Municipal Bonds: Weather Report
Technicals support short-term performance, but many municipalities are ill-prepared for an economic downturn.
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.
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.
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.
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*Assets under management is as of 6.30.2019 and includes leverage of $11.2bn. 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, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC, an affiliate of Guggenheim, SI, GFIA and GPIM.
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