Joe Deane, head of municipal bond portfolio management at PIMCO, portfolio manager Julie Callahan, and Sean McCarthy, head of the municipal credit research team, discuss munis’ strong showing in 2014, our outlook for credit and what we expect in the year ahead.
Q: What factors contributed to the great year municipal bonds had?
Joe Deane: Municipal bonds surprised many by ending the year as one of the best-performing asset classes – buoyed by investors’ search for yield in a low interest-rate environment. The Barclays Municipal Bond Index was up 9.05% for the year and this strong performance was attributable to a combination of factors.
Demand turned positive in the first quarter of the year from returning retail investors, who had pulled out of the market in 2013, and continued to improve throughout 2014. Municipal mutual funds received $21.4 billion in net inflows for the year – compared with outflows of $62.7 billion in 2013. Crossover investors such as banks and insurance companies also took advantage of attractive relative valuations, particularly early in the year. This returning demand was coupled with low market supply as municipalities remain reluctant to take on additional debt – even at today’s very low rates. Total supply of $335 billion for the year ended in line with 2013 levels, but aggregate new money issuance declined year over year and remains well below pre-recession levels.
Improving perceptions of credit risk in the municipal market have also been additive. The market was rattled midyear by a spate of downgrades in Puerto Rico, but since then, the commonwealth has bought itself some time with new debt issuance, and negative credit headlines have largely receded for the time being. It’s important to note that many state and local governments are still grappling with substantial unfunded pension liabilities, but it will likely take some time before the effects of this come to light. In the meantime, the market has seen some positives, including California’s rating upgrade, following voters’ passage of Proposition 2, which establishes a rainy day fund for the state, and improving tax revenues across a number of states, stemming from the strengthening U.S. economy.
Q: Sean, would you elaborate on Puerto Rico and discuss PIMCO’s outlook for credit more broadly?
Sean McCarthy: The Puerto Rico credit story continues to evolve, with the economy moving sideways as the government strives to address its fiscal and debt crisis. The market anticipates a $2.9 billion petroleum tax deal late first quarter which will support efforts to ring-fence the island’s central government from a key public agency. This is the second time in 12 months that Puerto Rico has urgently needed to print a new transaction to bolster the central government’s liquidity position.
The successful placement of the petroleum tax-backed deal may allow Puerto Rico’s current administration another fiscal year to address remaining budgetary challenges and implement comprehensive tax reform. However, the island has additional near-term refunding needs that must still be addressed, and a restructuring of the publicly-owned electric utility is likely in the next several months. We also believe there are increased risks related to the execution of policy and reform ahead of the island’s elections in 2016.
Looking beyond Puerto Rico, credit quality across state and local municipalities is expected to continue to improve in 2015. States are still exhibiting fiscal restraint, but are expected to modestly expand general fund expenditures in the 2015 and 2016 fiscal years. Conditions have improved due to increased economic activity and several years of revenue, aided in some instances by temporary tax measures taken to close structural budget deficits. However, recovery from the recession has been slower than typical and several states must contend with mandatory spending requirements and rising costs related to an aging population. There are also several states that have still not taken decisive steps to combat their large and growing unfunded pension and other post-retirement debt burdens. And many of these same actors are experiencing a tepid economic recovery. We expect retirement obligations will continue to be a major credit theme and will have an adverse effect on the credit quality of several key states in 2015 and beyond. In addition, recent changes imposed by the Governmental Accounting Standards Board (GASB) are likely to reveal that pension burdens are greater than previously reported.
Local government credit quality is also improving, but the recovery is slower than in the states, due in part to a lag in the frequency of assessments affecting property tax collections and an uneven recovery in housing across regions of the U.S. Local government agencies must also contend with large unfunded retirement obligations and often have less revenue flexibility to adjust to higher cost structures versus the states. In many instances, local government agencies are also adjusting to reduced intergovernmental transfers from the state relative to pre-recession levels.
Finally, we would note that the sharp drop in crude oil from June 2014 highs is likely to have a bifurcated effect on state and local government credit quality. The drop in crude to current levels is the equivalent of a tax cut for consumers at the gas pump, which could contribute to increased sales tax receipts and benefit certain municipal asset classes, including toll roads. On the other hand, the drop in crude will result in some budgetary stress for the energy-producing states, but we believe that this pressure will be absorbed over the current and following fiscal year as the states make necessary midyear adjustments. In addition, the largest U.S. energy-producing states either have ample budgetary reserves or depend less on oil and gas revenues to fund their operating budgets, as severance taxes collected on the extraction of oil and gas are often used to fund capital projects or reserves. There may be some isolated pockets of stress for local municipalities and counties in regions with a high dependence on energy. These communities may be affected by layoffs and a reduction of capital spending by drilling companies, and lower property tax collections from parcels with wells that are shuttered.
Q: Julie, why is active management so important in this market environment, especially in the context of the ladder strategies that you manage?
Julie Callahan: As Joe and I have discussed previously, today’s municipal market is large, fragmented and localized, with over $3.6 trillion in outstanding debt among more than 78,000 municipal issuers.* The financial crisis essentially transformed this vast market from a Treasury-centric market – with widespread use of insurance – into a credit market. Now, municipal issues trade to the strength of their underlying creditworthiness, making active management and credit due diligence much more important today.
This is part of the reason we’ve seen such success with our municipal ladder strategies. Many financial advisors, who had assembled and managed their own municipal bond ladders in the past, are turning to active managers like PIMCO because they don’t have the resources to conduct the rigorous credit due diligence that’s needed on their own. We currently manage $3.5 billion in ladder strategies (as of December 31, 2014), and our credit team has independently analyzed and rated every security in our portfolios.
Importantly, at PIMCO, our investment process has never relied on insurance or external credit rating agencies. Instead, we employ rigorous and ongoing credit analysis at both the issuer and obligor levels and have our own internal rating system – our analysts develop their own ratings, including their outlook on how those ratings might develop over the year. This forward-looking approach helps to mitigate credit risk and volatility across all of our municipal bond portfolios and was the reason we began to de-risk the Puerto Rico positions in our tax-exempt dedicated national and state-specific portfolios in 2011 – long before the island’s debt saw significant price declines.
Also, as Joe and Sean both mentioned, there are state and local budgetary problems that will play out over a long time horizon. Because investors in ladder strategies allocate a portion of their portfolios to longer-maturity municipal bonds and primarily expect to buy and hold these positions, they need to be confident that their investment manager’s credit research is forward-looking, so they don’t have unpleasant portfolio surprises five years from now.
Additionally, with rates expected to rise in the latter half of 2015, we expect increased market volatility. Skilled active managers can quickly take advantage of dislocations in the muni market that can stem from Federal Reserve (the Fed) policies, Treasury rate moves or negative headlines.
Q: Joe, have there been any recent changes to the way the team manages munis?
Deane: Our day-to-day portfolio management has not changed at all. In fact, Julie and I as well as the rest of the team continue to manage our portfolios the same way we’ve been managing them throughout our careers – by investing in attractive, high quality municipal issues.
Importantly, the team continues to benefit from PIMCO’s robust investment process, which adds value from top to bottom. The firm’s macro outlook is developed at our quarterly economic forums and distilled into investment guidelines by our Investment Committee (IC). One change that’s been a positive for our business over the past year has been a closer reporting relationship up to PIMCO’s CIOs and IC. The IC typically meets four times a week and is critical in setting investment strategy and risk targets across the firm. Having a closer link to the IC and to the senior thought leaders at the firm has definitely been a positive for our team.
From the bottom-up, we emphasize proprietary research, security selection and ongoing surveillance provided by our dedicated team of municipal analysts who leverage the expertise of more than 60 firm-wide credit analysts. Each municipal bond we own is monitored on an ongoing basis. We never rely on agency ratings, as Julie mentioned earlier, and we’re always on the lookout for indications of a potential downgrade.
Q: What’s your outlook for 2015, Joe? Can we expect more of the same?
Deane: Given last year’s strong returns, we’re positioned cautiously for greater volatility in the fixed income markets. We’re maintaining an up-in-credit quality bias and favor liquid securities that would be more resilient in adverse market conditions. In keeping with our investment thesis, we prefer revenue-backed bonds over most GO debt, as these sectors typically benefit from dedicated revenue streams and don’t have the pension challenges that many state and local governments face. While we remain underweight to GO debt generally, we’re investing in select GOs in geographies that are tied to a continued recovery in U.S. housing and are less vulnerable to pension issues.
Because PIMCO expects that the Fed will likely begin raising rates in the second half of 2015, we are also maintaining an underweight duration positioning across most of our strategies to help protect investor returns in a period of rising interest rates due to the high correlation between municipal bond yields and Treasury rates.
It’s important to note that there is also pent-up supply in the system. Net supply has been negative for three years in a row, meaning that new issuance levels have been lower than the amount of debt that has matured or been called. In the midterm elections, voters approved $37 billion of $44 billion in ballot measures, the highest level since the downturn, which is a sign that state and local governments are beginning to think about new capital projects again. However, with state general fund spending below the 25-year historical average, weak wage growth, and uncertain funding for road projects from the Highway Trust Fund, we expect many states to remain cautious with respect to new money issuance. Whether this pent-up supply comes to market remains to be seen, and will be the result of state and local government confidence in the economy as well as the rate environment.
If supply does pick up, it could put pressure on the market, as supply and demand imbalances can have a major impact on muni market returns. Importantly, this can create some very attractive valuations for active managers, like PIMCO, with the credit resources and market presence to take advantage of these market inefficiencies.