In Volatile Times, Windows of Opportunity
Periodic bouts of turbulence could provide opportunities to deploy investor cash in municipals.
The Federal Reserve reduced interest rates by 25 basis points at its September meeting—the second cut this year and a continuation of the “mid-cycle” adjustment that began in July. I haven’t met many people who think we are in the middle of a cycle, so maybe that was just a poor choice of words. Nevertheless, we don’t envy the position that Jerome Powell is currently in, with daily critiques from the executive branch that rates should be at zero and a trade war with China that changes by the second. Throw in geopolitical issues with Brexit, protests in Hong Kong, the troop withdrawal in Turkey and the uncertainty around impeachment, and it’s no wonder that the Fed’s crystal ball is a bit hazy.
What is most interesting to me is the widespread view in the political class that the Fed can and should counter just about any issue with a rate cut. The Fed’s dual mandate is supposed to be full employment and stable prices. If the economy is growing but not as quickly as some would like, “just cut rates.” If a trade war intensifies, “just cut rates.” I am starting to wonder if some people think rate cuts can cure the common cold!
All joking aside, the Fed is being asked to do all the heavy lifting as politicians postpone making decisions that could foster better long-term economic growth. Also, there is almost no discussion of the harm that artificially low interest rates inflict on some of the people the Fed is actually trying to help. For all the mortgage refis that results from lower rates, there are savers who must endure earning less on the assets they have dutifully squirreled away. Even worse, they may have to exceed their normal risk appetite in search of returns that match their “yield bogey.”
When risk exceeds an investor’s comfort level, things usually don’t work out well. If investors don’t think they can earn a decent enough rate of return on what they have saved, some may choose to reduce consumption and save even more in order to have enough money in retirement. That is the opposite of what the rate cuts were intended to accomplish. Finally, it is hard to imagine that a businessperson in Europe can look at negative yields at 30 years and feel confident about the future.
Stellar Nine Months
On a brighter note, municipal bonds have continued to produce stellar returns in 2019, with the full market returning 6.75% year-to-date through September 30, as measured by the Bloomberg Barclays Municipal Bond Index. What is most exciting from our perspective is that when volatility picked up in September, municipal yields moved higher across the curve, and high-grade municipals cheapened relative to Treasuries. Throw in the typical uptick in supply during the fall months and the landscape for investing in municipal bonds has clearly improved relative to early September. In our view, rates are likely to stay lower for longer given the accommodative stance of the Fed and central banks globally. As a result, when volatility picks up or we get a quick backup in rates, we believe such instances should be treated as an opportunity to deploy cash.
Finally, the tax efficiency of the municipal asset class should not be underestimated. At today’s valuations, high-quality munis offer a meaningful tax-adjusted pickup relative to Treasuries. As of September 30, a AAA 10-year muni yield of 1.43% would have a taxable equivalent yield of 2.43% for someone in the highest federal tax bracket. That’s compared to the 10-year Treasury’s yield of 1.66% on the same date—and represents a pickup of 77 basis points. In this high-tax world, investing is not only about what you earn, but what you ultimately keep.
MARKET REVIEW & OUTLOOK: Soft Backdrop, but Balanced Fundamentals
Slow-but-steady economic growth and healthy supply/demand could make for a constructive environment for the balance of the year.
Risk sentiment recovered late in the third quarter, as markets reacted to de-escalating trade rhetoric between the U.S. and China, mostly supportive U.S. economic data and accommodative central bank policy. Municipal bond returns were positive across the yield curve, with longer maturities generally outperforming shorter maturities. Returns trailed U.S. Treasuries, however, for the quarter and year-to-date. The Treasury yield curve flattened during the quarter, with the two-year moving down 14 basis points (bps) to 1.62%, the 10-year down 33 bps to 1.66%, and the 30-year down 42 bps to 2.11%. Dovish comments from the Federal Open Market Committee (FOMC) and expectations of additional short-term interest rate cuts helped fuel the rally at the front end of the yield curve.
Trade tensions between the U.S. and China eased somewhat in early September as President Trump agreed to delay increasing tariffs on $250 billion in Chinese goods and China said it would waive tariffs imposed on select U.S. agricultural products. The de-escalation came ahead of high-level meetings in early October. Away from China, President Trump faces a new challenge as impeachment hearings look imminent. Though there is no formal timeline to complete the inquiry, House Democrats have been vocal in wanting the investigation to wrap up swiftly in an effort to minimize the impact on the 2020 election year.
U.S. economic data was generally in line with expectations during September. The latest employment report was mixed, with nonfarm payrolls (+136,000 vs. +145,000) and average hourly earnings (+2.9% vs. +3.2%, year-over-year (YoY)) falling shy of estimates and the jobless rate coming in better than expected (3.5% vs. 3.7%). August core CPI (+2.4% vs. +2.3% YoY) and headline CPI (+1.7% vs. +1.8% YoY) continued the trend of positive inflationary dynamics, while retail sales increased more than expected at +0.4% vs. +0.2% (month-over-month).
As widely expected, the FOMC lowered rates by 25 bps following its September policy meeting. The accompanying “dot plot” projected no more easing for the remainder of the year, a pause through 2020 and possible hikes over the longer term in 2021 and 2022. In his post-meeting press conference, Chairman Jerome Powell emphasized the importance of data dependency in assessing future policy adjustments, and said the central bank would be willing to engage in a “sequence” of interest rate cuts if economic conditions warranted it.
The municipal market experienced a 0.82% loss in September, as represented by the Bloomberg Barclays Municipal Bond Index, the first down month of the year and the biggest decline since January 2018. The drop came as Treasury yields increased and new state and local government debt sales weighed on performance. The supply of bonds was 46% higher than it had been the same month a year earlier, as government issuers raced to capitalize on lower interest rates. According to SIFMA, gross municipal supply was approximately $36.1 billion in September. Year-to-date volume was 9.1% larger than in 2018. With regard to performance, longer maturities generally outpaced shorter maturities in the third quarter and lower-rated securities generally outperformed those with higher ratings.
Outlook: Expectations vs. Reality
Global growth has been at the center of investor worries, but for some, this is currently more a function of anticipation than hard data. From our perspective, a U.S. GDP slowdown is still more in the “expectation” phase than the “reality” phase. Second-quarter growth was 2%, personal consumption expenditures increased 4.6% and, outside of manufacturing, indications of a material U.S. slowdown remain limited. We believe that consumer spending and economic growth do not necessarily move in lockstep, but are instead influenced by factors such as confidence and uncertainty. Putting the macroeconomic outlook together, we come back to our main thesis since early 2019: that global growth will slow, but result in a global soft landing, which should ultimately provide support for fixed income assets.
Despite the strong sell-off in September, the outlook for the muni market continues to look promising for the balance of 2019, in our opinion. Slow-but-steady economic growth should continue to be beneficial for state and local government balance sheets. We expect that demand from retail and institutional investors will likely compensate for the increased supply that may be present during the fourth quarter. In a recently released report from the Internal Revenue Service, individual U.S. taxpayers reported a 1.6% increase in tax-exempt interest income in 2017, representing the third straight year of growth.1 This statistic is not surprising to us and is consistent with our belief that municipals remain one of the few tax-advantaged, high-quality options for high-tax-bracket investors. We continue to seek out attractive trading opportunities in both the primary and secondary markets.
Trading Notes: Turbulence, Coupons and Active Management
Current dynamics illustrate the benefits of a disciplined relative-value investment process.
August lacked any hint of summer doldrums for the municipal market as investors witnessed the 10-year AAA and 15-year AAA record their lowest yields on record. The volatility in fixed income markets reached a crescendo on August 14 as the U.S. Treasury yield curve inverted for the first time since the financial crisis, with the two-year Treasury yielding more than the 10-year—a rare anomaly.
Additionally, negative-yielding debt reached a historic $17 trillion globally (including the entire German Bund yield curve). Global economic weakness, further escalation of the U.S.-China trade war, dovish central banks and U.S. political uncertainty all contributed to these conditions.
The immediate reaction by investors was to purchase intermediate- and long-maturity Treasuries, locking in yield and perceived safety, with municipal bonds fully participating in this strong rally. Market participants historically perceive a yield curve inversion as a “red flashing” warning sign of economic weakness and potential recession in the months ahead.
In hindsight, perhaps the Fed and market pundits should have focused on the difference in yield between the federal funds rate and the 10-year Treasury, inverted since May. This inversion contributed to the shortage of liquidity during the “repo-rate shock” in mid-September as primary dealers were relied upon to buy 10-year Treasuries, further draining their cash reserves.
Benefits of Premium Coupon
As the above-mentioned August rally in longer-maturity municipal bonds unfolded, some bonds became overvalued, in our opinion, namely par coupon bonds priced as new issues. This sector of the market experienced larger losses than similar 5% coupon bonds during the September rate sell-off. Since the premium coupon is coveted for its above-market income stream and defensive qualities, we tend to favor a healthy allocation in all our portfolios. The ensuing volatility highlights the benefits of professional active management built around a strong disciplined relative-value investment process.
Awaiting Tax-Loss Harvesting Opportunities
For most of this year, investors have witnessed rates moving lower and bond prices rising, producing strong positive returns. September showed that stable economic data coupled with a divided Fed can lead to pockets of volatility and short-term bouts of higher rates. While 2019 tax losses have been scarce, they can provide a benefit to separately managed account investors where opportunities arise before year-end.
Current valuations versus 10-year Treasuries look “attractive” (10-year municipal general obligation bonds yield 85% of equivalent Treasuries) when compared to the rich ratios seen in late spring, creating a very compelling entry point. In addition to manageable new issue supply of $285 billion (year-to-date), positive inflows for the year total approximately $68 billion, a modern day record.2 As individuals continue to feel the full impact of tax reform and loss of deductions, municipals continue to benefit from supportive fund flows.
Healthy Demand for Munis
Fundamental Focus: Inside the Nonprofit Sector
Less familiar pockets of the nonprofit sector offer opportunities to municipal investors.
When most people hear the words “municipal bonds,” they think of debt issued by cities, schools and states. However, a large swath of bonds are issued by entities that are more like corporations, though without shareholders and a defined profit motive. These entities take many forms, but most carry a “501c3” designation from the Internal Revenue Service, which means they do not pay income taxes and can benefit from tax exemption on the bonds they issue. They are commonly referred to as nonprofits or not-for-profits.
The most common are hospitals and private colleges. Since these two types of institutions are well known in the municipal market, we thought it would be worthwhile to discuss a few other, less common types of nonprofits: cultural enrichment organizations, foundations and research groups. Despite their lower profile, all play a vital role in society and the municipal market.
Cultural Enrichment (Cultural, Arts, Museums, Advocacy)
Although typified by museums like the Metropolitan Museum of Art, organizations committed to cultural enrichment are exceptionally varied, and include aquariums, performing art companies/venues, public radio stations and other categories. These organizations may differ in their constituencies, admission and membership levels, revenue sources and financial flexibility. Constituencies or target demographics may include children (e.g., the Boston Children’s Museum) adults and families, occupations (the Museum of Nursing History) and interests (the Petersen Automotive Museum). Entities may focus on servicing a limited region (the Bainbridge Island Historical Museum) or draw attendees from across the world (American Museum of Natural History).
Looking at dollars and cents, support for some organizations may come through a combination of admissions/tickets, retail operations, grants and in-kind contributions. Another major source of revenue (and thus operations) may be donations from individuals, corporations and governments. Endowment draws may be a third source of financing.
Notably, a distinguishing feature of advocacy-focused organizations versus other cultural institutions is membership. Typically, the organization has a subscribed membership base (e.g., the American Dental Association) and may maintain a moat around an occupation or profession, as state bar associations do with legal services.
Foundations typically use a pool of money to advance a cause, for example in the areas of science, education or support for low-income groups. These organizations are typically started with assets from a namesake donor and generally have no source of income beyond investment earnings.
Foundations and endowments generally come in two forms—independent and grant-giving—although many overlap. Independent organizations may finance and execute their own programs whereas grant-giving organizations apportion and allocate their resources to other groups in order to achieve greater knock-on effects. While each method is effective, a distinguishing feature of grant-giving is the additional financial flexibility it affords, given their ability to curtail grants rather than take the more drastic step of eliminating entire social programs.
Consider the second-largest private foundation: the Ford Foundation. It was created in 1936 with an initial gift of $25,000 from Edsel and Henry Ford, which was followed by a donation of nonvoting Ford stock. By the end of 2018, the foundation had reached over $12.6 billion in assets. The Ford Foundation’s social justice mission centers on five “areas of action”: economic improvement, education, freedom and democracy, human behavior and world peace. Based on the foundation’s 2018 audited financial statements, proceeds of the sale of investments generated nearly all the cash used to finance operating activities. As a grant-making foundation, it retains the ability to determine to whom, when and how it distributes funds and finances programs and activities.
The last of the three broad nonprofit categories is research. Typically non-degree granting, nonprofit research organizations focus primarily on pioneering scientific research, advanced knowledge and/or the “democratization” of new technical ideas and products. U.S. taxpayers fund the vast majority of these efforts via grants issued through government agencies (such as the National Science Foundation, National Institutes of Health, Defense Advanced Research Projects Agency and Department of Energy, to name just a few). Through such agencies, the U.S. government is perhaps the nation’s largest financier of scientific research, spending $116 billion on research and development in 2017 alone.3
Historically, many of these research organizations were affiliated with universities, but have since become independent. Draper Labs, for example, was a part of MIT until 1973. Draper’s primary focus had been the development and early application of advanced guidance, navigation and control technologies for the U.S. Defense Department and NASA. While that continues, they have broadened into biomedical systems and energy solutions. The Stanford Research Institute became SRI International after separating from Stanford University in 1970. SRI performs client-sponsored research and development for government agencies, among other programs. It played a critical role in the development of what we now call the internet, as well as in wireless networking.
These organizations may appear to have sound funding streams, whether from the federal government as a financier without a significant profit motive or in light of their work on projects with often direct benefits to the government and society at large. However, the grant process is tremendously competitive and much depends on specific contracts and terms. Influential factors may include whether the research is classified and the specialty involved. An organization may be awarded a multiyear development contract; however, it may specifically exclude or limit cost recovery or facility costs. Moreover, specific grants and contracts (tied to specific projects) may face nonrenewal, funding cuts, definitive termination or even sequestration.
Looking at the group as a whole, credit analysis of nonprofit organizations varies depending on business model. For example, hospitals tend to be the most businesslike of the group; so, investors need to look at profitability, operating efficiency and market environment just as they would a corporation.
In contrast, foundations and endowments do not have an operational revenue stream from user fees or services; their credit quality is derived from an investment pool. In their case, we will often look at the allocation, risk and diversity of the investment portfolio, as well as historical spending trends. Cultural enrichment organizations are a hybrid of the two previous examples because they tend not to cover their costs with admissions. Most have endowments and are required to do fundraising. In this case, it’s important to see how the organization balances operating performance and fundraising skills.
Research is unusual in that such groups can do fundraising, but, more often, are supported by grant writing. This is a unique skill and also requires the ability to attract talented researchers.
In sum, cultural enrichment, foundations/endowments and research organizations are less well known than other nonprofits; and they not only have a vital role to play in society, but can offer opportunities for investors in the municipal space. As always, it’s important to assess the economic fundamentals and operating success of an organization, along with issuance details and pricing, in order to make appropriate decisions on whether to invest.