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Fixed-Income Insights

Returns on municipal bonds could vary widely by category in 2015. Here’s why.

 

In Brief

  • A variety of factors could result in significant performance differences among municipal securities in 2015, especially since overall returns likely will not be as strong as they were in 2014.
  • The likely absence of a dramatic movement in interest rates may mean that performance in the municipal market may be greatly influenced by credit-specific factors, including:
    - differences in fiscal management among U.S. states;
    - the economic impact of lower oil prices;    
    - merger activity among healthcare providers who access the muni market; and
    - the relationship of select types of revenue bonds to stronger U.S. economic growth.
  • The key takeaway— In such an environment, active managers may be best able to identify—and recognize investment opportunities resulting from—the factors that will produce performance divergence among municipal securities.

 

In previous columns, we’ve explored the concept of divergence—that is, the prospect of a greater variation in relative performances among global economies and within select fixed-income categories, such as the U.S. high-yield bond market and emerging market corporate debt. Here, we’ll examine how this concept could play out in the U.S. municipal bond market.

While investors’ “risk-on, risk-off” behavior in 2014 contributed to volatility among taxable fixed-income sectors, the municipal bond market remained a much calmer alternative after recovering from a tough second half of 2013. Perhaps the best explanation for such stability was the reduction in the net supply of municipal bonds in an environment where demand for munis kept rising. Net supply of outstanding municipal bonds fell about 4% in 2014 from the level in 2013, according to Bloomberg, meaning that the combination of maturing debt and early redemptions exceeded sales of new muni securities. 

At the same time, the tax-equivalent yields on municipal bonds remained attractive, based on Bloomberg data, reflecting the 2013 rise in the marginal federal tax rate, to 39.6%, along with the additional healthcare tax of 3.8% on taxable income. These factors, coupled with high tax rates in many states, helped to support investor demand for tax-favored securities. Municipal bonds outperformed their taxable equivalents in the intermediate and long-maturity categories, as investor demand pushed muni prices higher. Even after such outperformance, municipal valuations remain attractive relative to long-term historical relationships with Treasuries.

In 2015, the technical characteristics of the municipal market likely will not be much different from those of 2014. Net new supply of municipal bonds is not likely to change significantly, while high tax rates are still poised to support demand. At the same time, valuations of muni bonds relative to taxable securities, while still favorable relative to historical standards, leave less room for a repeat of the outsized performance of 2014 due to the lower overall level of interest rates.

Credit and Economic Factors
As with other investments in 2015, the likely absence of a substantial movement in interest rates may mean that performance in the municipal market may be greatly influenced by credit-specific factors. These factors could include differences in fiscal management among U.S. states; the consequences of lower oil prices; merger and acquisition activity among healthcare providers who access the muni market; and the relationship of select types of revenue bonds to stronger economic growth. This could result in significant performance differences among municipal securities, especially since overall returns likely will not be as strong as they were in 2014 because interest rates have already decreased so much.

Sovereign debt investors know that countries’ differing degrees of diligence in fiscal management can create performance divergence in their government securities. The same holds true for U.S. states and their offerings in the municipal market. Poor balance-sheet management and habitual postponement of pension funding may continue to create budget—and credit rating—pressures in 2015 in states such as Illinois and New Jersey. 

Conversely, New York and California are both benefiting from high tax revenues related to steady economic growth, along with effective fiscal management. Appreciating values for commercial and residential real estate, along with increases in the number of people employed in metropolitan centers of both New York and California, improves local as well as state balance sheets. And while Chicago also is benefiting from an improving commercial real estate market, the city continues to be hampered, much like the State of Illinois itself, by fiscal challenges and constitutional hurdles to pension reform.

In 2015, with less likelihood of additional interest-rate declines, municipal bond research likely will play a very important role in differentiating performance among securities in the asset class. Differences in the growth of revenues, funding of pension liabilities, the success of pension reform, and the prudence of fiscal management will translate into credit rating and performance divergence among municipal bonds.

Energy and Health Care
An improving U.S. economy also favors some municipal bond sectors more than others. Revenue bonds related to transportation and industrial development (IDRs) are likely to participate much more than other sectors in an economy where persistent, broad growth is amplified by lower energy costs. Airports and toll roads will directly benefit from lower fuel prices due to an increased volume of users, while broader economic growth can bolster earnings that support IDR corporate-backed debt.

The direction of oil prices also could affect specific regions. Although U.S. oil production is concentrated in Alaska, North Dakota, Oklahoma, Louisiana, and Texas, general obligation (GO) bonds of those states may experience less of an impact from lower energy prices than some observers fear. Issuance in these states (excluding Texas) is small, so the impact should not be notable. Furthermore, these states are all highly rated by credit-rating agencies. Both Alaska and North Dakota are rated ‘AAA,’ according to Standard & Poor’s, which could limit downside price risk. Both states also should be able to address revenue shortfalls with budget cuts. Texas, also rated ‘AAA,’ issues substantially more debt, but its economy is much more diversified than it was during the oil bust in the mid-1980s, and ratings pressure seems unlikely. 

However, the same cannot be said about municipalities within these oil states. Individual towns can be very dependent on drilling, so there is the potential for ratings pressure should lower oil prices affect economic performance and municipal revenues. Again, municipal bond research can identify—and minimize exposure to—potential areas of fiscal difficulty. In contrast, passive managers and municipal exchange-traded funds (ETFs), with a broader sector focus, may not exercise the same degree of discrimination in terms of security selection.

Finally, as ramifications of the 2010 Affordable Care Act continue to unfold, mergers and acquisitions within the hospital sector are creating opportunities. Large, well-managed hospital systems bring economies of scale, especially with regard to processing and operations, to less efficient, smaller hospitals. There were many acquisitions in this sector during the past year. Effective research and analysis can help identify issuers to avoid as well as others that might benefit from industry consolidation.  Similarly, nursing homes and continuing-care facilities, which are primarily in the high-yield muni sector, may see their credit ratings improve, as a more robust U.S. economy and a stronger real estate market may help broaden the population of individuals financially qualified to enter these facilities.

Investment Implications
The municipal bond market in 2015 should again broadly benefit from minimal changes in supply of outstanding muni securities, and a continued pickup in demand for munis, as long as the interest rate environment does not become too volatile. However, valuations, while still attractive, do not favor the outsized returns broadly enjoyed by municipal bonds in 2014, primarily because overall interest rates are so much lower than they were a year ago. Factors that affect specific states or sectors, and even individual issuers, may influence returns as much as the impact of supply and demand. 

In such an environment, the ability to identify the differences that will produce credit rating changes and performance divergence—along with the willingness to act to take advantage of those differences—could meaningfully distinguish the portfolio results of research-driven active management from those of a more passive approach to municipal bond investing. 

 

RELATED TOPICS

ABOUT THE AUTHORS

THE EMERGENCE OF DIVERGENCE

What’s the watchword for fixed-income investors in 2015? Divergence. In this series, Zane Brown looks at the prospects for widely varying performance—and investment opportunities—within:

Global Economy & Policy 
High-Yield 
Emerging Markets
• Municipal Bonds

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