Rising pension liabilities remain a concern, but strong technicals support the municipal market.
States’ fiscal-year 2016 financial statement disclosures have illuminated a common theme of substantial net pension liability growth overwhelming operating results, growth of tax receipts, and the replenishment of rainy day funds. A combination of poor investment results relative to inflated return assumptions, rising pension costs, and underfunded contributions have yielded countless negative headlines. We expect many states and municipalities will face significant financial choices as rising pension costs threaten other policy initiatives in 2017, placing pressure on capital projects and appropriation-backed bonds. Against this backdrop, strong technicals continue to support the municipal market, primarily driven by 52 consecutive weeks of inflows to mutual funds by the traditional investor base. Enhancing this demand is a new group of investors from Asia and Europe who are attracted to positive yields, diversification, and low historic default rates. For both traditional and foreign investors, a rise in interest rates may not dampen their respective appetite as alternatives to the municipal market’s risk-adjusted yields become harder to find. Our focus continues to be on credit discipline and bonds supported by dedicated revenue streams and/or statutory liens as robust technicals drive the market toward conceding on legal structures.
Municipal Bonds’ Investor Base Broadens
While individuals and mutual funds have historically been the largest source of demand for municipal bonds, our analysis shows that they have been losing market share by 1-2 percent per year since 2009, from 78 percent to 69 percent as of the third quarter. Life insurance, U.S. chartered depository institutions, and foreign holdings combined have gained that 9 percent difference. We believe this to be a positive shift, as it diversifies and broadens the buyer base.
Source: SIFMA, Guggenheim Investments. Data as of 10.15.2016.
Municipal bonds posted their first quarterly loss of the year in the third quarter of 2016, with the broad Municipal bond index falling 0.3 percent. All credit ratings suffered losses, with AAA, AA, A, and BBB-rated bonds posting losses of 0.5, 0.4, 0.1, and 0.3 percent, respectively. Hardest hit were long-dated municipal bonds (+22 year maturity), which lost 0.7 percent.
Separate from fundamental credit risk and money market reform, the ensuing investor redemptions of short-term paper have pushed the SIFMA Municipal Swap Index, a benchmark used for short-term municipal borrowing, to over 80bps, up from 1bp in early 2016. The sharp increase in the SIFMA rate will directly impact roughly $175 billion of variable-rate demand notes (VRDNs). While U.S. regulations have caused higher financing costs for state and local governments, further unintended consequences can be expected subsequent to the policies of the next presidential administration in 2017.
Floating-Rate Assets Look Increasingly Attractive
Money market reform and the ensuing investor redemptions of short-term paper have pushed the SIFMA Municipal Swap index, a benchmark used for short-term municipal borrowing, to over 80 basis points, up from 1 basis point in early 2016. VRDNs have floating coupons which reset based on this swap index rate. These assets are looking more attractive on a taxable-equivalent basis as the benchmark rate rises.
Source: Federal Reserve Financial Accounts, Guggenheim Investments. Data as of Q2 2016.
—James Pass, Senior Managing Director; Allen Li, CFA, Managing Director
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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, Transparent Value Advisors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management.
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