Municipal bonds held their ground in 2018, and truly shined when equity markets were punished during the fourth quarter. For the year, munis outperformed not only equities, but other major fixed income sectors as well. We are optimistic about opportunities in the muni market in 2019. Rising uncertainty for risk assets, coupled with a favorable mix of healthy demand and limited supply, offer a promising backdrop. In particular, we are looking at opportunities in the BBB-rated space, and in revenue sectors such as hospitals and airports. Here’s a quick recap of 2018 and our thoughts heading into 2019.
2018: Tough Conditions Prove Helpful for Munis
Muni returns outpaced those of all other fixed income sectors last year (see chart below), generating positive results while stocks declined alongside both investment-grade and high-yield corporates. Despite municipal fund outflows for the year, price levels were supported by limited supply (as we discuss below, the 2017 tax overhaul eliminated a component of the muni market that historically accounted for approximately one-quarter of total annual issuance).
SLOW AND STEADY WON THE RACE
Municipal bond returns bested those of stocks as well as all other fixed income categories in 2018.
SOURCE: Bloomberg. Data as of 12/31/18. Coportate Bonds refers to Bloomberg Barclays U.S. Corporate Bond Index. HY Corporate Bonds refers to Bloomberg Barclays U.S. Corporate High-Yield Bond Index. Treasury Bonds refers to Bloomberg Barclays U.S. Treasury Index and Municipal Bonds refers to Bloomberg Barclays U.S. Municipal Bond Index .See Index disclosure for a list of index definitions.
Last year was a tale of two markets. Through October, conditions were stable and relatively benign for municipal bonds, but by November, volatility had spiked for equities. Trade conflict anxiety, Fed-related jitters, worries about slowing global growth—all of these factors hurt risk assets, and sparked a flight to quality that drove higher demand for high-grade fixed income. After reaching a near-term peak of 2.79% on November 6, 10-year muni yields fell sharply, alongside U.S. Treasury yields in late November and December 2018.
Considerations for 2019
We feel optimistic about the muni market currently, in terms of both the macro environment and the specific opportunities we see in BBB-rated credits and revenue bonds that offer strong relative value.
Favorable Supply / Demand Dynamics
Supply in 2018 was net negative and we anticipate similar dynamics in 2019. When net supply (total new issuance minus total called, refunded and matured debt) turns negative, it tends to be a helpful tailwind for returns. Total muni issuance for 2018 was 25% below 2017 levels and supply projections for 2019 are expected to remain tight. Federal gridlock is likely to slow the pace of infrastructure project approvals. Moreover, the 2017 tax overhaul eliminated advance refunding bonds, thereby stripping away what was historically roughly one-quarter of new-issue supply from the market.
Demand is much harder to gauge in advance, but demand for munis (and interest in stability and/or coupon-paying assets in general) is a likely outcome if broad-market equity volatility persists.
Strong Value in BBB Credits
With concerns around rising recession risks, it is understandable that there is caution in the BBB arena, or lower end of the credit spectrum; however, this is an area where our rigorous research and active, bottom-up security selection has proven to be a competitive advantage. Historically, we have often found value in the BBB muni credit band, where good bonds can offer a great combination of low default probability and favorable yield.
BBB munis have an extremely low historical default rate—on par with, and at times even lower over periods than AAA-rated corporate bonds. We can think of several fundamental reasons why this might be the case—for example, many BBB-rated municipal entities operate essential functions within state and local governments, bolstering their stability. But overall, the favorable default rate for BBB munis as compared to corporates suggests that the ratings simply do not imply the same level of risk across fixed income sectors.
Additionally, BBB munis have a yield advantage that has meaningfully contributed to their stronger returns over time relative to the broader BBB universe. We have found that over the long-term, substantially all of the total return in municipal portfolios is explained by income generation, rather than price appreciation, and that higher income levels can provide a cushion against volatility. BBB munis produced a 32% cumulative return over the five years ended December 31, 2018, compared to just 19% for the entire BBB universe.
Given the current state of the yield curve, we believe this yield/income advantage offers a durable source of return going forward. We believe the lower default rates of these bonds provide greater resiliency in the event of slowing growth or a recession, and more broadly we still see greater value in credit risk versus duration risk. Over time we have been able to generate close to 100 bps of yield from our BBB allocations over and above what the broader BBB muni universe offers. Of course, conditions are constantly changing for both the economy and for specific issuers, so keeping focused on doing our credit homework is the key to continued success.
Revenue Bond Opportunities: Hospitals and Airports
Revenue bonds, in our view, consistently offer favorable relative value compared to general obligation (GO) securities; conditions in various sectors and industries influence where we will find that value at any given time. The health care sector has been an area of focus for us, as it has benefited from years of growth, healthy financials and improved utilization trends, and uncompensated care costs have reached multi-decade lows. Accordingly, health care bond spreads have compressed over the past few years, but we continue to find value in the sector. One example is Catholic Health Initiatives, one of the largest health systems in the country, currently in the process of merging with Dignity Health. We view the credit positively, as active restructuring, divestiture, and operational improvements have led to beneficial financial results. Further, we continue to see upside potential upon closing of the merger from purchasing power and other operational synergies. Finally, as of year end, merger risk has greatly decreased with the conditional consent of the California Attorney General. This milestone is one of the last regulatory approvals needed for the merger to proceed.
Airport bonds have also offered us value in the past, benefiting from defensive characteristics such as strong backing from transportation authorities and long-term growth in air travel. Despite the headline prominence of airport delays stemming from the government shutdown, we are positive on this sector for 2019. One airport bond we view positively at the moment is Chicago’s O’Hare Airport. We own several of the bonds, most recently participating in the late November issuance for bonds maturing in 2033. We like the dual-hub nature of the airport for diversification, as well as the fact that it is the third largest domestic airport (by origin and destination passengers). The City recently executed a new Airline Use and Lease Agreement through the terms of our bonds with strong bondholder support mechanisms from the vast majority of airlines using the airport, further supporting our thesis on the name.
Municipal bonds are often seen as a late-cycle haven, given their low correlation to corporate earnings, broad sector diversification and generally longer credit cycle. Political uncertainty and late-cycle economics are likely to drive investors to seek stable assets such as munis. Alongside a constrained supply pipeline and attractive opportunities in the segments mentioned above, we are optimistic about the prospects for our portfolios in 2019.
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
Bloomberg Barclays U.S. Corporate Bond Index (“IG Corporates”) covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index (Agg).
Bloomberg Barclays U.S. Treasury Index (“Treasuries”) includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have $250 million minimum par amount outstanding and at least one year until final maturity.
Bloomberg Barclays U.S. Corporate High-Yield Bond Index (“High-Yield”) covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
Bloomberg Barclays U.S. Municipal Bond Index (“Investment grade municipals”) is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The Bloomberg Barclays U.S. Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.
Bloomberg Barclays 1-10 Year Municipal Blend Index is a market value-weighted index which covers the short and intermediate components of the Barclays Municipal Bond Index—an unmanaged, market value-weighted index which covers the U.S. investment-grade tax-exempt bond market. The 1-10 Year Municipal Blend index tracks tax-exempt municipal General Obligation, Revenue, Insured, and Prerefunded bonds with a minimum $5 million par amount outstanding, issued as part of a transaction of at least $50 million, and with a remaining maturity from 1 up to (but not including) 12 years. The index includes reinvestment of income.
Bloomberg Barclays US AAA Aggregate Bond Index is a subset of the Aggregate Bond Index measuring AAA-rated fixed income securities.
Bloomberg Barclays US BBB Aggregate Bond Index is a subset of the Aggregate Bond Index measuring BBB-rated fixed income securities.
Bloomberg Barclays Municipal AAA Bond Index measures the universe of AAA-rated municipal debt securities.
Bloomberg Barclays Municipal BBB Bond Index measures the universe of BBB-rated municipal debt securities.
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