"The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” This quote from American writer William Arthur Ward seems apt when considering the municipal investment landscape in the final quarter of 2017 – a time when strong winds, both literal (in the form of a punishing hurricane season) and metaphorical (in the form of policy headwinds and tailwinds), are buffeting the muni markets. And it has never been more important to respond with a pragmatic, active approach.
In this edition of Munis in Focus, we discuss how we’re “adjusting the sails” of our portfolio positioning to help investors address both the short-term and longer-horizon challenges of extreme weather events and policy shifts, while taking advantage of opportunities they may create.
Lessons from a brutal hurricane season
Hurricanes Harvey, Irma and Maria have taken a devastating toll this year on the communities and citizens affected. While their impact on municipal credit is likely to be somewhat muted – neither S&P nor Moody’s has ever recorded a bond default resulting directly from a natural disaster – credit deterioration is possible. In fact, the rating agencies have assigned negative credit outlooks to a number of smaller borrowers (primarily utility districts) in the regions affected by the hurricanes.
When assessing the risk to a bond posed by potential natural disasters, it’s important for investors to consider several key factors:
The bond’s security features. We view asset-dependent bonds to be most at risk, and bonds secured by revenues from a single asset are of particular concern. Examples include certain types of lease revenue bonds and bonds secured by student housing facilities, assisted-living and senior facilities and single-site hospitals. While various forms of property insurance would generally be included in the security packages for these bonds, they may not be sufficient to prevent credit impairment.
Expected federal disaster relief. The federal government will provide assistance in rebuilding efforts, with FEMA covering up to 75% of storm-related repairs and debris removal. Legislation is already moving through Congress to provide additional relief.
Initial conditions of the local economy and the financial health of the credit itself. This is perhaps the most important consideration, as the following examples illustrate (we discuss Puerto Rico in greater depth below):
Hurricane Katrina and the City of New Orleans. In the year following Hurricane Katrina, the City of New Orleans saw its population drop by more than half, sales tax revenues fell by 20% and the regional economy contracted over 7% in real terms. While the city avoided default, it experienced significant credit deterioration, and its population remains below pre-Katrina levels, with regional GDP still 12.3% below 2004 levels as of year-end 2016.
Superstorm Sandy and the New York MTA. Increased credit risk can manifest itself in increased leverage, as we saw with the New York Metropolitan Transportation Authority (MTA) following Superstorm Sandy. In response to the storm, the MTA revised its capital plan up by roughly $5.674 billion. The MTA relied on a combination of short-term borrowing to bridge the gap before receiving federal reimbursement. Favorably, the local economy and the MTA’s resources and capabilities were strong enough to withstand the impact.
Hurricane Harvey and the City of Houston. Despite some recent weakness related to the energy sector, the Houston economy appears well positioned to weather Harvey’s impact. The city’s population has grown at a 1.6% compound annual growth rate since 2010. Prior to the storm, unemployment was a modest 4.7%, and total employment was up 1.2% year-over-year as of July. Houston’s controller has also stated that it will not sell new or unplanned bonds to pay for Harvey-related expenses.
All told, we expect Hurricanes Irma and Harvey to inflict transient modest fiscal stress on municipal credits in the areas affected, while the rebuilding efforts will likely provide a temporary surge in economic activity.
Hurricane Maria and the case of Puerto Rico
The Commonwealth of Puerto Rico was already in the midst of a complex bankruptcy process when it was devastated by Hurricane Maria, and addressing urgent needs, including restoring power and clean water, are the top near-term priorities. Looking ahead, an effective long-term rebuilding effort will be the key to restoring economic growth to the island and preventing more-rapid depopulation. To this end, municipal bondholders and citizens appear aligned in support of many policy initiatives that could boost prosperity over the next decade, including Medicaid equality (in terms of federal funding relative to states), relief from the Jones Act and the possible reintroduction of certain tax benefits whose expiration helped precipitate the island’s economic decline. Ideally such measures would be lasting or permanent to avoid future policy cliffs and give individuals and businesses the confidence to reinvest in the commonwealth.
PIMCO has long eschewed Puerto Rico government debt, given our view that market prices underappreciated the potential difficulties of servicing the debt burden. With Puerto Rico GO (general obligation) bond prices down more than 40 points since March, trading for roughly 30 cents on the dollar, we think valuations are looking more favorable than in the past. Still, the road to conviction is long and complex. Investors considering Puerto Rico GO debt have much to think about: In addition to an undefined capital structure, ambiguity about the security of specific liens and an untested bankruptcy process, investors must also consider the potential size, scope and form of the federal government response to a natural disaster or other unforeseen event and the impact it may have on the commonwealth’s demographics and economy for years to come.
Policy shifts (and lack thereof) drive healthcare-related muni performance
The U.S. presidential election in 2016 signaled big changes in U.S. healthcare policy – chief among them a potential repeal of the Affordable Care Act (ACA), including a roll-back or cap on Medicaid expansion. A unified vision among the legislative majority in the Senate has proved elusive, however, making a large-scale healthcare policy shift less and less likely as the year progresses. This has benefited municipal not-for-profit healthcare markets and issuers, which have outperformed the broader investment-grade muni market this year. Lower-investment-grade (‘BBB’) credits, primarily safety-net and “charity care” providers, have led the way (see Figure 1), with spreads now back within striking distance of pre-election lows.
While Medicaid headline risk has abated, other policy risks could squeeze profit margins for lower-rated safety-net and charity-care providers. Seventeen states are considering funding freezes or reductions that would disproportionately hurt these issuers, as would proposed cuts to the federal 340B Drug Pricing Program (which subsidizes drug prices and financial performance for many).
President Trump’s recent executive order expanding the use of association health plans and short-term insurance will likely cause a modest rise in uncompensated care, and the growing prevalence of high-deductible health plans (a trend in place well before the 2016 election) will likely also result in higher bad debt expenses for hospitals (see Figure 2).
Given these trends, PIMCO is constructive on high quality healthcare systems with diverse revenue streams and payer mixes that are less reliant on government programs. While safety-net and charity-care providers have benefited from the lack of healthcare policy progress in 2017, we are underweight these bonds at current valuations given the other policy risks they face. It’s worth noting that the recently proposed House tax reform plan may eliminate the ability for health care providers to access the tax-exempt financing market in the future. If this is enacted, it will likely raise funding costs and squeeze margins for all health care issuers, and the credits with the most to lose are likely the lower-rated safety net providers.
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Tax reform fears that spurred muni outflows haven’t been realized
Tax reform concerns contributed to $17 billion in outflows from open-end muni mutual funds in the six weeks following the 2016 election, and these fears appear to have lingered. Despite the relatively benign interest rate environment this year, only $15 billion has returned to the market.
Among investors given pause are banks and insurance companies, which have been buying federally tax-exempt munis at a significantly slower pace in 2017 (see Figure 3). The planned reduction in the corporate tax rate, along with large insurance claims related to natural disasters, remain near-term headwinds to additional allocations.
Meanwhile, the probability that tax reform will reduce the value of the muni tax exemption continues to shrink; in fact, the House tax plan in its current form would likely increase the value of the exemption due to reduced forward supply. Hospitals, private higher education and private activity issuers all would lose the ability to issue tax-exempt bonds. Advance refundings of existing outstanding debt issues would also be prohibited beginning in 2018. In aggregate, this policy mix could lead to a 25% (or more) decline in tax-exempt new issue supply over the next few years. While the ultimate policy path for tax reform still remains difficult to predict, the House plan has introduced a balance of risks for muni investors to consider: Long thought to be solely a downside risk to munis, tax policy changes could in fact be a positive catalyst for investors, with lower supply leading to higher valuations.
A steeper curve means richer front-end valuations – making longer maturities more attractive
Because banks and insurers tend to buy longer-dated maturities, their absence has contributed to a steeper curve for muni bonds (see Figure 4). We currently favor 20- to 25-year maturities over the richer front end – a relative value call that is evident in the ratio curve and aligns with PIMCO’s Cyclical Outlook. Over the next year, we expect the Federal Reserve to raise the policy rate two to three times, which will likely put more pressure on the front end of the curve relative to the long end.
Adjusting the sails: key investment takeaways
Tight valuations in other U.S. credit markets are informing our muni portfolio positioning, with the relative underperformance of municipal credit spreads since the 2016 election pointing to further upside in spread tightening (see Figure 5). We remain constructive on “traditional” high yield (‘BB’ rated) munis (i.e., excluding MSA tobacco, Puerto Rico and healthcare) and continue to prefer revenue bonds over GOs, with some exceptions. For example, with both Chicago and Illinois GO bonds, we see compelling valuations combined with fundamental uplift in the credit trajectory over our cyclical (six- to 12-month) horizon. Lastly, we continue to focus on identifying opportunities arising from the complexity premium in MSA (Master Settlement Agreement) tobacco asset-backed bonds.
What does adjusting the sails mean for an active municipal bond manager? For us, it entails closely monitoring changes in the market, adapting our outlook in response and repositioning our portfolios accordingly. With this approach, we look to help investors weather periods of turbulence while positioning them to seize opportunities that may emerge in their wake.
Muni positioning snapshot
Underweight: safety-net providers and not-for-profit healthcare issuers
Modestly underweight: duration
Constructive on ‘BB’ rated securities; longer maturities versus the rich front end; structurally overweight revenue bonds versus GO bonds
Constructive on select GO bond risk with positive credit trajectory (Chicago and Illinois)
Identify opportunities in MSA tobacco bonds given the complexity premium associated with less-predictable timing of cash flows
Provide opportunistic liquidity to harvest bid/ask spreads
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