Municipal fixed income markets: Second quarter review
June 30, 2013
Notes: Market activity cited throughout this commentary is supported by data published by sources that include Barclays, Bloomberg, Municipal Bond Buyer, and Thomson Municipal Market Data (MMD).
Broad market overview
Treasury rates spiked higher on Jan. 3 when the Federal Reserve released the minutes from its December 2012 meeting indicating dissent among members about the duration of quantitative easing (QE). The underlying theme of the markets (both equity and fixed income) for the first five months of this year was risk-on. However, since the release of the December minutes, investors have appeared to be on “QE watch.” Whether markets were responding to positive economic news or the crisis in Cyprus, market participants closely monitored Fed communications for any indications of what “triggers” would result in a pullback on stimulus. As the second quarter of 2013 progressed, although the liquidity trade continued, it appears investors were increasingly concerned about “if,” “when,” and “by how much” the Fed would begin to wind down its $85 billion-a-month bond-buying program. The markets’ fears were realized when three Fed communications, two in May and one in June, led to a market selloff that resulted in significant negative returns on fixed income instruments and a lower equity market with increased volatility. The first communication came in the Q&A session that took place after Fed Chairman Ben Bernanke testified before a congressional committee. In that communication, he hinted that QE might be “tapered” if labor markets continued to improve, as seen in recent nonfarm payroll releases. That same afternoon, the minutes of the Fed’s April 30 – May 1 Federal Open Market Committee (FOMC) meeting showed a willingness by some Fed participants to adjust the flow of purchases downward as early as the June FOMC meeting. Finally, in the press conference following the June FOMC meeting, Chairman Bernanke laid out a potential timetable for the removal of QE. The committee anticipated moderating purchases later this year and ending them by mid-2014 if the incoming economic data are broadly consistent with the Fed’s forecast.
Municipal bond yields rose sharply during the second quarter of 2013 and the Barclays Municipal Bond Index returned -2.97%. With the exception of the 1-year maturity, which declined 1 basis point, AAA general obligation rates rose across the yield curve, from 35 to 84 basis points, with the largest rise coming in the 20-year maturity category (data: MMD). Along with rising rates, the municipal bond market experienced a steepening yield curve, widening credit spreads, and underperformance versus U.S. Treasurys (see statistics below).
We believe the primary drivers of the municipal market’s negative return were the Federal Reserve communications, the resulting rise in all fixed income yields, and a particularly harsh response by retail investors in the form of outflows from tax-exempt mutual funds. After seasonal weakness in March and April, typically associated with quarter-end and tax season, municipal bond fund flows began returning to positive in the latter part of May. By May 29, municipal bond mutual funds had received $4.55 billion in inflows for all of 2013. Over the next four weeks, however, municipal bond funds experienced $10.35 billion in outflows, leaving net flows for 2013 at negative $5.80 billion (data: J.P. Morgan, Lipper). These Fed communications caused what could be perceived as widespread panic in the market. In order to meet redemptions, mutual funds were forced to sell bonds into a weak demand environment from investors and an ever-weakening bid side from dealers. Certainly, the municipal market was not alone in this market sentiment. We believe the more limited audience for municipal bonds, primarily based on its tax exemption from U.S. federal taxes, and possibly state and local taxes, caused it to fall harder and faster. Generally, only when the market becomes extremely cheap versus other fixed income asset classes does it draw in buyers seeking total return rather than tax exemption, and this appears to have occurred during the last few trading sessions of June, providing some much needed support. One effect from this lack of demand was to have many new issues postponed in late June and now the market is anticipating heavy supply in July.
Below are some returns across major market indices for the period:
|Barclays Municipal Bond Index
|Barclays U.S. Treasury Index
|Barclays U.S. Aggregate Index
|Baclays U.S. Government/Credit Index
|Barclays U.S. Corporate High-Yield Index
|Dow Jones Industrial Average
|S&P 500® Index
(Data: Barclays, Bloomberg. Accessed on or about July 1, 2013. Index performance reflects past performance and does not guarantee future results.)
Municipal markets: Statistics
Treasury yields on 5-, 10-, and 30-year bonds increased by 62, 64, and 39 basis points, respectively, during the second quarter of 2013. Municipal yields also increased over the 5-, 10-, and 30-year periods by 56, 65, and 74 basis points, respectively. This resulted in underperformance of municipal securities versus U.S. Treasury for the 10- and 30-year periods as demonstrated by the following chart:
|AAA MMD/U.S. Treasury ratios
(Data: Thomson Municipal Market Data, accessed on or about July 1, 2013. Index performance reflects past performance and does not guarantee future results.)
The municipal curve steepened by 55 basis points to 333 basis points, as measured by the spread between 2- and 30-year MMD AAA yields. Two-year high-grade tax-exempt bond yields increased 19 basis points for the period while 30-year high-grade tax-exempt yields increased by 74 basis points. (Data: Thomson Reuters.)
The Barclays Municipal Bond Index returned -2.97% for the quarter. The best-performing maturity segment was the 1-year Index (bonds with 1–2 year maturities), which generated a 0.03% return; the worst-performing maturity segment was the Long Index (22+ year maturities), which returned -4.35%. (Data: Barclays.)
AAA-rated securities provided the best return during the second quarter of 2013. Credit spreads, as measured by MMD yields on 30-year BBB general obligation (GO) securities minus 30-year AAA GO securities, flattened by approximately 14 basis points. At the end of the second quarter, the spread was 117 basis points.
For the second quarter of 2013, the total return within the Barclays Municipal Bond Index by rating, as well as the Barclays High-Yield Municipal Bond Index (representing noninvestment grade bonds) was as follows:
|Barclays High-Yield Municipal Bond Index
(Data: Barclays, accessed on or about July 1, 2013. Index performance reflects past performance and does not guarantee future results.)
Housing, which returned -1.44% for the period, was the best-performing sector within Barclays Municipal Bond Index, followed by electric (-2.69%), and resource recovery
(-2.75%). High yield tobacco was the worst overall performing sector for the period, returning -7.75%.
Supply for the second quarter of 2013 was $89 billion, representing a 22% decrease as compared to the same period last year. (Data: Municipal Bond Buyer.)
The market now appears to have gone from a “QE watch” to a “QE warning” mode. The psychological shift has investors consumed with the Federal Reserve’s timetable for the reduction of stimulus. The Fed has made it clear that any changes it makes will be data-dependent. It currently has a 2.5% outlook for 2013 gross domestic product (GDP), which will be harder to achieve now that the first-quarter GDP has been revised from 2.5% to 1.8%. Also, during the press conference following the June FOMC meeting, Chairman Bernanke stated that the recent decline in inflation is “transitory.” This remains to be seen.
In last quarter’s review and outlook, we discussed our preference for credit over curve and the ability of credit to outperform in a moderate and orderly rate rise. The second quarter was anything but an orderly rate rise, and both credit and curve underperformed. We chose not to make impulsive portfolio adjustments in this illiquid market. We believe we are back to the same point we were at in the first quarter, where we will have to evaluate the ability of credit to perform if rates continue to rise. However, it is also possible that a new trading range has been established and now income will once again be the driver of performance.
We will continue to monitor both the economic data and Fed policy. We have recently seen the effect of a volatile and illiquid market on our mutual fund portfolios. In the interest of long-term performance, our investment philosophy focuses on income. We are hesitant to make wholesale changes to the core of our mutual fund portfolios at this time, as we believe the credits we own are fundamentally sound and may not be easily replaced.
Additional statistics at the state level, briefly noted
(State-specific developments noted below are based on information published by each state’s respective budget authorities and supplemented by sources that include Standard & Poor’s, the National Conference of State Legislatures, the U.S. Labor Department, and the National Association of State Budget Officers.)
- Idaho’s unemployment rate totaled 6.2% in May, lower than the national rate of 7.6%. Year-to-date revenues for the first 11 months of fiscal 2013 are coming in 3.1% better than expected and 6.2% higher than the previous year. The state passed its $2.781 billion 2014 General Fund budget, a 2.9% increase over fiscal 2013. The budget includes a 2% increase in education spending and a personal property tax relief package exempting the first $100,000 valuation of personal property taxes. It does not include expansion of Medicaid eligibility.
- In Arizona, the unemployment rate totaled 7.8% in May, improved from prior months but slightly above the national average. For the first 11 months of fiscal year 2013, revenues are 5.8% higher than last year and 2.3% above forecast. Fiscal year-to-date, General Fund revenues of $8.11 billion have been offset by $7.99 billion in spending. The governor signed the 2014 $8.8 billion General Fund budget into law on June 17, 2013. This represents a 3.4% increase from fiscal 2013. Base revenues are projected to increase by 4.9%. However, one-time factors, including the expiration of the temporary $0.01 sales tax (loss of $924 million), would reduce 2014 collections by $253 million compared to fiscal 2013. This would result in an ending balance of $298 million and a Budget Stabilization Fund of $450 million. State officials currently project a small $40 million shortfall in fiscal 2015 and a $217 million shortfall in fiscal 2016.
- The unemployment rate in Minnesota totaled 5.3% in May, significantly lower than the national rate of 7.6%. Minnesota operates on a biennial basis. The two-year $38 billion budget closed a $627 million shortfall. The budget increases the income tax on high-income earners to 9.85%, eliminates some corporate tax subsidies and raises tobacco tax by $1.60, while reducing property tax pressures through refunds and more funding for aids to local governments. It not only closed the deficit, but also allowed Minnesota to make overdue payments to schools. The state now projects an ending budgetary balance of
$46 million at the end of fiscal 2015.
- Colorado’s unemployment rate totaled 6.9% in May, lower than the national rate. The June 2013 General Fund revenue forecast for fiscal 2013 is 3.7% higher than the March forecast, due largely to stronger individual income tax payments received in April. Revenue for fiscal 2013 is estimated to increase 11.1% over fiscal 2012. The state projects a year-end General Fund surplus of $1.1 billion, all of which will go to the State Education Fund. General Fund revenue for fiscal 2014 is expected to increase 0.8%, less than what was anticipated in March, due in part to the surge of income tax revenue in the current year. The governor signed an $8 billion 2014 General Fund budget into law in April 2013. This represents a 6.8% increase over fiscal 2013. It projects that General Fund revenue will be $181.4 million more than the required reserve at the end of fiscal 2014. Under current law, $30 million would be transferred to the Colorado Water Conservation Board’s fund and $113.6 million would be transferred to the State Education Fund.
- The unemployment rate in New York reached 7.6% in May. State tax collections totaled $66.3 billion in fiscal 2013, 3.1% higher than fiscal 2012. This was 0.6% above February estimates but 0.1% below initial estimates due to unexpected costs from Hurricane Sandy. The state ended fiscal 2013 with a General Fund balance of $1.61 billion, 9.9% less than the prior year but 9.2% more than the last financial projection. This includes a $1.4 billion combined balance in the Tax Stabilization Reserve Fund and Rainy Day Fund. For the first two months of fiscal 2014, tax collections were up 25.8% from collections during the same period last year due to strong personal income tax collections, which grew 33.3%. However, more than 87% of this growth is primarily driven by strong estimated tax collections in April due to taxpayers’ efforts to shift income from 2013 to 2012 to avoid paying higher federal taxes. The General Fund closing balance of $3.7 billion at the end of May was $287.9 million higher than budget projections. This reflects $448.9 million in higher-than-anticipated receipts offset by $161 million in higher-than-anticipated spending.
- In California, the unemployment rate totaled 8.6% in May, an improvement over prior months. For the first 11 months of fiscal year 2013, California revenues are coming in 0.9% above the May estimates and 20.6% above prior-year revenues. This is partly due to temporary increases in the sales and personal income tax rates. The governor signed a $96.3 billion 2014 General Fund budget into law (meeting the deadline) that relied on his more conservative revenue estimates and provided for a $1.1 billion reserve. The budget found room for additional spending on education, social services, and healthcare by reducing plans to repay money owed to schools by roughly $650 million and using the more optimistic estimates for property taxes, freeing up an additional $300 million because it reduced the state’s obligation to fund schools. The budget overhauls the state’s K-12 system by creating a more just allocation of resources (committing new funding to low income districts and ones serving English-language learners) and providing expanded flexibility. It also expands Medicaid to 1.4 million low income residents. The state’s wall of debt will be reduced to less than $27 billion at the end of fiscal 2013 and projections show it will be reduced to less than $5 billion by the end of fiscal 2017.
- The unemployment rate in Pennsylvania totaled 7.5% in May, slightly lower than the national rate of 7.6%. Through the first 11 months of fiscal 2013, General Fund revenue collections totaled $26 billion, 0.4% above estimates. Sales taxes came in 3.7% below budget, while personal income taxes came in 1% above estimates. Corporate taxes beat projections by 6.2%. The governor signed the 2014 $28.4 billion budget on June 30, 2013. The budget increased spending by approximately 2%. Spending is roughly flat across sectors with the exception of a $120 million increase in school funding. The budget did not include liquor privatization, transportation funding, or pension overhaul. These issues may be taken up in fall legislative sessions.
- The unemployment rate in Puerto Rico weakened to 14.5% in February. The Commonwealth has struggled to come out of its recession that started in 2006. The Puerto Rico Planning Board revised its economic growth projections, saying that during fiscal 2013, the economy declined by 0.4%, instead of the 1.1% expansion that was originally projected. The Board estimates a growth rate of 0.2% during fiscal 2014. Fiscal 2013 revenues through May totaled $7.408 billion. The projected deficit for the year ended June 30, 2013, is now $295 million, reduced from $965 million in February and
$445 million below budget in March. The Commonwealth plans to address the remaining shortfall with a combination of tax amnesty, tax liens, closing agreements, audits to law 154 (which represents a system of temporary excise taxes imposed on purchases made by offshore companies), and other pending initiatives. The governor signed into law a $9.77 billion 2014 budget, which is 7.6% higher than the 2013 budget. The budget includes approximately $1.38 billion of new revenue derived from (1) a scaled-back version of a business-to-business tax proposal expanding the sales and use tax base; (2) a gross receipts tax on businesses generating $1 million in sales; (3) an increase in cigarette taxes; and (4) an increase in corporate tax rates to 1994 levels (with a top rate of 39%). While technically balanced, the budget projects a structural deficit of $810 million. Recently enacted pension reform was upheld by Puerto Rico’s Supreme Court.
The views expressed represent the Manager’s assessment of the market environment as of June 30, 2013, are subject to change, and may not reflect the manager’s current views. Views should not be considered as recommendations to buy, hold, or sell any security, and should not be relied on as research or investment advice. Please see important disclosures and definitions at the end of the document.
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Unless otherwise noted, the sources of statistical information in this document are Bloomberg, Municipal Bond Buyer, Barclays, and Thomson Municipal Market Data. Data were originally accessed on or about July 1, 2013.
The information is provided with the understanding that Delaware Investments is not engaged in rendering accounting, legal, or other professional services. Seek the services of a competent professional if legal advice or other expert assistance is needed.
Advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.
Joseph R. Baxter and Stephen J. Czepiel are officers of Delaware Management Company, a series of Delaware Management Business Trust and a registered investment advisor.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. These funds may also be subject to prepayment risk, the risk that the principal of a fixed income security may be prepaid prior to maturity, potentially forcing a fund to reinvest that money at a lower interest rate.
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This document may mention bond ratings published by Standard & Poor’s, a nationally recognized statistical rating organization. Bonds rated AAA are rated as having the highest quality and are generally considered to have the lowest degree of investment risk. Bonds rated AA are considered to be of high quality, but with a slightly higher degree of risk than bonds rated AAA. Bonds rated A are considered to have many favorable investment qualities, though they are somewhat more susceptible to adverse economic conditions. Bonds rated BBB are believed to be of medium-grade quality and generally riskier over the long term.
This document may mention bond ratings published by Moody’s, a nationally recognized statistical rating organization. Bonds rated Aaa are rated as having the highest quality and are generally considered to have the lowest degree of investment risk. Bonds rated Aa2 are considered to be of high quality, but with a slightly higher degree of risk than bonds rated Aaa. Bonds rated A2 are considered to have many favorable investment qualities, though they are somewhat more susceptible to adverse economic conditions. Bonds rated Baa3 are believed to be of medium-grade quality and generally riskier over the long term.
This document may mention bond ratings published by Fitch, a nationally recognized statistical rating organization. Bonds rated AAA are rated as having the highest quality and are generally considered to have the lowest degree of investment risk. Bonds rated AA are considered to be of high quality, but with a slightly higher degree of risk than bonds rated AAA. Bonds rated A are considered to have many favorable investment qualities, though they are somewhat more susceptible to adverse economic conditions. Bonds rated BBB are believed to be of medium-grade quality and generally riskier over the long term.
The Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.
The Barclays High-Yield Municipal Bond Index measures the total return performance of the long-term, noninvestment grade tax-exempt bond market.
The Barclays U.S. Aggregate Index is a broad composite that tracks the investment grade domestic bond market.
The Barclays U.S. Corporate High-Yield Index is composed of U.S. dollar–denominated, noninvestment grade corporate bonds for which the middle rating among Moody’s Investors Service, Inc., Fitch, Inc., and Standard & Poor’s is Ba1/BB+/BB+ or below.
The Barclays U.S. Treasury Index measures the performance of U.S. Treasury bonds and notes that have at least one year to maturity.
The Barclays U.S. Government/Credit Index is composed of investment grade corporate and U.S. government debt securities with at least one year to maturity.
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The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market.
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