Updated: Jan 23, 2019
January 15th, 2019
To say that 2018 was a banner year for the high yield municipal sector would be an understatement: this asset class was the fixed-income investment of choice last year as it outperformed most taxable vehicles, including equities, on a tax-adjusted basis. 2019 could turn out to be a whole different story.
High Yield Municipal Performance In 2018
For calendar year 2018, the S&P Municipal Bond High Yield Index posted a positive total return of +5.28%, in contrast to the broader S&P Municipal Bond Index, which produced a narrowly positive return of only 1.36%, most of which attributable to the December rally. A large portion of the HY outperformance was attributable to the rebound in Puerto Rico names, however. The YTD return of the S&P Municipal Bond High Yield Ex-Puerto Rico Index was a more subdued 3.26%, still impressive nonetheless.
This was attributable to a combination of positive factors, namely: (1) strong economic fundamentals as the economic expansion got an additional shot in the arm from last December’s tax reform package; (2) strong technicals, as demand for incremental yield continued to outstrip supply, much of which has been pulled forward last year in anticipation of the tax reform bill; and (3) improved investor perception of municipal credit risk in general, as most of the credit trouble spots from years past (e.g. Puerto Rico, Illinois, New Jersey, Chicago etc…), as well as distressed sub-sectors such as development districts, have all rebounded strongly, at least for the time being.
2018 should be remembered as the comeback year for distressed muni credits: the S&P Municipal Bond High Yield & Defaulted Index and the S&P Municipal Bond Puerto Rico & Defaulted Index were up 11.78% and 59.48% (!) respectively.
The top performing sectors in 2018, again according to the S&P Muni Bond Indices, included all the traditional high yield opportunities: Tobacco (+3.60%); Incremental Tax (+3.08%); Student Loan (+2.53%): Resource Recovery (+1.93%); Dedicated Tax (+1.92%); Nursing (+1.89%) and Land-Backed (+1.87%).
The blowout performance from the former credit junk pile can also be seen on a state by state basis. The top six performing states or territories YTD include: US Virgin Islands (+62.04%); Puerto Rico (+23.70%); New Jersey (+1.99%); Maine (+1.79%); Illinois (+1.76%) and Connecticut (+1.75%). Five out of these six States or territories, the exception being Maine, had been viewed as troubled credits in prior years.
The fourth quarter, particularly the month of October, did mark a significant reversal for the HY sector, as the stock market's massive sell-off re-ignited the "risk off" trade and led to significant fund outflows. Between 9/26/18 and 1/02/2019, according to Lipper, the HY Muni funds (including ETFs) experienced aggregate net outflows of about $2.3 billion, partially offset by about $851 million in positive market change from the rate rally in December.
Given the selling pressure on high yield names in Q4 due to fund outflows, many of the HY sectors ended up at the bottom of the performance list in the last quarter of the year, with Tobacco taking a negative 3.13% hit.
Looking ahead, the HY Muni market’s strong showing this past year appears quite unlikely to be repeated in 2019 as the risk of a national economic slowdown, triggered perhaps by trade policy uncertainties and an extended federal government shutdown, is expected to rise significantly in the second half of the year. Whether the fourth quarter performance reversal in HY was just a temporary correction or a harbinger for 2019 remains to be seen.
That said, the HY Muni sector has historically shown greater resilience than the investment grade market during the initial stages of any major market selloff, for the simple reason that institutional investors tend to sell what they can easily buy back at a later date, i.e. general market names, before they would touch hard-to-replace HY issues. Yield maintenance considerations are also supportive of HY outperformance in a major selloff scenario, assuming no significant change in credit fundamentals. HY Muni underperformance would be conceivable, however, in a protracted credit crunch scenario or a major market liquidity event.
A more probable scenario for 2019 would entail more sector-specific performance issues, depending on each sector’s economic fundamentals, rather than any broad-based retrenchment. Stepped up credit surveillance efforts on a sector-by-sector basis will be key to avoiding performance (and liquidity) pitfalls in the coming year.
Outlook for Key High Yield Sectors
1. Puerto Rico
Last summer, creditors involved in the key legal case in the Puerto Rico bankruptcy, the so-called “GO vs Cofina” case, reached a breakthrough agreement which triggered a massive rally in Puerto Rico paper (the rally even extended to other US territories who had been stigmatized by association, such as the US Virgin Islands). Although such an agreement has a few more legal hurdles to overcome before it becomes reality, it still augurs well for a faster-than-expected ultimate resolution to the Puerto Rico debt crisis. In fact, Judge Swain is expected to rule on the proposed settlement this very week.
Of course, when it comes to Puerto Rico, nothing is ever certain until it's actually done, and this week's attack by the Oversight Board on the legality of the G.O. bond issues from 2012 and 2014 will certainly open yet another new can of worms.
Be that as it may, our prior recommendation favoring the Senior Lien Lien Cofina bonds, dating back to 2014, finally appears to be on point, although we have to admit there have been times over the past four years when we've lost faith in any rational resolution to the PR debt crisis.
2. The Illinois “Credit Cluster”
The so-called Illinois “credit cluster”, which includes the State of Illinois and its agencies, the City of Chicago and its Board of Education (aka Chicago Public Schools) represents the single largest geographic concentration in most HY indices.
In the aftermath of the midterm elections, Illinois is now one of the six new “trifectas” claimed by the Democrats. The much reviled but powerful Speaker Mike Madigan now enjoys Democratic supermajorities in both the Illinois House and Senate, which allows him to override any veto from the Governor. Such an override may no longer be needed, however: unlike his predecessor Bruce Rauner, Governor-Elect J.B. Pritzker is expected to have a much less confrontational working relationship with Speaker Madigan.
Given the new political regime, we would expect to see a more stable outlook for the State’s credit, more creditor-friendly, if not necessarily taxpayer-friendly. Governor-Elect Pritzker is already on record supporting a graduated income tax structure and legalized marijuana sales. One area of ongoing concern: we still don’t know how he plans to address the public pension crisis, although the presence of former Governor Jim Edgar, architect of the infamous “Edgar Ramp”, on Pritzker’s transition team does not bode well for the prospect of achieving a fiscally responsible solution.
In contrast to the State, the outlook for the City of Chicago has become much more uncertain, now that Mayor Rahm Emanuel has decided not to run for another term. The Emanuel Administration has made significant headway in terms of the City’s fiscal practices and there is now a risk that those efforts may not be sustained by a new, more union-friendly mayor. A crowded field of as many as 21 candidates, now whittled down to 14, is joining the race, with the election scheduled for February 26th 2019.
At this point, we believe the front runners, if only from a name recognition standpoint, are Toni Preckwinkle from Cook County and Susana Mendoza (the recently re-elected State Comptroller), both well-known to municipal investors. Ms Preckwinkle in particular appears to have a leg up on the rest of the field, given her deep ties to the Chicago Democratic Machine and assuming she can distance herself from Alderman Ed Burke's ongoing corruption scandal.
Former US Commerce Secretary Bill Daley has also thrown his hat into the ring, however, it's not clear whether the Daley family name will help or hurt him in the voters' eyes.
Not surprisingly, none of the mayoral candidates have advanced a credible plan to address Chicago's looming pension cliff. Since any long-term solution will take at least a year or two to implement, we believe there's a high probability that Mayor Emanuel's parting recommendation, to issue as much as $10 billion in Pension Obligation Bonds, will be adopted by the next occupant of 121 N. La Salle St, whoever that might be.
3. Tobacco Bonds
Tobacco settlement bonds have been an anchor for HY muni performance over the past 5 years, with an impressive annualized return of 11.01%. However, the sector has started to underperform the rest of the market quite significantly over the past 6 months: the S&P Municipal Bond Tobacco Index was down -3.13% and -2.88% for the past 3 and 6 months, respectively. In contrast, the S&P Muni HY Index showed returns of -0.20% and +0.87% for the past 3 and 6 months, respectively.
This recent underperformance is captured in the graph below, courtesy of ICE Data Services.
Chart: Yield Change: Tobacco Bonds vs 10 Yr UST & 10 Yr High Grade Muni (9/28-11/20/18)
Source: ICE Data Services
The tobacco spread widening of about 50 bps vs the ICE High Grade Muni 10 yr tenor from 9/28/18 through 11/20/18 may be attributable to a confluence of technical and fundamental factors: crossover investors who have historically trafficked in this sector may have simply decided to take profits, using the FDA’s recent crackdown on menthol cigarettes as an excuse. It’s certainly ironic that the FDA’s renewed assault on cigarette smoking came partially as a result of increasing concern about the rise of teenage vaping. Contrary to the common wisdom, what’s bad for e-cigarettes may not necessarily benefit regular cigarettes.
4. Health Care
The midterm election results were initially viewed as positive for the health care sector, however, a Texas judge's ruling in December that the ACA is unconstitutional has introduced some degree of uncertainty into the industry's long-term outlook. The ruling is under appeal and any potential impact is more likely to hit in 2020, not this year. In the meantime, the new Democratic House majority is expected to be supportive of the ACA and Medicaid expansion. In fact, three states (Idaho, Nebraska and Utah) actually approved Medicaid expansion measures.
In a couple of states, the governor races also meant good news for Medicaid expansion. In Maine, incoming Democratic Governor Janet Mills is expected to finally implement expansion, which was approved by voters last year, but has been opposed by outgoing GOP Gov. Paul LePage. Similarly, the State of Kansas is expected to be the next battleground for Medicaid expansion under governor-Elect Laura Kelly, a Democrat.
5. Senior Housing
The threat of overbuilding is hanging over the senior housing sector following the surge in new construction in 2016. According to the National Real Estate Investor (NREI) survey for the first quarter of 2018, the senior housing sector national occupancy rate reached its lowest point in 6 years to 88.8%, a 90 bps drop YOY and a 50 bps drop from 2017Q4.
This negative trend, which industry experts attribute to this year’s particularly rough flu season as well as to rising oversupply conditions, has had a greater impact on Assisted Living (AL) facilities than on the Independent Living (IL) facilities, reflecting a growing divergence between the two market segments. According to the National Investment Center for Seniors Housing & Care (“NIC”), AL occupancy fell to a record low of 85.7% in 2018Q1, as inventory grew 4.7% while absorption slipped to 3.2%. In contrast, inventory growth for IL facilities outpaced absorption by only 70 bps.
Since all real estate markets, including senior housing, are local by nature, the NIC data also highlights a growing polarization of occupancy levels among different markets, ranging from 95.1% for the San Jose, CA market to only 78.3% for San Antonio, TX.
Senior living projects which are still going through their construction or major capital improvement phases are reporting rising cost pressures, both on the labor side and on the materials side.
As mentioned above, the more supportive environment for the Medicaid program post-midterm elections will be a credit positive for many Assisted Living facilities with nursing home components, at least in the near term.
Cost inflation, labor shortages and a softening housing market will be the major threats to the Senior Housing sector, particularly for those new construction projects of 2016-2017 vintage that are just now entering their fill-up phase.
6. Charter Schools
The charter school movement is facing new headwinds as a result of the midterm elections. Despite its supporters’ claim of bipartisan support, support for charter schools have traditionally come from GOP legislators as a way to keep public teachers unions in check. As the New York Times pointed out, “charter school supporters are now wrestling with the unpleasant reality that a supposedly bipartisan movement, intended to rescue students from failing public schools, has been effectively linked to Wall Street, Mr. Trump and Ms DeVos by charter school opponents.” As a result, the recent Democratic wins will surely usher in a more hostile environment for charter expansion and more regulation, particularly in states such as New York and Illinois. From a credit standpoint, the potential cap on new supply may actually benefit existing, seasoned facilities.
In any event, the midterms were a mixed bag for education funding, as voters elected several candidates who have expressed sympathy for the teachers’ cause, while refusing to approve new taxes designed to support education.
The growing trend toward unionization of charter school personnel, in Chicago for instance, may also lead to erosion of the cost advantage traditionally enjoyed by charter institutions. Charter school accountability is also on the local educators' grievance list as teachers go on strike this week at the nation's second largest school district, the Los Angeles USD.
Potential Risk Themes Going Into 2019
Away from sector-specific factors, there are a few emerging risk themes that we believe bear watching as we start the new year:
• Potential Global Economic Slowdown:
Most credits held in HY funds will be directly or indirectly affected by the national economic outlook. Retail projects such as the American Dream Mall at The Meadowlands will be directly impacted by any major economic slowdown, the so-called “retail apocalypse” notwithstanding. A slowdown in the housing market will affect lease up rates at seniors housing projects, particularly those have been under construction and entering their initial fill-up phase.
• Potential “Crowding Out” effect from Puerto Rico’s Re-Entry Into The Market
Puerto Rico’s potential exit from bankruptcy, even a partial one, in 2019 will be deemed a credit positive for the tax-exempt market, however, its re-entry into the market may have the effect of crowding out other high yield investments, particularly if the new PR supply comes in securitized form at above market yields (This was mentioned in a recent Morgan Stanley strategy piece).
The tobacco sector may also be adversely affected by Puerto Rico’s re-emergence, as crossover traders tend to switch back-and-forth between two sectors as their trading vehicle of choice. In other words, if they perceive the new Puerto Rico supply to be the better trading vehicle, they may be tempted to take profit in their tobacco holdings.
• Growing Illinois component of HY Supply:
With the City of Chicago still contemplating the potential issuance of as much as $10 billion in pension obligation bonds, and the State’s seemingly unending appetite for debt, bond issuance level from the Prairie State should continue to outstrip the rest of the “high yield” market, raising the risk of geographic over-concentration.
• Impact of Trade Tariffs on Construction Costs for Projects Still Under Construction:
Many standalone project financings which are still in the construction phase are reporting difficulties in finding subcontractors and sharp increases in construction costs. This will have an impact on high yield sectors with construction risk, such as student housing and start-up seniors living.
As we have noted in previous articles, the highest default rate on high yield projects historically tend to occur about 3-5 years after bond issuance, Assuming this holds true once again in this credit cycle, investors should be very wary of issues of 2016-2017 vintage.