July 15th, 2018
The municipal market spent much of the first quarter of 2018 in what we would call "price discovery mode", as both investors and underwriters struggled to find market clearing yield levels in reaction to a massive 59% decline in new issue volume following the prior quarter's tax reform-induced supply surge. Benchmark curve setting services such as Municipal Market Data ("MMD") rely on new issue pricing scales to determine the tone of the market on any particular day and, in the absence of a decent new issue calendar, their job was made more complicated by the Treasury market's more bearish tone early in the year, with ten year Treasuries continuing to test the key 3.00% level. This resulted in the worst first quarter performance for the tax-exempt sector in years: the S&P Dow Jones ("S&P DJ") National AMT Free Municipal Index returned a negative 1.16% for the quarter ended 3/30/18.
Fortunately, the second quarter turned out to be a period of consolidation, and then recovery for municipals. The new issue calendar did firm up modestly, although it was dominated by a few very large transactions, such as the $3.2 Biilion New Jersey Tobacco refunding deal. According to SIFMA, municipal bond issuance totaled &97.1 billion in 2018Q2, up 49.6% from 2018Q1.
More importantly, fund flows turned strongly positive again as the seasonal reinvestment demand for June/July started to reassert itself, further bolstered by a short term rally in Treasuries. Ironically, the more constructive tone in the Treasury market came in response to increasing concern about the US economic outlook, as the risk of an all-out trade war with China (and with some of our long-standing trade partners) escalated. This, of course, may have negative credit implications for the states that depend heavily on the affected industries (e.g. Autos) and on global trade in general.
The second quarter's improved technicals helped the S&P DJ National AMT Free Municipal Index record a positive 0.82% total return for the quarter. bringing it closer to breaking even for the year (-0.35% YTD). The real breakaway performance was to be found in the credit space, however, as the top five performing sectors were all traditional "high yield" sectors: Tobacco (+4.87$ in Q2, +6.67% YTD); Nursing (+1.34% for Q2, +1.39% YTD); Lifecare (+1.20% for Q2, +1.22% YTD); Incremental Tax (+1.35% for Q2, +1.15% YTD); and Land Backed (+1.23% for Q2, +0.95% YTD). The Tobacco sector itself benefited greatly from a couple of sizeable refundings.
From a geographic standpoint, the most dramatic outperformance (based on the S&P DJ Indices) came from all the US territory credits which got destroyed in the market last year on the back of one of the worst hurricane seasons in memory: US Virgin Islands (+19.97% for Q2, +43.78% YTD), Puerto Rico (+8.98% for Q2, +18.89% YTD) and Guam (+2.28% for Q2, +0.54% YTD).
Of the three US territories, the USVI bonds' rebound made the most sense to us, as Governor Mapp's Administration continued to deal with its fiscal adversities in impressively professional fashion, as evidenced by the recently announced $1.4 billion deal with ArcLight Capital Partners to re-open the former Hovensa oil refinery on St Croix. In contrast, when faced with the critical task of rebuilding an economy ravaged by Hurricane Maria, the government of Puerto Rico continues to exhibit extreme bad faith in dealing with its creditors and to put local politics ahead of substantive economic policy initiatives to put the island back on a growth path. If you need any proof of this, just look at what's going on with PREPA, which we will discuss in an upcoming piece.
Thus, the rebound in Puerto Rico paper from depressed year-end trading levels may have been a bit more technical in nature, especially when one considers the leverage inherent in buying distressed paper in the low 20s (cents on the dollar). it doesn't take much good news to spark a major rally from such levels, and investors did find good reason for optimism in the prospect of a deal between the Commonwealth and the COFINA Senior Lien bondholders regarding the allocation of sales tax receipts. Although the G.O. bondholders still have to be brought into the fold, a negotiated settlement in the GO vs COFINA case would help avoid any legal challenge to the COFINA structure and, by extension, to other revenue securitization structures in the market. Yes, holders of the Chicago sales tax securitization issue (affectionately known as "Chifina"), you may breathe a little easier now!
So here we are at mid-year, just before the summer doldrums start to set in. For the time being, the municipal market appears to be in cruise control mode and many state and local governments are enjoying the temporary financial windfall stemming from last December's tax reform act.
The Supreme Court of the United States ("SCOTUS") has certainly done its share this quarter to bolster the long-term fiscal outlook for the states. Aside from the watershed "Janus vs AFSCME" decision, which we discussed at length in a previous post, the Justices also overturned on June 21st, in the "South Dakota vs Wayfair" case, a two decade old ruling that prevented states from collecting sales on online purchases. Although the potential financial impact to the states is projected to be modest (between $8 and 13 billion in the aggregate by some estimates), it may provide a much needed fiscal cushion should the economy start to slide into recession next year. If nothing else, the Wayfair ruling will allow states to finally update their revenue structure to recognize the fact that there's something out there called Amazon.com that's trying to devour the entire economy!
At the end of the day, the outlook for municipals in the second half will depend. as usual, on what happens in the Treasury market and on the potential impact of trade policy on various areas of the country. Will the trade wars pull the rug from under the nascent global economic rebound? In the US, as the short term economic boost from tax reform wears off and the regional impact of trade policy start becomes apparent, the risks of a recession within the next 12 months will be rising. As Gabe Petek from S&P recently pointed out, most state and local governments have not taken advantage of this prolonged economic recovery period to rebuild their reserves and thus, will be ill-prepared for any economic downturn. This scenario, if it does unfold, will be good for high quality bonds but bad for credit spreads, which already stand at a cycle low.
In the meantime, the Boston Globe just reported that lobster prices have collapsed as a result of a retaliatory 25% tariff by the Chinese on imports of the beloved crustacean. So please go out and enjoy that lobster roll before coming back in September to deal with all the vagaries of public finance.