positioning.

Health Care
The major issue for this sector for several years has been the Affordable Care Act (ACA), as hospitals have been adapting to the new system, including significant investment in technology. The ACA has prompted many mergers of hospital operators. This sector has outperformed, as uncertainty has turned into better than expected financial performance primarily due to fewer uninsured patients. Solid credit performance is likely to continue because healthcare systems have cut expenses considerably in order to prepare for tighter margins in government payments, and in many states, hospitals are benefiting from lower unpaid revenues, as more people have become insured. Credit rating agencies have also changed their outlooks on this sector, from negative to stable. That said, investors need to be careful with some of the lower-rated hospitals that have not had the capital needed to fully upgrade their systems and, therefore, have not been able to reduce their expenses or capture new sources of revenue. There is likely to be volatility as health insurance companies continue to adapt, but overall, hospital systems appear well prepared for the new environment.

Education
While this sector features issuers with a wide range of credit quality, it offers many good investment opportunities. Demand for college remains strong, and many schools have earned attractive returns on their endowment funds in recent years. The only strain is that some of the lower-rated, smaller schools have seen some stress, as the number of college-age students has fallen a little from its peak a few years ago. Some of the smaller, less selective colleges are, therefore, under some pressure, but this issue affects only a limited number of schools. So, overall the education sector should continue to present a number of attractive investment opportunities in both private and public educational institutions.

Transportation
This sector features several options for investors. Some examples are airports, toll roads, and ports. With lower oil prices spurring increased traveling, many of these issuers are doing well, and should continue to be favorably positioned. Many airports have monopolies on their regions, and many airlines have been upgraded by rating agencies as their finances have improved. Toll roads are seeing heavier usage, and although many operators will be borrowing for capital needs, they should be able to raise tolls if necessary, because consumer demand should remain strong while oil prices are low. There still needs to be some caution with startup toll roads, which need to reach targeted volume levels; but most are meeting their projections. Many ports have enhanced their ability to handle larger ships, so they are also well positioned for international trade, which has been strong on both U.S. coasts. Given these dynamics, the transportation sector should continue to present some attractive investments.

Utilities
Utility operators typically have strong positions in their markets. Many face the challenge of convincing regulators to allow them to increase rates when necessary, but they have had success in raising revenues, while at the same time facing significant capital needs in recent years. With the low cost of natural gas, many power providers have been converting from other fuels, and that is likely to continue, along with many operators adding alternative sources of energy. With energy costs being low, most utility systems are well positioned within the industry.

Industrial Development
This sector comprises mostly corporations that are able to issue bonds in the municipal market for uses such as pollution control equipment at their plants. For the most part, corporations have been performing well, excluding some in commodity-based industries, and should continue to be stable investments. While the U.S. economy is not booming, it is growing at a sufficient enough pace to create steady corporate profits. Within this sector, companies with exposure to the energy market are likely to continue to face pressure with low commodity prices, so they are likely to continue to underperform.

Government-Lease Obligations
Another sector that could underperform, while still offering high credit quality for the most part, is that of government-lease obligations. This is not strictly a revenue-bond category, but falls outside the general obligation designation. These bonds are issued by some states and local governments when they are not using their general-obligation capacity, and interest payments typically are subject to appropriation from their local legislature for the debt-service coverage. And because Puerto Rico defaulted on some of these types of bonds during the summer of 2015, there is more skepticism about the strength of this type of security, so spreads have widened. This will continue to lead to some underperformance in states, such as New Jersey, where this bond structure is used for the majority of the state’s borrowing. There is some value in this sector, especially those with stronger lease structures, but it has the potential to continue underperforming.

Summing Up
Overall, the outlook for 2016 appears positive for the municipal bond market. Supply should remain on the higher side, but demand has been consistently strong during the latter third of 2015, and appears to be on a solid path going forward. Other than the few high-profile troubled issuers in the headlines, credit quality should remain on a positive trend, based on tax-revenue strength and the volume of upgrades compared with downgrades from the ratings agencies. Illinois and Puerto Rico are likely to remain under pressure, but their issues should remain isolated to a small number of credits rather than affecting the entire market. Within most sectors, trends are positive, so investors are likely to find attractive opportunities in both the general obligation and revenue sectors.

The wild card is the Federal Reserve (Fed). Although the Fed is likely to raise short-term interest rates, the U.S. economy is only growing slowly, so there isn’t a need for drastic policy action. Also, increases in yields could increase investor demand for municipal bonds due to more attractive interest rates available. The municipal bond market has had a good year, and we think it likely will perform well relative to other fixed-income markets during 2016.

 

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