Q&A: What's the municipal bond market outlook for 2014?
As if the threat of tapering and rate increases weren’t enough of a challenge in 2013, the municipal bond market confronted added concerns generated by a small number of high-profile distressed cases and broadening awareness of the challenges presented by underfunded pension obligations. Will 2014 offer some clarity and opportunity for investors? We asked R.J. Gallo, senior portfolio manager, for his views.
Q: What’s your outlook for the municipal bond market this year? Given the challenges of the past year, we are more optimistic than might be expected. Of course, concerns over rising interest rates hurt most fixed-income sectors over the last year, munis included. The Detroit and Puerto Rico dynamic gave investors one more reason to move away from municipal bonds. On the plus side, that has put into place the opportunity for more attractive relative valuation for munis. As we move into 2014, we anticipate market interest rates, Treasury and municipal, will face upward pressure, but to a lesser degree than in 2013. In addition, we don’t anticipate municipal yields will increase at a basis-point by-basis-point level with Treasuries, so the relative performance of municipal bonds versus Treasuries should fare better.
Generally, if we are right, and Treasury and municipal yields rise more slowly and to a lesser degree than they did in 2013, we believe there is a fairly compelling opportunity for risk-averse fixed-income investors to garner favorable after-tax returns in a variety of areas within the municipal bond market.
Q: Outside the headline cases of Puerto Rico and Detroit, how are state and local finances now faring? Municipal credit fundamentals across the board are steadily improving and state revenues have been on an upward trajectory for 14 straight quarters. Consider the state general obligation bonds of California, Texas and New York, the country’s three largest and most populous states. Each of these state governments has been upgraded and/or received positive ratings outlooks by at least one rating agency in the last year, largely thanks to sharply rising income and sales tax revenues and discipline on their expenditures. Municipal bonds from these three large states comprise almost 40% of the S&P Municipal Bond Index. By comparison, Puerto Rico and Detroit represent just 2.74% and 0.17%, respectively, within the index. Unfortunately, steady financial improvements aren’t as news worthy as exceptional crises.
Nonetheless, strengthening state government finances is key to improving overall municipal finances within that state. For example, financially improving states can become more generous in supporting local governments; they are in better position to fund Medicaid expenditures, benefitting health care providers. There’s a positive and widespread trickledown effect. As for the local governments, they have been slower to come around because they are primarily supported by property taxes, which due to the housing crisis, haven’t rebounded as quickly. But steady improvements in the housing market will eventually lead to higher property valuations and, ultimately, more tax revenue for local governments.
Q: What about other areas of the municipal market? In general, we are positive about segments of the revenue bond space that are linked to improving economic activity. This would include sales tax revenfue bonds, bonds linked to real estate values and transportation revenue bonds, both flight- and vehicle-related. We also expect positive performance from industrial revenue bonds, which are the municipal variety of corporate credit exposure, and thus benefit from strong corporate balance sheets and better economic growth. These bonds have potential to provide attractive diversification and are reasonably valued.
Q: Is the Affordable Care Act, aka Obamacare, a positive or negative for municipal finances? The biggest impact is related to the law’s Medicaid expansion. This expansion will be overwhelmingly funded by the federal government, at least for the next several years, so it was anticipated to be mostly budget-neutral for the states in the near term. A complicating factor arose when the Supreme Court ruled to allow states to choose whether they wanted to expand their Medicaid coverage, and many states have opted out. Because the costs of the ACA are partially funded by cutting Medicare reimbursements to hospitals, those hospitals in states that opted out of expanding Medicaid will face lower Medicare reimbursement without the expected benefit from greater Medicaid coverage for serving indigent patients.
The large health complexes, for the most part, are financially sound and equipped to work through implementation of the ACA and its various consequences. We are cautious about the credit trajectory of the small- and mid-sized hospitals that don’t have the deep financial resources and flexibility to do so. Hospitals not receiving the compensating revenue from the law’s Medicaid expansion are confronted with providing care to low-income, non-Medicaid-covered patients all while receiving less in Medicare reimbursements. From an investment standpoint, the valuations of the lower-quality hospitals may not compensate for the greater risks, and we are being much more selective in this space as a result. Long-term, there remains some concern that federal funding for the Medicaid expansion may fade, leaving states holding more of the burden, but that remains to be seen over time.
Q: Are states and local pension obligations likely to remain a major obstacle? It is a material factor that investors must consider when evaluating the credit quality of both state and local governments,and the degree of funding varies widely. Illinois and Chicago, for example, each has pension funding levels of less than 50% and face escalating demands on their current budgets to address the underfunding. (The State of Illinois finally enacted some meafningful pension reform in late 2013 to help meet this challenge at both the state and local level). Meanwhile, states like Tennessee and cities like San Antonio, Texas report funding ratios of 90% or higher.
The pension funding problem at the state and local levels was created over decades and it will take time to correct. The good news is that both state and local governments are beginning to reform their programs, with many making material and necessary changes. These include reducing cost-of-living adjustments, increasing employee contributions, raising retirement ages, revising formulas for determining pension payouts and closing defined benefit plans to new hires. It is a contentious and high-visibility issue, but the magnitude and urgency of the problem, combined with a decline in union influence, is translating into growing public and political support for reforms.
Another positive is that the Government Accounting Standards Board, which governs municipal and state financial disclosure standards nationwide, has strengthened its pension accounting rules, to be implemented over the next two years. Previously, underfunding of pension obligations would only be documented in the notes of financial statements. Now, a portion of this underfunding must be accounted for on state and local government balance sheets. The result will be greater transparency related to pension funding levels. In the short-term, there will be concern about the short-falls and effects on budgets, but this is exactly what is needed to encourage continued reforms.
At the state level, underfunded pension obligations are likely to be more manageable over time given the broader financial flexibility of state governments and their ability to implement legislative reform. Local governments have more limited financial resources than states, in general, and more limited legislative authority to adjust pension rules. Thus, those local governments that do face high levels of underfunded pensions may experience greater downward credit pressure as they struggle to find resources to make escalating payments.
Q: What are you watching? Three factors have potential to cloud our outlook. One that I referred to earlier would be rapidly rising interest rates, which would weigh on total returns for the muni sector. Another would be if the economy stumbles to any significant degree, which would cause market yields to fall. That would increase total returns on high quality municipal bonds but havd a secondary negative impact on economically sensitive credit factors in various municipal sectors. We do not expect either of these outcomes. A final risk we are monitoring would be distress of a major municipal borrower, such as Puerto Rico. For example, if Puerto Rico would enter into default, this could further drive investors from the municipal market. But Puerto Rico seems apt to muddle through in the near term, and even if it did default in some manner, the growing awareness among investors that Puerto Rico is an exceptional case compared to the improving credit and budgetary conditions across the states and most American cities may mitigate the market reaction somewhat.
Thank you, R.J.