January 20, 2015
This week we examine the thesis that the high level of ratios of municipal bond yields to Treasury yields means that munis are “cheap” and discuss some of the devil in the details of the President’s community college proposal. We also reprint a chart from Forbes highlighting increasing concentration in the U.S. hospital market.
Are Munis Really Cheap?
Municipal bonds have been lagging the recent rally in Treasury bonds, leading some pundits to pronounce that munis are “cheap”. These pundits usually point to the ratio of municipal bond yields to the yields on comparable maturity Treasury bonds.
We are skeptical: “Cheap” ratios can sometimes send false signals.
Over the long run, the ratio of munis to Treasuries is highly correlated to the level of interest rates. Due to the flight to safety nature of many Treasury rallies; the tendency of retail investors to withdraw from the municipal market at lower rates; and the callability of many munis, municipal rates rarely keep pace as Treasury rates decline.
In the chart below we plot the ratio (y-axis) of the yield for the Bond Buyer 25-Bond Revenue Index against the yield on the 30 Year Treasury Bond.
Bond Buyer 25-Bond Revenue Index as % of 30 Year Treasury
(Weekly data since 1990)
Source: Bond Buyer, U.S. Department of the Treasury, DIVER Data Solutions
Each data point represents a weekly observation of the ratio. The chart shows a clear correlation between ratios and rates (especially when Treasury rates fall below 5%). The bright blue data point is last week’s value (2.37%, 171%). The data points at the upper left corner of the chart correspond to December 2008 and January 2009 (ouch!).
Looking at this chart, it is appears that our skepticism is justified: munis may not be as cheap as the pundits believe.
The solid line is a curve fitted to the data. Last week’s ratio value of 171% is below the level of the plotted curve at last week’s 2.37% Treasury yield. While we acknowledge that 2.37% 30 Year is uncharted territory, we think the comparison has value.
To get some historical context for the difference between the current ratio and the plotted curve, we chart a history of the difference of each weekly ratio data point and the plotted curve.
Actual Ratio vs. “Plotted Curve Ratio”
(3 week moving average)
Source: Bond Buyer, U.S. Department of the Treasury, DIVER Data Solutions
This is a very rough analysis, subject to many caveats, but the results contradict the pundits.
This chart shows that instead of being cheap, munis may well be expensive given the current level of yields. The muni to Treasury ratio may decline in the future, but it will likely require an increase in rates for that to happen. Making a bet on muni ratios right now is an interest rate call, not an asset class call.
Is Plan to Provide “Free” Tuition for Community Colleges Going to Work?
Last week President Obama proposed that the Federal government spend $60 billion over 10 years to provide a 75% tuition subsidy to qualifying students attending community colleges. The plan would require participating states to match 33% of the Federal subsidy. The demands the State match will place on State budgets, and the presence of community colleges as municipal borrowers, means that this proposal has municipal bond market implications.
Among the laudable goals of the proposed program are increased enrollments and improved graduation rates. But, to achieve these goals, community colleges would need to add capacity. Finding the money to pay for this additional capacity would be a major challenge.
Like most of our higher education institutions, community colleges do not (could not?) survive as “fee for service” businesses: tuition only covers a portion (20%) of the expenses of the institution. Other revenue sources, primarily subsidies, cover the rest.
Public Community College Revenue by Source
Source: AACC, IPEDS, DIVER Data Solutions
For each additional student enrolled or retained above the existing dropout rate, the average community college would collect only 20% of the additional cost via tuition, and would need to figure out some way to cover the other 80% of the cost.
Additional State support is unlikely; the State match means that the State is already providing an additional 5% of total community college revenue (~10% increase in State subsidy).
Additional revenue from local appropriations seems just as unlikely.
Why do we say additional State support is unlikely? Because States already provide substantial subsidies to community colleges and other public higher education institutions:
Higher Education Budget as % of State
(2014)
Source: NASBO, DIVER Analytics-Map Module
Due to budget pressures since the financial crisis, the States have been reducing their contribution to higher education. In most cases, States are shifting more of the cost burden onto students via higher tuition. In order for the President’s plan to be successful, he would need to convince the States to reverse this trend. Even if he manages to get Congress to agree to the plan, the level of State participation will likely be low.
State Spending on Higher Education as % of Budget
Source: DIVER Data Analytics-Data Access Module, DIVER Data Solutions
A column by Matt Reed, a community college Dean, highlights another issue of concern; that community college enrollments tend to be counter-cyclical to the economy and the burden of State matching payments would pressure State budgets at just the wrong time.
In Mr. Reed’s words:
The federal government is allowed to run deficits, so it can borrow money to spend more during recessions. (In policy speak, it can engage in Keynesian stimuli.) But states mostly aren’t allowed to run deficits, so they can’t borrow to make up for lower tax revenues during recessions. If states are required to pony up a set percentage of community college costs, and a recession hits, they’ll be caught in a double bind of expenses going up just as their ability to pay will go down.
States may well need a role, but as long as they’re unable to do countercyclical spending, the feds may have to be flexible on the 75/25 split. Otherwise, they’re setting up a pincer movement that will hit hard when the next recession happens. (emphasis ours)
If States decide to participate, the demands placed on State budgets in order to maintain their match to the Federal subsidy would be most severe when States are least able to pay.
U.S. Healthcare Market is Becoming Increasingly Concentrated
A column by Avik Roy in Forbes this week responded to a segment on 60 Minutes featuring Steven Brill discussing his book America’s Bitter Pill.
The column was highly critical of the healthcare market in the U.S. and the impacts of Obamacare; Roy stated: “the U.S. hospital industry is crony capitalism at its finest”.
Without opining on the merits of Roy’s assertions, we share a chart from the column, which portrays the increasing concentration of the U.S. healthcare market since 1990. While the data sets in the chart end in 2012, it is clear the trend toward concentration has continued.
Because of the extra yield offered by hospital bonds and ample supply, healthcare has long been a dominant sector in the municipal market. In addition to the normal credit risks in the sector, investors also need to cope with major structural changes in the industry.
Impact of Mergers and Acquisitions on Hospital Market Concentration
(1990-2012)
Source: Forbes
This week the Lumesis team will be in St. Louis, Memphis and Houston for the NFMA’s Advanced Seminar on America’s Urban Agenda.
Have a great week,
Michael Craft, CFA
CLICK HERE to Subscribe to the Weekly Commentary
Are Munis Really Cheap? ; The Risks of “Free” Community College; Hospital Market Concentration
January 20, 2015
This week we examine the thesis that the high level of ratios of municipal bond yields to Treasury yields means that munis are “cheap” and discuss some of the devil in the details of the President’s community college proposal. We also reprint a chart from Forbes highlighting increasing concentration in the U.S. hospital market.
Are Munis Really Cheap?
Municipal bonds have been lagging the recent rally in Treasury bonds, leading some pundits to pronounce that munis are “cheap”. These pundits usually point to the ratio of municipal bond yields to the yields on comparable maturity Treasury bonds.
We are skeptical: “Cheap” ratios can sometimes send false signals.
Over the long run, the ratio of munis to Treasuries is highly correlated to the level of interest rates. Due to the flight to safety nature of many Treasury rallies; the tendency of retail investors to withdraw from the municipal market at lower rates; and the callability of many munis, municipal rates rarely keep pace as Treasury rates decline.
In the chart below we plot the ratio (y-axis) of the yield for the Bond Buyer 25-Bond Revenue Index against the yield on the 30 Year Treasury Bond.
Bond Buyer 25-Bond Revenue Index as % of 30 Year Treasury
(Weekly data since 1990)
Source: Bond Buyer, U.S. Department of the Treasury, DIVER Data Solutions
Each data point represents a weekly observation of the ratio. The chart shows a clear correlation between ratios and rates (especially when Treasury rates fall below 5%). The bright blue data point is last week’s value (2.37%, 171%). The data points at the upper left corner of the chart correspond to December 2008 and January 2009 (ouch!).
Looking at this chart, it is appears that our skepticism is justified: munis may not be as cheap as the pundits believe.
The solid line is a curve fitted to the data. Last week’s ratio value of 171% is below the level of the plotted curve at last week’s 2.37% Treasury yield. While we acknowledge that 2.37% 30 Year is uncharted territory, we think the comparison has value.
To get some historical context for the difference between the current ratio and the plotted curve, we chart a history of the difference of each weekly ratio data point and the plotted curve.
Actual Ratio vs. “Plotted Curve Ratio”
(3 week moving average)
Source: Bond Buyer, U.S. Department of the Treasury, DIVER Data Solutions
This is a very rough analysis, subject to many caveats, but the results contradict the pundits.
This chart shows that instead of being cheap, munis may well be expensive given the current level of yields. The muni to Treasury ratio may decline in the future, but it will likely require an increase in rates for that to happen. Making a bet on muni ratios right now is an interest rate call, not an asset class call.
Is Plan to Provide “Free” Tuition for Community Colleges Going to Work?
Last week President Obama proposed that the Federal government spend $60 billion over 10 years to provide a 75% tuition subsidy to qualifying students attending community colleges. The plan would require participating states to match 33% of the Federal subsidy. The demands the State match will place on State budgets, and the presence of community colleges as municipal borrowers, means that this proposal has municipal bond market implications.
Among the laudable goals of the proposed program are increased enrollments and improved graduation rates. But, to achieve these goals, community colleges would need to add capacity. Finding the money to pay for this additional capacity would be a major challenge.
Like most of our higher education institutions, community colleges do not (could not?) survive as “fee for service” businesses: tuition only covers a portion (20%) of the expenses of the institution. Other revenue sources, primarily subsidies, cover the rest.
Public Community College Revenue by Source
Source: AACC, IPEDS, DIVER Data Solutions
For each additional student enrolled or retained above the existing dropout rate, the average community college would collect only 20% of the additional cost via tuition, and would need to figure out some way to cover the other 80% of the cost.
Additional State support is unlikely; the State match means that the State is already providing an additional 5% of total community college revenue (~10% increase in State subsidy).
Additional revenue from local appropriations seems just as unlikely.
Why do we say additional State support is unlikely? Because States already provide substantial subsidies to community colleges and other public higher education institutions:
Higher Education Budget as % of State
(2014)
Source: NASBO, DIVER Analytics-Map Module
Due to budget pressures since the financial crisis, the States have been reducing their contribution to higher education. In most cases, States are shifting more of the cost burden onto students via higher tuition. In order for the President’s plan to be successful, he would need to convince the States to reverse this trend. Even if he manages to get Congress to agree to the plan, the level of State participation will likely be low.
State Spending on Higher Education as % of Budget
Source: DIVER Data Analytics-Data Access Module, DIVER Data Solutions
A column by Matt Reed, a community college Dean, highlights another issue of concern; that community college enrollments tend to be counter-cyclical to the economy and the burden of State matching payments would pressure State budgets at just the wrong time.
In Mr. Reed’s words:
The federal government is allowed to run deficits, so it can borrow money to spend more during recessions. (In policy speak, it can engage in Keynesian stimuli.) But states mostly aren’t allowed to run deficits, so they can’t borrow to make up for lower tax revenues during recessions. If states are required to pony up a set percentage of community college costs, and a recession hits, they’ll be caught in a double bind of expenses going up just as their ability to pay will go down.
States may well need a role, but as long as they’re unable to do countercyclical spending, the feds may have to be flexible on the 75/25 split. Otherwise, they’re setting up a pincer movement that will hit hard when the next recession happens. (emphasis ours)
If States decide to participate, the demands placed on State budgets in order to maintain their match to the Federal subsidy would be most severe when States are least able to pay.
U.S. Healthcare Market is Becoming Increasingly Concentrated
A column by Avik Roy in Forbes this week responded to a segment on 60 Minutes featuring Steven Brill discussing his book America’s Bitter Pill.
The column was highly critical of the healthcare market in the U.S. and the impacts of Obamacare; Roy stated: “the U.S. hospital industry is crony capitalism at its finest”.
Without opining on the merits of Roy’s assertions, we share a chart from the column, which portrays the increasing concentration of the U.S. healthcare market since 1990. While the data sets in the chart end in 2012, it is clear the trend toward concentration has continued.
Because of the extra yield offered by hospital bonds and ample supply, healthcare has long been a dominant sector in the municipal market. In addition to the normal credit risks in the sector, investors also need to cope with major structural changes in the industry.
Impact of Mergers and Acquisitions on Hospital Market Concentration
(1990-2012)
Source: Forbes
This week the Lumesis team will be in St. Louis, Memphis and Houston for the NFMA’s Advanced Seminar on America’s Urban Agenda.
Have a great week,
Michael Craft, CFA
CLICK HERE to Subscribe to the Weekly Commentary