As we cruise into the New Year, we look back at a number of meaningful themes that we discussed during 2015.
Muni supply slowed down
We had record municipal bond issuance in the first half of 2015. With over $217 billion issued––a 45% increase over last year––2015 would have been a record year for issuance had the second half of the year been as large as the first. Most of this issuance was to refinance older bonds with 2015 call dates.
There was great pressure on issuers to refinance this debt, since this year’s interest-rate levels would have saved issuers over 1% (100 basis points) on much of the 5%+ yield debt issued in 2005. The bulk of 2005’s issuance was front-loaded into the first part of that year; hence, the call dates on this debt became effective during the first half of the year.
Indeed, 4Q2015 has seen to date $78.6 billion in issuance versus last year’s $88.2 billion, an 11% decrease. Predictably, this means that tax-free bonds have put in a good relative performance versus the 10-year and 30-year Treasury bonds. The yield ratio between AAA-rated tax-free municipal bonds and U.S. Treasuries in the 10-year and 30-year ranges started 4Q2015 at 97% and 105% respectively. By mid-December those ratios dropped to 88% and 96% respectively. This drop in ratios was true for AA-rated and strong A-rated bonds as well. We think there is much more movement to come in relative value.
Fed rate hikes generally mean good relative performance for munis
During the last Fed rate-hike cycle of 2004–2006, the muni/Treasury yield ratio dropped from 103% to roughly 85%. This drop was the result of higher overall yield levels and is consistent with periods of rising Treasury yields. The math is straightforward. If we assume a 30% marginal tax rate, muni yields would have to increase approximately 70% as much as Treasuries (100% minus 30%) in order to have the same approximate upward movement in taxable equivalent yield. Given that top federal marginal tax rates are higher than they were in 2006, the math augurs well for muni performance going forward. It is also important to remember that in 2004–2006, Federal Reserve fund rates increased 425 basis points, from 1% to 5.25%, while 10-year and 30-year Treasuries increased only 85 and 75 basis points respectively.
Some clarity in the Puerto Rico mess
Though Congress has not yet moved on the latest developments in the Puerto Rico mess, House speaker Paul Ryan says that Congress will act before the end of March 2016. We do not know the form, if any, of Congressional intervention and whether there will be an oversight agency, but some action is better than none.
Puerto Rico Electric Power Authority (PREPA), the island’s beleaguered utility, reached an accord last week with debtholders and insurers on a deal that will reduce the over $8 billion owed by PREPA. This is only the first step; however, it could be a road map for Puerto Rico – which currently does not have access to Chapter 9 bankruptcy reorganization – to gain breathing room and avoid outright default. There is a long road ahead. We will keep readers informed as events unfold.