/perspectives/sector-views/municipal-bonds-weather-report

Municipal Bonds: Weather Report

Technicals support short-term performance, but many municipalities are ill-prepared for an economic downturn.

November 19, 2018


This Municipal Bonds sector report is excerpted from the Fourth Quarter 2018 Fixed-Income Outlook.

Favorable technical dynamics and positive headlines buoyed municipal bond performance in 2018. While total issuance declined by 20 percent year over year, new money supply increased by 22 percent over the same period and has been consistently met with excess demand. Meanwhile, the AAA-rated tax-exempt municipal yield curve experienced a more parallel shift higher versus the bear flattener seen in Treasurys, providing greater relative compensation for assuming duration risk.

AAA Tax-Exempt Munis Offered Better Risk Compensation than Treasurys

The AAA-rated tax-exempt municipal yield curve experienced a more parallel shift higher versus the bear flattener seen in Treasurys, providing greater relative compensation for assuming duration.

AAA Tax-Exempt Munis Offered Better Risk Compensation than Treasurys

Source: Bloomberg, Guggenheim Investments. Data as of 9.28.2018.

Since 2017, historically tight spreads have reflected improving credit developments, highlighted by timely state budgets, Supreme Court decisions with favorable fiscal implications (e.g., South Dakota v. Wayfair, Janus v. AFSCME), and Puerto Rico’s consensual restructuring negotiations. However, we believe these favorable factors are more than offset by states’ mounting fiscal challenges ahead of the next recession, which we believe will begin in the first half of 2020. We expect municipalities to be less prepared to weather the next economic downturn given the smaller relative size of their reserves compared to past cycles, and rigid budgets hampered by growing healthcare and pension costs.

Most States' Reserves Have Declined Since the Last Downturn

Change in State Fund Balances as % of Expenditures Since 2007

Favorable factors are more than offset by many state issuers’ mounting fiscal challenges as we approach recession in the first half of 2020. We expect municipalities to be less prepared to weather the next economic downturn given the smaller relative size of their reserves compared to past cycles.

Most States' Reserves Have Declined Since the Last Downturn

Source: Pew Trusts, Guggenheim Investments. Data as of 8.29.2018.

Structural pension issues will only compound in the economic downturn as pension assets are directly vulnerable to equity market performance. Our Macroeconomic and Investment Research Group's work indicates that U.S. stocks could see peak-to-trough declines of more than 40 percent in the next bear market, which would further undermine municipal issuers' credit quality by expanding pension funding gaps—or in other words leverage.

Over the past year, the municipal market has been amenable to issuers' undesirable late-cycle behavior such as replacing bond documents with weaker provisions, employing aggressive financing strategies (e.g., use of pension obligation bonds), and issuing tax securitizations with zero-sum implications for general obligation bondholders. As we continue to observe diminished market liquidity, we remain focused on the need for credit discipline and defensive positioning.

—James Pass, Senior Managing Director; Allen Li, CFA, Managing Director; Michael Park, Vice President

 
Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management. ©2018, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.


FEATURED PERSPECTIVES

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Forecasting the Next Recession: The Yield Curve Doesn’t Lie

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October 15, 2018

Beneath the Tide of Rising Earnings

Factors that have contributed to strong earnings growth this year will fade in 2019 and turn into headwinds in 2020, exposing leveraged corporate borrowers.


VIDEO

Forecasting the Next Recession 

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Global CIO Scott Minerd and Head of Macroeconomic and Investment Research Brian Smedley provide context and commentary to complement our recent publication, “Forecasting the Next Recession.”

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In his market outlook, Global CIO Scott Minerd discusses the challenges of managing in a market melt up and highlights several charts from his recent piece, “10 Macro Themes to Watch in 2018.”







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