As we look forward to 2019, our individual sector outlooks are generally stable. However, there are a few points worth noting for individual investors in the municipal bond market as we move into the New Year. Here, we address key themes from 2018 and provide our outlook for what’s ahead.
Credit Spreads Beginning to Soften
The past two years have shown a decline in BBB rated spreads versus AA counterparts by almost 37 basis points (bps) and are now below one standard deviation of the 68 bps average spread. This is significant because BBB rated bonds have been the clear winner in terms of performance in 2018, returning 60bps year-to-date compared to a -50bps loss for AAA debt.
While predicting the degree of compression is difficult, we do not expect the same pace of compression we’ve seen in the past two years. Our opinion is partially influenced by recent trends in the corporate credit market, which has flashed signals of softening.
State Budgets Are Up, But Will It Last?
Using total tax collections as the sole metric, the state and local muni bond sector would earn extra points on our weighting scale. However, improving tax collections only tell a portion of the story, as state and local governments continue to deal with legacy retirement costs and the true impact of tax reform.
U.S. Census data through the end of Q2 2018 shows combined collections of property, sales and income taxes of $373 billion, a 6.5% increase from the same period in 2017. While it’s an impressive increase, how much of the year-over-year growth came from prepayment of taxes in early 2018 is uncertain and we would be more on board with a revenue growth narrative after a complete tax collection cycle.
Despite the equity markets reaching new highs, public pension plans have not appreciably improved their funding status, with the year-over-year aggregate funding ratio growing to 73.7% from 71.1%. States with the worst funding ratios continue to be Kentucky, New Jersey, Illinois and Connecticut. Over the same period, state liabilities for other post-employment benefits (OPEBs) increased by 10% to $678 billion.
The long-term impact of the cap on state and local tax deductions, combined with higher mortgage rates has yet to play itself out in the sector in the form of softer housing prices and increased inventory.
Lastly, the increasing trend toward subordination of the general obligation pledge from larger bond issuers, by selling securitized debt, is something to be aware of as fiscally constrained issuers look for ways to access the capital markets at more advantageous rates. A positive from 2018 has been the improvement of state budgets that have passed without excess delays, something that could be associated with an election year and cannot be eyed as a longer-term trend.
Tailwinds and Headwinds for Transportation
As discussed in our October post “The Oil Price Connection”, we can point to a historical relationship between periods of declining oil prices and a corresponding decline in both retail gas prices and aviation fuel prices. The impact of extra dollars in the hands of consumers can result in additional travel volume for both the roadways and airports, helping strengthen debt coverage ratios within the sector.
Transportation credits are already feeling the positive impact of another year of increased traffic both for vehicle miles traveled and for enplanements. While the latest drop in oil prices has not yet resulted in a material decline in either of these fuel prices, the potential for declines is expected over time. We believe bias should be given to toll road and bridge systems with regular or annual revenue increases, which will help combat any potential downtick in traffic.
Some headwinds that transportation issuers may face could actually come in the form of a proposed infrastructure plan. Some proposals being considered would be leveraging an increase in the passenger facility charge to help pay for airport improvement projects. Additional fees that would be folded into airline ticket prices would serve to offset any traction made from declining fuel prices. Any increase in the national gas tax would also serve to offset declines from sustained lower crude oil prices.
Credit Selection Remains Key for Healthcare
After avoiding the potential loss of Private Activity Bond financing in last year’s tax reform legislation, the Health Care sector has performed admirably in what has been a down year for munis. While the Bloomberg Barclays Revenue Bond Index is down -0.34% year-to-date, the Health Care/Hospital sector has outperformed with a year-to-date return of -0.24%.
The outperformance, on a relative basis, has come amidst a backdrop of consolidation of bigger players in the municipal healthcare space as margins continue to compress, especially for lower rated entities. The Health Care sector is facing headwinds from reimbursement levels for care while at the same time incurring sizable technological and capital outlays. However, we believe the demographic changes for the U.S. point to continued growth in utilization of services.
In our view, credit selection in the Health Care sector is very important and we remain cautious of single-site hospitals and those providers who have a lagging market share within their main service territory.
Higher Tuition and Higher Education
Both private and public higher education institutions are fighting a battle on the value proposition of the cost of college. According to a study in May 2018 conducted by the National Student Clearinghouse Research Center, nationwide declining enrollment trends that began in 2012 have persisted. The four-year for-profit sector continues to experience the largest reductions stemming from closures and increased scrutiny of that particular sub-sector.
The enrollment declines come amidst a backdrop of growing debt borrowing in the sector. Based on data from Merritt Research Services, public higher education and community colleges registered the largest increases in long-term debt outstanding over the past decade, outpacing toll roads and hospitals. Private higher education borrowers were also voracious issuers of debt, with total debt outstanding expanding by almost 40% since 2007.
With stronger competition for qualified applicants, lower high school graduate numbers and an increased liability side of the ledger, bias in the sector should be given to those schools who have adequate reserves and cash flow relative to debt and expenses, a well-defined but diversified suite of offerings for both undergraduate and graduate programs, and seasoned management teams.
We continue to favor revenue bonds from sub-sectors that we view as “essential” in nature. Over the past several years, the water/sewer sector has been riding a trend of growing revenues and improved coverage levels that has helped to broadly strengthen the credit profile of the sub-sector. As with many areas of the municipal market, demand has outstripped supply and helped to compress credit spreads.
Further, as it appears more buyers want to attach themselves to an identifiable revenue stream, compared to an ad valorem pledge, it makes sense that “A” rated water/sewer spreads are tracking tighter than comparably rated general obligation debt.
Based upon the latest data from the American Society of Civil Engineers, the current projected need for water/sewer infrastructure projects exceeds $270 billion over the next 20 years. Unfortunately, 2018 has been notably absent of a federal infrastructure plan and the likelihood of one coming soon appears slim. While water/sewer needs are an essential portion of the market, it is our belief than any future attempts at a federal infrastructure plan will focus on more headline grabbing projects for roads, bridges and airports.
Power and Energy Remain Reliable
Despite headline making news such as with Santee Cooper/Vogtle and JEA, we largely anticipate credit to be stable for this corner of the municipal market. We remain focused on completed projects to eliminate any construction risk and remain confident on the strength of take-or-pay contracts, despite recent litigation.
We will continue to monitor shifts in power supply sources to renewables and increased battery storage capacity, which could cause a disruption to the sector longer term. Demand should remain strong as we head into a heating season that should be outside of seasonal norms and there is anticipated relief to the capital expenditure plans for some coal dependent issuers. Credit within public power has been noted for not only a willingness but an ability to raise utility rates, if needed.
Entities in this space should also be supported by continued low natural gas/oil prices and the unshackling of environmental regulations that came with the Clean Power Plan. Prior to the Trump administration’s executive orders that began to undo the Obama-era plan, those issuers that relied heavily on coal faced sizable carbon emission reduction costs.
The 2015 Obama administration rule aimed to reduce greenhouse gas emissions from power plants, now the second-largest source of greenhouse gases in the United States. The plan gave 47 states individual emissions targets while leaving it up to the states how to achieve those goals. In contrast, the new 2018 Trump administration proposals would recommend regulating the emissions of individual coal plants and call for modest upgrades, such as improving efficiency or substituting fuel.
Municipal entities have little choice but to engage in varying degrees of capital expenditure spending to ensure infrastructure and buildings do not begin to fail and essential services are continued without interruption.
In 2018, municipal issuers seemingly shrugged off higher rates and the impacts of tax reform, pushing new money issuance to a five-year high. While we expect the trend of new money issuance to be net positive in 2019, we believe that total municipal issuance will continue to remain below long-term averages, with our projection for 2019 fixed rate issuance circling around $330 billion.
Moving into the next year, our focus continues to be on revenue bonds versus general obligations with a bias toward what we view to be higher quality names in the portfolio. Absent an unforeseen credit event within the tax-exempt sector or additional super downgrades from the rating agencies, we believe credit spread compression will continue to be a theme over the next year. As such, we would opt for the additional security and liquidity of higher rated entities.