December 21st, 2015
This week we look at a gauge of market sentiment and discuss the current disconnect between high yield corporate and high yield municipal markets.
Municipal Market Sentiment is Subdued: Positive Technicals Offset by Risks
The end of the year in the municipal market is usually marked by positive sentiment in anticipation of strong technical factors stemming from a combination of light new issue supply and heavy cash flows from early January coupon payments and redemptions.
This year, market sentiment, as measured by Municipal Market Data, is more subdued than usual. We can think of a few possible reasons.
Some of the reasons are macro risks (impact of Fed actions, conditions in taxable credit markets) and some are specific to the municipal market (primarily specific credit situations).
The potential impact from these risks is magnified by the municipal market’s reliance on retail investors which could lead to worse than expected outcomes. As we have seen before, the psychology and state of mind of the retail investment community can be more important to municipal market health than the underlying investment fundamentals.
Like all fixed income markets, the municipal bond market faces risks from the beginning of the Fed tightening cycle. If the Fed’s actions lead to higher rates, municipal bonds will lose value. (Municipals may “outperform” when measured using yield ratios to Treasuries, but a loss is a loss.) If that loss is severe enough, retail investment flows into municipals could reverse.
The problems of Chicago, Illinois, and Puerto Rico continue to simmer. One could argue Puerto Rico is already at a boil. Most market observers believe that these are idiosyncratic credit situations, which do not reflect systemic problems. Unfortunately, due to the importance of retail investor psychology, bad headlines, even related idiosyncratic situations, can lead to systemic market issues.
Another risk that we perceive is contagion from other markets. Since the financial crisis, many have observed that the municipal market has transitioned from a “rates-driven market” to a “credit-driven market”. If weakness in the taxable “credit-driven markets” continues while the “rates-driven markets” remain strong, this thesis could be tested.
Municipal bonds (both investment grade and high yield) have dramatically outperformed their corporate counterparts this year, especially in the last several months.
While the factors that have lead to the recent weakness in the high yield market do not have direct impacts on the credit-worthiness of municipal borrowers, we see some potential linkages:
- Corporate credit held in municipal funds,
- Municipal credit held in corporate funds.
Many municipal funds (both “investment grade” and high yield) hold bonds which are backed by corporate credits of entities which also borrow in the taxable markets. The municipal bond version of these corporate credits is often very thinly traded, but the presence of taxable bond versions, which do trade (and have been trading lower), should lead to lower valuations on the municipals.
In recent years, taxable mutual funds and hedge funds have held increasing amounts of municipal bond debt. These holdings are primarily in the higher risk municipal sectors. The Financial Times reports (subscription required), that taxable corporate bond funds experienced record outflows last week. If these outflows continue, the managers of those funds will need to sell bonds to fund the redemptions. As the portfolio managers drain their initial liquidity buckets, they will be looking for bonds which are easy to sell and/or have held their value. If the corporate market is stressed enough and the municipal high yield market has not declined, it’s possible that municipals could fit the bill. In this scenario, selling from corporate managers would likely dwarf new investments (if any) from retail investors into municipal funds.
If the taxable market’s difficulties do spillover to the municipal high yield market, we suspect that the evidence will appear in the markets for individual bonds well before it is reflected in the Net Asset Values of mutual funds or ETF’s. There is a substantial inertia to the evaluated prices used to generate municipal bond NAV’s, especially in the higher yielding sectors.
One of the largest, most widely held, and most liquid bonds in the municipal high yield universe is the 2047 maturity of the Buckeye Ohio Tobacco deal. Over the last week, according to trades reported to the MSRB, the value of these bonds declined by 2.9%. Note that the value of the Market Vectors High Yield Municipal ETF increased by 0.2%.
Trying to decipher market trends in thin year-end markets is possibly foolish, but we think that the potential spillover risks to municipal credit markets from taxable credit markets should be monitored closely.
Have a great week,
Michael Craft, CFA
Municipal Market Sentiment is Subdued: Positive Technicals Offset by Risks
December 21st, 2015
This week we look at a gauge of market sentiment and discuss the current disconnect between high yield corporate and high yield municipal markets.
Municipal Market Sentiment is Subdued: Positive Technicals Offset by Risks
The end of the year in the municipal market is usually marked by positive sentiment in anticipation of strong technical factors stemming from a combination of light new issue supply and heavy cash flows from early January coupon payments and redemptions.
This year, market sentiment, as measured by Municipal Market Data, is more subdued than usual. We can think of a few possible reasons.
Some of the reasons are macro risks (impact of Fed actions, conditions in taxable credit markets) and some are specific to the municipal market (primarily specific credit situations).
The potential impact from these risks is magnified by the municipal market’s reliance on retail investors which could lead to worse than expected outcomes. As we have seen before, the psychology and state of mind of the retail investment community can be more important to municipal market health than the underlying investment fundamentals.
Like all fixed income markets, the municipal bond market faces risks from the beginning of the Fed tightening cycle. If the Fed’s actions lead to higher rates, municipal bonds will lose value. (Municipals may “outperform” when measured using yield ratios to Treasuries, but a loss is a loss.) If that loss is severe enough, retail investment flows into municipals could reverse.
The problems of Chicago, Illinois, and Puerto Rico continue to simmer. One could argue Puerto Rico is already at a boil. Most market observers believe that these are idiosyncratic credit situations, which do not reflect systemic problems. Unfortunately, due to the importance of retail investor psychology, bad headlines, even related idiosyncratic situations, can lead to systemic market issues.
Another risk that we perceive is contagion from other markets. Since the financial crisis, many have observed that the municipal market has transitioned from a “rates-driven market” to a “credit-driven market”. If weakness in the taxable “credit-driven markets” continues while the “rates-driven markets” remain strong, this thesis could be tested.
Municipal bonds (both investment grade and high yield) have dramatically outperformed their corporate counterparts this year, especially in the last several months.
While the factors that have lead to the recent weakness in the high yield market do not have direct impacts on the credit-worthiness of municipal borrowers, we see some potential linkages:
Many municipal funds (both “investment grade” and high yield) hold bonds which are backed by corporate credits of entities which also borrow in the taxable markets. The municipal bond version of these corporate credits is often very thinly traded, but the presence of taxable bond versions, which do trade (and have been trading lower), should lead to lower valuations on the municipals.
In recent years, taxable mutual funds and hedge funds have held increasing amounts of municipal bond debt. These holdings are primarily in the higher risk municipal sectors. The Financial Times reports (subscription required), that taxable corporate bond funds experienced record outflows last week. If these outflows continue, the managers of those funds will need to sell bonds to fund the redemptions. As the portfolio managers drain their initial liquidity buckets, they will be looking for bonds which are easy to sell and/or have held their value. If the corporate market is stressed enough and the municipal high yield market has not declined, it’s possible that municipals could fit the bill. In this scenario, selling from corporate managers would likely dwarf new investments (if any) from retail investors into municipal funds.
If the taxable market’s difficulties do spillover to the municipal high yield market, we suspect that the evidence will appear in the markets for individual bonds well before it is reflected in the Net Asset Values of mutual funds or ETF’s. There is a substantial inertia to the evaluated prices used to generate municipal bond NAV’s, especially in the higher yielding sectors.
One of the largest, most widely held, and most liquid bonds in the municipal high yield universe is the 2047 maturity of the Buckeye Ohio Tobacco deal. Over the last week, according to trades reported to the MSRB, the value of these bonds declined by 2.9%. Note that the value of the Market Vectors High Yield Municipal ETF increased by 0.2%.
Trying to decipher market trends in thin year-end markets is possibly foolish, but we think that the potential spillover risks to municipal credit markets from taxable credit markets should be monitored closely.
Have a great week,
Michael Craft, CFA