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Fixed-Income Insights

Where might the best opportunities lie within the revenue-bond segment of the muni market? Here’s our view. 

 

In Brief

  • One of the key decisions for municipal bond portfolio managers is making selections among the wide array of sectors in the revenue-bond segment of the market.
  • That’s especially important, as nearly two-thirds of the muni market is composed of revenue bonds.
  • In this article, we will tell you why we think four particular sectors provide what we believe are some of the most attractive investment opportunities among revenue bonds:

    Transportation
    —Health care
    —Industrial development
    —Education
  • The key takeaway: We believe that the most favorable opportunities in the municipal bond market are available in revenue sectors. To identify the best candidates within these groups, investment managers must weigh the economy’s impact upon the sector, the credit quality of each issuer, and which global changes can affect their outlooks.

 

There have been 50 consecutive weeks of inflows into municipal bond funds through September 21, according to Lipper, so it is clear that investors have responded to the attractive tax-equivalent yields versus other investments—and the solid credit quality—the asset class has recently offered. Year-to-date performance for the overall muni market has been strong, as witnessed by the 3.9% return for the representative Barclays Municipal Bond Index (through September 22). [Due to market volatility, the market may not perform in a similar manner in the future. During other time periods index returns may have had different results.]

With all the new assets coming in, municipal bond portfolio managers have been scouring the market to find compelling investments. Each portfolio typically has a short-, intermediate-, or long-maturity focus; portfolio managers are choosing the most attractive maturities within the targeted ranges. Beyond setting the portfolio’s interest-rate risk with those choices, there are many other parts of the investment decision for managers to consider. 

One of the key decisions is making selections among the range of sectors in the municipal bond market. Because it is extremely rare for the media to examine the performance of specific municipal bond-market segments, many investors likely have not been receiving updates regarding which sectors appear attractive. While investment company websites offer detailed, useful information on municipal bond portfolios, investors might want to know more details about how the muni sectors are faring, and where money is being invested by portfolio managers.

Some investors may be surprised by how diversified the sectors are within the municipal bond market.  That’s understandable, as most news reports have focused on the general obligation (GO) bonds of municipalities and state governments.  But state and local GO bonds, which generally are funded by tax revenues, comprise less one-third of new issue supply.  The rest of the market is composed of revenue bonds in many sectors, all of which are supported by flows from specific revenue sources.  We believe there is greater opportunity to find value in the revenue-bond segment rather than among GOs.

Where, then, are we seeing the best opportunities? Many people are familiar with equity sectors such as technology and consumer products, since they are frequently discussed in the media, but investors might not be as familiar with the sectors of the municipal bond market—and there are many. After reviewing the full range of sectors in the municipal bond universe, we are finding strong value in revenue sectors such as transportation, health care, industrial development, and education. The following are descriptions of each of our favored sectors and some of the reasons we are focusing on them:

Transportation
This group includes a range of subsectors, such as airports, toll roads, bridges, and ports. There are many attributes that these credits share, but one commonality among them has been the effect of low oil prices on the outlook and performance of the sector. Oil usage in each category has increased, as costs to use the various forms of transportation have come down. Also, with the U.S. economy growing (albeit modestly), usage has continued to strengthen since the end of the recession in 2009. What is our view at the subsector level?

  • Airports are attractive, since airlines recovered from their financial difficulties several years ago and because consumer demand has increased. Flight volumes also keep increasing at many airports around the country, leading to expansion projects that require borrowed funds. Most airports have been controlling their financial leverage, and have been able to pass on the costs to users, so there are many attractive investments available.
  • Toll roads and bridges have been benefiting substantially from increased car volumes, as low oil prices encourage more driving. As long as the entities that operate toll roads and bridges continue to keep capital expenditures under control and are able to increase user fees when necessary, their bonds will remain attractive investments.
  • Many ports have been preparing for the expansion of the Panama Canal (completed in June 2016) by deepening their water levels in order to accommodate the larger ships that the canal can now handle, so many ports are in a position for growth in the upcoming years.

Health Care
This widely followed industry represents one of the larger revenue sectors in the municipal bond market.  The main subsectors are hospitals or healthcare systems (our focus here), along with senior living facilities, which largely are considered a high-yield sector. The facilities in the hospital/healthcare system subsector are not-for-profit, and their bonds are backed mostly by payments from health insurance providers, in addition to government programs such as Medicare and Medicaid. There are many large systems throughout the United States, so there are many large deals with good liquidity characteristics, allowing for a relatively active secondary market for these bonds. This liquidity allows us to make investments in securities from these issuers in confidence that we can sell them when we find better alternatives. There also are some small hospitals with near-monopolies in the markets they serve that are interesting credits. 

This sector has performed well over the past couple of years, as it has rebounded from overly pessimistic concerns about the potential impact of the Affordable Care Act (ACA). Perception has improved as healthcare systems have worked hard to prepare for the changes brought about by the ACA by taking actions such as cutting costs and merging with competitors to create better economies of scale. Since many healthcare systems have been effective in making these adjustments, their balance sheets look good, and we believe they remain attractive credits.

Industrial Development
Some may be surprised that a corner of the municipal bond market—namely, the industrial development sector—features issues from publicly traded corporations. But this is actually one of the more actively traded revenue-bond sectors. Corporations that issue municipal bonds come from a range of industries, including energy, airlines, waste management, and manufacturing. Issuing companies receive the tax exemption because they are viewed as providing economic development and employment opportunities to a region. 

The benefits of investing in industrial development bonds include the fact that issuing companies provide more regular financial disclosure than traditional municipal issuers. Also, since the companies are familiar to so-called crossover buyers—those who do not regularly participate in the muni market—they may have appeal for a wider range of investors, which can help provide liquidity to our portfolios. Since the U.S. economy has been providing slow, stable growth and corporate earnings have been steady, many of these bonds have been performing well—similar to the taxable fixed-income markets—and continue to have attractive attributes going forward.

Education
This sector features issuers with a range of credit quality characteristics and outlooks, but offers some very good opportunities. Within municipals, this sector is composed of public and private schools. The public side includes state universities, which typically have strong market positions because of their relatively lower costs and are most often high-quality, investment-grade credits. Private schools include the well-known, very selective universities, along with smaller ones that try to fit into a niche. They also can include secondary schools. Many private universities are doing very well, as people increasingly recognize the positive economic impact from earning a college degree, and applications continue to increase for the competitive schools. They also have large endowments. Some small niche schools are facing challenges due to their high costs and demographic shifts, which has led to a reduced number of college-age students. The number previously was higher when large numbers of children from baby-boomer parents were in the age range.

In many cases, the bond issues are being used to upgrade campus facilities or provide additional student housing. Although credit quality is a very important factor in selecting securities within the education sector, we believe there are many attractive investments from which to choose.

Summing Up
While it is extremely important to pick the sectors carefully, portfolio managers also need to stress the caliber of the structures when selecting the individual bonds under consideration. In order for investment decisions to help provide strong performance, managers need to weigh attractive attributes such as coupon, maturity, and call protection, along with analysis of each credit, in order to improve the prospects for success in a selected sector. It can be frustrating for investors of all stripes to get the sector selection correct while not having an individual investment perform well for a non-credit reason, but this is what makes municipal bond investing fascinating and challenging. [Keep in mind investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities.]

So, when investors are watching the financial news channels and hearing interesting discussions about key corporate sectors, they can rest assured that municipal bond investment professionals are having the same types of conversations about their unique sectors. As regular market participants, we constantly are watching the changing sector and credit dynamics so that we can adapt our outlooks when necessary.  We also are following the supply and demand characteristics of the market, along with U.S. Federal Reserve policy, to make the necessary adjustments to the structures of the bonds in our portfolios, even if our sector outlooks are not changing. Of course, portfolio management continues to evolve, and we are always looking to refine and enhance our selection process, as we seek the attractive opportunities available among the well-diversified sectors of the municipal bond market.

 

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