The Municipal Market: Optimism in 2015 Market Commentary
Fourth Quarter 2014
THE U.S. ECONOMY IS STRENGTHENING, with gross domestic product (GDP) and jobs growth exceeding expectations. But that has not translated into a bond market sell-off, in part due to concerning global economic data. A potential double- or triple-dip recession in Europe has the European Central Bank (ECB) developing creative stimulus programs. As Japanese GDP growth hovers just below zero, Prime Minister Abe is buying both bonds and stocks to stimulate the economy. As a result, the dollar is strengthening against the euro and yen, which has contributed to commodity price weakness.
Commodities Are Putting Downward Pressure on Inflation Oil prices started the fourth quarter at $90 per barrel, then began falling consistently to end the year at $53. Prices of other key commodities such as iron ore and copper are also decreasing significantly due to at least two main factors: ▪▪ THE STRONG DOLLAR. Because most commodities are priced in dollars, a stronger dollar makes commodities less expensive.
▪▪ WEAKENING GLOBAL DEMAND. While the U.S. economy is strengthening, our service-
oriented economy is not a major contributor to marginal demand for commodities. The wild card for commodity demand is China. China’s growth may be lower than the government has reported, and even the Chinese government is lowering its GDP expectations. Demand for commodities has weakened in Japan and Europe. If China’s growth rate falters as well, these prices may have further to fall.
Falling commodity prices are important in part because they put downward pressure on inflation. The most recent release of the U.S. producer price index (PPI) was slightly negative, with the core PPI at zero (core excludes food and energy). Similarly, the headline consumer price index (CPI) was -0.1% while the core rate was 0.1%. If this continues, CPI year-over-year could fall to 1% or less in early 2015. While actual inflation is falling, inflation expectations have dipped below 2% over the next five years. Inflation expectations could continue to decline if the strong dollar and weakening demand for commodities persist.
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John V. Miller Co-Head of Fixed Income Nuveen Asset Management, LLC
The Municipal Market: Optimism in 2015
Fourth Quarter 2014 ▪▪ GLOBAL MARKET DYNAMICS are having a more pronounced
The Fed Is Supporting Falling Inflation Expectations
effect on Treasuries. These include lower inflation, strong foreign demand and yield curve flattening.
The Federal Reserve (Fed) has shifted to a more hawkish tone by emphasizing the lower U.S. unemployment rate and discussing the timing of rate increases. When the Fed seeks to tighten monetary policy in a low inflation environment, this lends further support to falling inflation expectations in the bond market.
▪▪ A FLIGHT TO QUALITY has boosted Treasury demand. If oil
prices remain low, it may lead to an increase in corporate bankruptcies, particularly in the energy sector. Many highly leveraged energy companies need higher oil prices to survive longer term. As a result, credit spreads have widened. Although the effect is predominantly in corporates, municipals can be intertwined with corporates in terms of risk and spread.
Quantitative easing (QE) ended during the fourth quarter as expected. But when the Fed stopped buying bonds, yields ▪▪ PORTFOLIO MANAGERS AND TRADERS ARE BUILDING CASH actually fell and Treasury prices rose. This runs contrary to the expectations of many market observers. If a large buyer BALANCES for year end after strong 2014 performance. of Treasuries exits the market, one might expect prices to ▪▪ NEW ISSUE SUPPLY HAS BEEN HEAVY in the fourth quarter. fall. However, QE is stimulative and ▪▪ MUNICIPAL CHARACTERISTICS DIFFER potentially inflationary, so the end of the easy money program reduces the FROM TREASURIES. Municipal bonds inflationary risk, which kept prices steady. TYPICALLY, MUNICIPAL YIELDS are callable, which generally gives them shorter durations, with credit move in the same direction as Similarly, the Fed is expected to raise and supply/demand components that short-term interest rates in 2015. This will Treasuries but with less magnitude, can affect performance outside of likely continue to flatten the yield curve, interest rate moves. which increases the municipal-toas long-term bonds outperform shortterm bonds. Countries with stronger Treasury ratio. Long-term, high quality municipal bonds growth rates and tighter central bank outperformed in the fourth quarter. We policies tend to have the appreciating saw some spread widening of high yield currency compared to countries with low interest rates and indices primarily driven by Puerto Rico bonds. Puerto Rico weaker economies. This will be become more pronounced as the bonds actually declined in price/increased in yield, which is Fed raises interest rates. the opposite of the investment grade market. In other sectors, spreads are neutral or slightly wider.
Municipals Are Cheap Versus Treasuries
New Issuance Was Equal to 2013, but with Higher Demand
Treasuries outperformed municipal bonds in the fourth quarter. The 30-year Treasury yield ended the year at 2.75% after starting the quarter at 3.21%, for a decline of 46 basis points (bps). The 30-year AAA municipal yield declined only 21 bps, moving from 3.09% at the start of the fourth quarter to 2.88% at year end.
New issuance totaled $335 billion in 2014, which is virtually the same as 2013. Refinancing, rather than new projects, has been an unusually large component of supply. On the demand side, fund inflows of more than $20 billion are a significant improvement from the massive outflows of 2013. Steady fund inflows, evenly spaced throughout the year, have been a big positive to municipal liquidity and performance in 2014. Even so, the $71 billion in outflows over the second half of 2013 and the high level of bond call activity makes it safe to say that investors have substantial cash on the sidelines.
It can be challenging in some markets for municipals to rally as much as Treasuries, particularly when credit is a concern. Typically, municipal yields move in the same direction as Treasuries but with less magnitude, which increases the municipal-to-Treasury ratio. This is currently happening for a number of reasons:
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The Municipal Market: Optimism in 2015
Fourth Quarter 2014
Credit Developments Were Mixed
Detroit’s bankruptcy plan was approved with no surprises and the city emerged from its reorganization in the fourth quarter. As in the Stockton case, it was made clear that Chapter 9 bankruptcy law allows a city to cut pension obligations by unilaterally rejecting contracts. However, in these two cases the government opted to go after the bondholders.
PUERTO RICO bonds trended weaker in the fourth quarter. Tax revenues have been running lower than the budget demands, but that is not surprising. The surprise was that the total liquidity of the Government Development Bank (GDB) decreased by approximately $2 billion in 2014, leaving just $1.5 billion in cash on hand at year-end. This is dangerously low for an institution of such size and importance to the Commonwealth’s economy and financial stability.
Assuming that politics leads a city’s government to seek most of its cost savings from bondholders in a reorganization, the recovery rate on the bonds will be heavily The governor of Puerto Rico has influenced by the security level and the responded to the liquidity decline at the value of the underlying assets. As is often THE $71 BILLION IN OUTFLOWS GDB by attempting to raise money with a the case, the COP structure for Stockton over the second half of 2013 and new bond issue. The new bond issue would and Detroit had the weakest security the high level of bond call activity in theory be supported by a 66% increase and the least valuable underlying assets. makes it safe to say that investors in the petroleum tax. Unfortunately, As a result, Stockton COPs received have substantial cash on the the legislation simultaneously creates a approximately 2 cents on the dollar, while sidelines. mandate to roll back the tax before it Detroit COPs received approximately 10 actually goes into effect. Adding to the cents (before including the value of any complexity of the situation, the petroleum insurance policy). tax increase is linked to an overall tax reform on the island, Bondholders have a much better chance for a high recovery including the implementation of a value-added tax. Whether a rate in essential service revenue bonds, which are secured by the large Puerto Rican bond deal can be priced on the basis of this underlying project. This is particularly true if the underlying legislation is an open question for the first quarter of 2015. project has the capability of generating adequate revenues Puerto Rico rallied in the third quarter based on postponing through user fees. This has recently been exemplified by Jefferson the restructuring of the Puerto Rico Electric Power Authority County Water & Sewer (retail and mutual fund bondholders (PREPA), but that rally was short lived. In addition to received 80 cents on the dollar) and Detroit Water & Sewer restructuring PREPA, the island must also manage a potential (bondholders remained unimpaired throughout the city’s bond deal to support Puerto Rico Aqueduct and Sewer Authority reorganization). (PRASA), the GDB liquidity issue and tax reform all in the first quarter of 2015. The marketplace is appropriately concerned Mid-Term Elections Offered Surprises that the government may not be able to handle all of these ILLINOIS elected Bruce Rauner as its next governor. This could issues at once. create near-term volatility for the state’s credit, as Rauner wants to scale back the 5% temporary state income tax toward STOCKTON AND DETROIT exited bankruptcy in October. Stockton 3%. This would decrease state revenues and trigger a budget had the option to negotiate pension agreements in their deficit. However, pension underfunding is the most important bankruptcy. This was based on the judge’s ruling that federal component of the stressed credit profile. This is somewhat out of law trumps state law and therefore pensions can be rejected Rauner’s control. An Illinois appellate court declared the Illinois in Chapter 9. Nevertheless, politics was a dominant driver, pension reform unconstitutional, and it is expected to work its and the city decided to leave public pensions unchanged. In way to the Illinois Supreme Court. Stockton’s case, the target of the cost savings was a certificate of participation (COP) bond used to finance non-essential assets. CALIFORNIA passed Proposition 2, which forces the state This serves as a reminder to bond investors of the importance government to save some of California’s budget surplus for use in of differentiating bonds by security features, lien position and a future revenue downturn. Immediately following the election, underlying asset values. S&P upgraded the state again from A to A+. Moody’s has already 3
The Municipal Market: Optimism in 2015
upgraded it to AA3. The cyclical nature of the state’s revenue profile has been one of the biggest detractors from the state credit, which is otherwise very good.
Fourth Quarter 2014
should be in good shape. The high yield area is more complex and spreads could widen for a few reasons: ▪▪ PUERTO RICO will likely be weaker in January due to tax reform,
REPUBLICANS handily gained control of the Senate and gained liquidity concerns, PREPA and PRASA. Solving all these seats in the House by running more moderate candidates. This issues in the first quarter will be a daunting task. should reduce government shutdown risk ▪▪ THE OIL PRICE DECLINE has hurt high because the moderate candidates are not yield corporates, as have international so adversarial about budget issues. Any jitters regarding slowing growth. Fixed ALTHOUGH MUNICIPAL HIGH efforts for tax reform would be focused income assets that function on the basis YIELD SPREADS have remained on corporations and inversions rather of spreads – like high yield corporates and than reform of personal income tax where steady, other credit components sovereign debt – have weakened. municipals might be involved. have weakened, which could widen credit spreads. Although municipal high yield spreads Outlook have remained steady, other credit The yield curve continues to flatten. The components have weakened, which could long end is experiencing strong demand widen credit spreads. We don’t believe due to low inflation, and this should continue in the first quarter. low oil prices will hurt municipalities in general, although areas January is usually a good month for municipals because there are that benefit from energy production could see moderation of tax typically few new issue pricings to absorb investors’ excess cash. receipts. In general, the offsetting benefits of lower energy prices are more important and credit conditions should stay fairly Municipals have not kept pace with Treasuries in recent months constructive. The market is very diverse. If anything, sector and and are relatively cheap. Long-term BBB and better bonds credit selection is even more important. ▪
For more information, please consult with your financial advisor and visit nuveen.com. Treasury Yields and Ratios: Bloomberg (subscription required) Municipal Bond Yields: Municipal Market Data ICI Fund Flows: http://www.ici.org/research/stats Municipal Issuance: Seibert Research Standard & Poor’s and Investortools: http://www.invtools.com/ Flow of Funds, The Federal Reserve Board: http://www.federalreserve.gov/releases/Z1/Current/z1.pdf Payroll Data: Bureau of Labor Statistics New Money Project Financing: The Bond Buyer
RISKS AND OTHER IMPORTANT CONSIDERATIONS
This report provides general information only. The analysis contained herein is based on the data available at the time of publication. This information represents the opinion of Nuveen Asset Management, LLC and is not intended to be a forecast of future events and this is no guarantee of any future result. It is not intended to provide specific advice and should not be considered investment advice of any kind. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell specific securities or investment products. Information is current or relevant as of the date indicated and such information may become outdated or otherwise superseded at any time without notice. This analysis is based on numerous assumptions. Different assumptions could result in materially different outcomes. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds,
Puerto Rico: “Puerto Rico’s Senate Passes Oil Tax Hike Needed for $2.9 Bln Bond,” Reuters, December 3, 2014. http://www.gdb-pur.com/investors_resources/presentations.html Illinois Pension System: “Illinois Pension Reform in Question on Insurance Ruling,” Bloomberg, July 3, 2014. Jefferson County, Alabama: http://www.kccllc.net/jeffersoncounty Detroit Eighth Amended Plan for the Adjustment of Debts: http://www.detroitmi.gov/EmergencyManager/BankruptcyChapter9.aspx Standard & Poor’s, Moody’s, Fitch Stockton, California, Bankruptcy, Transcript of Confirmation of Plan: http://www.stocktongov.com/government/departments/manager/bankruptcy/
hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurers ability to meet their commitments. This information should not replace an investor’s consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc.
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