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Munis in Focus: 2019 Midyear Outlook – Strong Momentum Should Continue

After a strong first half, munis may continue to offer investors an attractive late-cycle refuge.

The municipal bond market enjoyed a strong first half of 2019, with robust returns and a record $43.8 billion of inflows to the asset class through the end of June, according to Lipper. Investment grade and high yield munis have returned 5.1% and 6.7%, respectively, to date in 2019 (as measured by the Bloomberg Barclays Municipal Bond and Bloomberg Barclays High Yield Municipal Bond indices as of 30 June 2019). Tight supply along with increased demand arising from the cap on state and local tax (SALT) deductions have been key drivers of performance and flows, while lower rate expectations and lower rate volatility underpin a broadly supportive macroeconomic backdrop.

While munis have richened in recent months, we remain constructive on the asset class and see several areas of opportunity for active investors in the second half of 2019. These include new entrants to the market, a rise in private placements, and potential to exploit the market’s mispricing of bonds with embedded call options. We continue to emphasize rigorous credit analysis both to uncover opportunities and avoid potential pitfalls.

Policy will continue to move the muni market

Policy expectations will likely drive muni supply and performance for the remainder of the year. The upcoming 2020 presidential election has raised prospects for higher taxes given many Democratic candidates’ progressive agendas, contributing to demand for tax-efficient investments such as munis. Net muni supply remains negative as issuance continues to lag bond maturities and calls (see Figure 1), and with no major infrastructure plan on the horizon, new issuance is likely to remain tight.

A confluence of factors has contributed to recent tightening in muni supply. These include the Tax Cuts and Jobs Act (TCJA)’s elimination of advance refundings, which had represented roughly 20% of annual muni issuance historically. However, investors should not mistake the favorable technical backdrop of flat debt as a sign of overall deleveraging: Unfunded pension liabilities continue to grow, crowding out investment in other areas and creating budget pressures that warrant caution.

Figure 1 is a bar chart showing gross and net issuance of munis, from 2007 to 2019. The bar for 2019 is annualized, and shows that both projected gross and net issuance for the year was on track for new lows for the 13-year time frame. Gross issuance was projected to come in about $270 billion for 2019, while net issuance at negative $140 billion. Only 2011 had a similar low in gross issuance, and net issuance for 2019 would far exceed the last low in 2018 of negative $100 billion. If the projection for 2019 holds, net issuance will have been negative nine out of the last 10 years. 

Unfunded pension liabilities constrain muni supply

As state and local governments continue to repair their balance sheets and right-size operations following the Great Recession, budgetary pressure from growth in unfunded pension liabilities (see Figure 2) has been a key factor constraining supply of bonded debt. Funding pensions diverts resources away from other investments, including servicing additional debt. These liabilities pose a growing challenge for some muni issuers, and recent bankruptcy court rulings suggest to us that they should not be ignored when performing fundamental credit analysis.

Figure 2 is a line graph of debt outstanding for various asset classes, from 2008 to 2019. Treasury debt climbed to about $16 trillion in 2019, up from roughly $6 trillion in 2008, and corporate debt to around $9.5 trillion, up from about $5.5 trillion. Unfunded liabilities rose to about $4 trillion, up from about $2.5 trillion. While municipal debt is about at the same level over time, it started falling from about $4 trillion in 2017 to around $3.75 trillion in 2019.

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The degree of pension concerns varies widely across the country, and this dispersion highlights the need for rigorous credit analysis and a thoughtful framework for assessing appropriate credit risk premiums. True pension funding stress is somewhat isolated: Wilshire Associates notes that at the end of fiscal 2018, the average funded ratio for state plans was 72%, and most plans with funding ratios below 50% were concentrated in a handful of states. Moreover, a recent analysis of city-level pension funding from Merritt Research Services noted that among cities with populations exceeding 30,000, only 3% had pension funding levels below 50%.1

That said, pension strain is a secular force that will likely pressure state and local government operations and balance sheets to varying degrees for years to come, especially as the U.S. labor force ages. Municipal issuers may seek a reprieve through reform measures, although the obstacles to pension reform vary widely by state. Pledging a dedicated revenue source for pensions could alleviate this pressure and lead to additional municipal bond supply for infrastructure or other budgetary priorities.

Opportunities for active muni managers in the second half of 2019

We see multiple sources of alpha potential for active investors in the second half.

Structural opportunities from mispriced callable bonds and steep curves. Roughly two-thirds of outstanding muni debt has an embedded call option, which the market does not price efficiently, in our view. An investor who purchases a callable bond is effectively short that call option to the issuer. As such, the value of the option can have a significant impact on the bondholder’s expected returns over time. Many market participants do not attempt to value the call option when selecting bonds to purchase. PIMCO uses a proprietary quantitative option model to price call options and seek attractive bonds on an option-adjusted spread (OAS) basis across the curve. Mispriced options can create significant opportunities to generate alpha by seeking to maximize OAS without adding duration or credit risk.

The muni curve has flattened on the year, with the spreads between two-year and 30-year munis narrowing to about 105 basis points (bps) from 125 bps as of 30 June. However, the curve remains steeper than for U.S. Treasuries. This gives investors an opportunity to extend the duration of some holdings, potentially increasing roll-down and carry and improving after-tax income streams. A barbell approach that marries longer-maturity callable bonds with short-term variable-rate demand notes (VRDNs) can help manage absolute levels of interest rate risk while taking advantage of steeper curves.

Active credit selection and avoidance of economically sensitive assets. Credit conditions remain relatively strong across much of the municipal landscape, but the U.S. is reaching the later stages of a long economic expansion. In this environment, it’s important for investors to discriminate between economically sensitive credits, which could be susceptible to large price declines in a contraction, and those with more defensive characteristics. PIMCO is positioning out of asset classes, sectors, and credits we view as most susceptible to declines in consumer spending, located in less economically resilient regions, or exhibiting high sensitivity to declining macro fundamentals, including commodity prices.  

Despite tight supply, the diversity of the $3.6 trillion municipal market creates ample opportunities for investors with sufficient resources and credit expertise to uncover value (see Figure 3). General obligation (GO) bonds make up less than 30% of the index, and specialized sectors such as healthcare and transportation are notable contributors. The broader market includes assets with exposure to housing and commercial real estate development, corporate credit risk, and commodities. New sectors are also emerging, including renewable energy projects, as investors and municipal issuers focus more on sustainability.

Figure 3 shows a pie chart of various asset classes in the muni market. General obligation comprises 29% of the market, the largest category. Transportation is next, with 17%. Special tax represents 10%, healthcare, 9%, water and sewer, 9%, education, 7%, lease-backed, 6%, power 5%, industrial development, 3%, pre-refunded, 2%, and housing 2%. Other munis represent 1%.  

Market confusion over the security benefits of “special revenue” bonds. In March, a U.S. court of appeals upheld a controversial ruling in the bankruptcy case involving Puerto Rico’s Highway and Transportation Authority, stating that payment of special revenues to bondholders is optional while the debtor’s bankruptcy settlement is pending. Despite the ruling, the bond revenues retain their “special” status under the bankruptcy code, given that the continuation of the lien on those revenues post-settlement was not affected. Nonetheless, the ruling resulted in a number of negative rating actions more broadly and created confusion and overreactions in the market, which have in turn given rise to investment opportunities. 

PIMCO continues to believe revenue bonds with a pledge of cash flows considered “special” are attractive relative to the unsecured nature of most GO pledges. Essential service enterprises, including those that deliver water and waste services to communities, typically exhibit inelastic demand, and their capital structures often include less pension-related debt than for the associated municipality. Even before the ruling, special revenue bonds tended to exhibit positive correlations with the credit quality of the underlying municipality. For example, when the City of Detroit filed for bankruptcy protection, the Detroit Water and Sewer Department’s special revenue bonds experienced price and ratings volatility but were ultimately tendered at par, while the GO bondholders suffered larger impairments (as did pensioners).

Growth in private placements and unrated issues. Lastly, we’ve observed significant growth in private placements and Rule 144A securities. Since the beginning of 2017, more than half of new entrants to the Bloomberg Barclays High Yield Municipal Bond Index have been private placements, and the vast majority are not rated by the rating agencies. Unrated deals have grown from 27% to 53% of the index over the last five years. Many of these deals have unique characteristics, and we believe discerning opportunities requires broad credit resources that go beyond dedicated muni analysis. These trends tend to limit participation by individual investors, but opportunities can still be tapped via managers like PIMCO that meet the qualified investment buyer (QIB) standard (often required for private placements) and with the credit capabilities to assign internal credit ratings to these bonds. Lower competition for these new issues can create additional spread over traditional public market deals that can be purchased directly by a wider investor pool.

Investor takeaways: Munis continue to offer late-cycle benefits

While municipal bond yields have fallen in recent months, we think valuations still look attractive on an after-tax basis relative to corporate bonds and other credit markets. Given the broadly accommodative environment since the financial crisis and the Fed’s pivot to a more dovish policy stance, we see the potential for excesses in corporate credit valuations and an environment that could give rise to liquidity concerns in the event of a significant shift in sentiment.

We remain constructive on municipal allocations given a continued supportive macroeconomic backdrop and favorable technical dynamics, including lower issuance and steady demand, particularly in high-tax states where SALT deductions were curtailed. Municipal bonds may offer investors late-cycle advantages, including attractive tax-efficient income, low correlations to riskier asset classes, and default rates that have been low historically. However, credit selection will become more critical as economies cool. We continue to emphasize credits backed by dedicated revenue streams less subject to politics and pension stress.

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1For the related analysis, see “Not All Cities Have A Pension Problem,” by Richard A. Ciccarone, published June 26, 2019, by MuniNet Guide.
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David Hammer

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