Municipal Bond Portfolio Construction in the Current EnvironmentBy Bob Andres | Aug 01, 2017
The first in a series of portfolio construction pieces Andres Capital Management published (July 14t ) a broad overview article titled “Fixed Income Portfolio Construction: How it Should Be Accomplished”
We present a second article in the series specific to Municipal Portfolio construction. The execution of our approach is supported by decades of experience from managing Merrill’s Municipal Bond Department with responsibility for all securities trading and underwriting to managing hundreds of millions of high net worth and mutual fund assets.
The Building Blocks:
- Ongoing Economic Assessment – Designed to identify the economic impact on future interest rate levels –
- Supply/demand analysis – Municipals are heavily influenced by supply/demand characteristics –
- Yield curve analysis – This is where current value is identified –
- Credit analysis – Assesses the borrower’s ongoing financial viability to borrow and repay debt
- Couponing and call features – A critical component in the building of a successful portfolio
Ongoing Economic Analysis of the current economic environment and an assessment of where we are heading economically is the first critical step in the process of building a viable portfolio. Our view is that the United States economy remains fragile with under 2.0% GDP growth likely for the foreseeable future. We have argued in other articles that the Fed has made itself irrelevant – 10-year treasury rates are fractionally lower today after four rate increases going back to December of 2015. We’re comfortable siding with the bond market’s reflective view of economic growth. Our assessment of the monetary aggregates, productivity data and debt levels does nothing to improve our economic outlook. The bulls look to employment growth to suggest that everything is ok. We do not see employment growth as a leading indicator – in fact we see the junction of 4.4% unemployment and GDP growth of 2.0% or less as a paradox and a major yellow warning light. We see the unemployment rate as close to its nadir with the strength of the data mostly behind us. Recent economic data has been underwhelming and we are in the very late stages of the business cycle. If confirmed, these views don’t bode well for those calling for a pick-up in growth or higher interest rates. In addition, inflation, the worst enemy of bonds is virtually, nonexistent and future expectations are declining. Finally, equity valuations are at historic highs by almost any traditional measuring metric which leaves the door open to a price adjustment and a subsequent flight to quality.
Supply/Demand Metrics: The Municipal Bond Market has traditionally been heavily impacted by supply/demand metrics. This is true in 2017 as demand continues to grow while supply shrinks. Despite low interest rates, State and Local governments have been reluctant to borrow for new money purposes. Revenue flows into their coffers are, at best growing anemically, and many are grappling with pension fund liability issues. Municipalities, faced with a broad array of spending pressures have opted to maintain budgetary discipline and borrow less in the face of revenue uncertainties. In addition, Municipalities have over the last few years taken advantage of market levels by swapping/refunding their high coupon debt for lower coupon current market debt. This refunding phenomenon has basically run its course and is contributing to the decline in new supply. Much of the refundings that have taken place were issued with 5.0% coupons, driving tremendous cash flow into investor hands. This occurred as professional investors insisted on larger coupons in compensation for the early retirement of their holdings. Huge cash flows and deal volume that is declining by approximately 15% point to a situation where there is simply “too much money chasing too few securities.”
Yield Curve Analysis: Our analysis of the municipal yield curve is a critical component in our search for relative value. The curve is currently compressed at 185 basis points front to back for AAA bonds, 205 basis points for AA names and 220 basis points for A rated paper. In our search for value we analyze the curve from the perspective of its slope. We want to know where the curve’s steepness disappears. The current curve starts out with 11 basis point of slope which gradually increases to 15 basis points in 2027 – it then decreases to 6 basis points a year from 2032 to 2034, after which it slows dramatically to 3 basis points for 2 years, then 2 for two more years and finally 1 basis point a year for six years ending in 2047. This analysis tells us that in 2034 we are capturing 90% of the curve’s increase but have only extended out 57% of the curve’s total length. In addition, the municipal A rated curve represents value versus treasuries providing 102% of the value of treasuries in 17-years. This value is of course enhanced by the tax-exempt feature of municipal securities.
(curve provided by Bloomberg)
Credit Analysis: The importance of fundamental credit research cannot be understated even as default rates in the municipal sector continue to decline. It is an essential step in the certification process that defines credit worthiness of individual holdings that make up a portfolio. With multiply decades of experience and leadership in the municipal industry we understand how to differentiate and apply the tools necessary to analyze both General Obligation and Revenue Securities. Our credit analysis seeks answers to a broad list of questions, some of which follow: 1) what is the demographics profile, 2) are there concentration issues, 3) how leveraged is the borrower, 4) are taxes or fees already leveraged, 5) what are net revenues to debt service, 6) what do reserves look like, 7) are there additional borrowing requirements, 8) how strong is management, 9) are contracts and indentures restrictive? In addition to our proprietary assessments we utilize the published ratings of Moody’s, S&P, and Fitch Ratings. We think the rating agencies do a very good job in general and they have become more aggressive in the aftermath of the collapse of the mortgage market in 2008 where their greed caused them to underperform egregiously. We also use “street pricing” as a tertiary or back-up rating system, in addition to employing Vendors like Bloomberg, Thompson Reuters and the Bond Buyer. Recent court decisions have made us less comfortable with tax based debt and have reinforced our view that essential serves revenue bonds are preferable in most cases. Other revenue based enterprise debt falls into place just behind water, sewer, and electricity providers in our opinion.
Couponing and call features: Couponing and the effect of call features on returns is significant and not fully understood by a sizable segment of the investing public. This is something we take very seriously. The municipal market offers buyers three coupon choices – discounts, premiums or current coupon/par bonds. In a flat or rising yield environment we will employ premium coupons – in a meaningful declining yield environment we will utilize discount securities, on a comparison basis we see no value in current coupon/par bonds. In today’s environment, we look to purchase 5.0% coupons with 10-year call protection. The cash flow drives total return and clearly offsets the amortization costs. The premium bond will also act as a hedge, declining slower if interest rates unexpectedly rise.
Virtually all bonds that are issued with maturities longer than ten years are sold with an option for the issuer to “call” the debt before its stated maturity date. While most of these early retirements are done because interest rates are lower than when the bonds were issued, some calls may be exercised for other legal purposes such as restructuring, indenture changes, etc. Call features have a tremendous impact on the value of securities and there are strategies used to take advantage of this fact. There is a category of bonds known as “kicker bonds” which specifically apply. The connection between time value of money and a security’s delta are the primary factors which impact yield to maturity with callable bonds and we’ll use an example to demonstrate.
Keep in mind that the value of a basis point is dramatically different depending on the maturity and you begin to understand what happens when a bond’s call feature comes into play. There is a current offering in the market of South Texas Community College District, Texas Water Revenue 5.00% 8/15/2034. The bonds are AA2 Moody’s and AA S&P, are callable in August 2023 at par. The bonds are offered at a 2.25 priced to the 2023 call. A basis point with these characteristics is worth $0.61 to that call date and is worth $1.37 to maturity. The impact of this differential is the “kick” because if these bonds are not called we own them at 3.75 to maturity. The AA scale today in 2034 is 2.73, so you are potentially picking-up 100 additional basis points.
Summarizing Our Approach: We see the combination of anemic economic growth and declining inflationary pressures as a solid environment for municipal investors. The fact that demand remains robust while supply shrinks only adds to our confidence. We do not think the 30-year bull market in bonds is complete. We expect rates to move unevenly lower as the current business cycle is completed and the nonsense in Washington continues to unravel. Our curve analysis suggests risk/adjusted value in the 15-17-year maturity range. We of course will diversify by security and maturity dependent on portfolio size and client risk parameters. We remain strong advocates for A rated essential service bonds (electric, water, sewer). We make very attempt to utilize our nationwide municipal dealer relationships to purchase securities on the bid side of the market knowing that every basis counts in the current low interest rate environment.
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