Muni
Quarterly
April 2017
The
Analysis and Commentary
on Municipal Bonds
INSIDE THIS ISSUE
AN UNCERTAIN PROGNOSIS
FOR U.S. HOSPITALS AS MEDICAID
CHANGES LOOM
n An Uncertain Prognosis for
by Kari Gauster, Research Analyst
n Getting Up to Speed on
U.S. Hospitals as Medicaid
Changes Loom.....................1
Puerto Rico..........................2
Efforts underway in the Republican-controlled U.S. Congress to reach consensus
on new healthcare legislation, following the failure of an earlier bill in March 2017,
pose an ongoing negative headwind to not-for-profit U.S. hospitals, a major sector
of the municipal bond market, with nearly $250 billion under issuance, according to
Bloomberg. Above all, the most recent bill under consideration likely would have a
negative impact on the Medicaid program, which covers 69 million Americans and
accounts for 14.4% of hospitals’ gross revenues.
However, regardless of whether Congress successfully passes legislation to “repeal
and replace” the existing Affordable Care Act (ACA)—in the coming weeks or next
several months—we anticipate additional changes to the ACA to come via administrative actions taken by the U.S. Department of Health and Human Services and the
Centers for Medicare and Medicaid Services, in particular through the approval of
Section 1115 Medicaid demonstration waivers. We believe that the vast majority of
healthcare systems will be able successfully to adapt to the changes, but careful analysis
is necessary to avoid investing in the small number that could face downgrades along
with significant financial challenges.
RISING COSTS SPUR CHANGES
Medicaid currently accounts for, in aggregate, the largest portion of U.S. state
budgets, at 25.6% (see accompanying chart), crowding out other spending priorities,
such as education. These cost pressures, coupled with the conservative policy direction
of the new administration, likely will drive an increasing number of states to redesign
their Medicaid programs through the use of Section 1115 waivers. These waivers allow
states to test new approaches in Medicaid that differ from federal program rules. While
the parameters of the Section 1115 waivers are restricted by federal guidelines, the new
administration is expected to be more accepting of “conservative” elements rejected by
previous administrations, such as imposing work requirements or requiring premiums
for beneficiaries with income less than 100% of the federal poverty level.
n International Student-
Enrollment Growth Has Been
a Double-Edged Sword for
U.S. Universities..................4
n Texas Two-Step: What Dallas
and Houston Teach Us about
Muni Credit Risk..................6
n Muni Market Monitor...........8
Proposed changes to states’
Medicaid programs regarding
coverage, eligibility, and
financing could have a
negative impact on
hospitals’ finances.
It is widely assumed that such obligations for Medicaid beneficiaries would result in
coverage losses, as seen in recent waivers provided to Indiana and Michigan. In order to
provide incentives for Indiana and Michigan to expand Medicaid, the Obama administration approved waivers that included so-called conservative elements such as charging
premiums above federal limits and requiring the use of health savings accounts (HSAs).
Early results indicate that these states’ Medicaid programs enroll fewer people than they
would without the waiver. Even modest premium costs tend to deter eligible people from
enrolling due to lack of affordability and logistical impediments, and the perceived
complexity of HSAs tends to prove daunting for potential enrollees.
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IN AGGREGATE, MEDICAID ACCOUNTS FOR THE LARGEST SINGLE PORTION OF U.S. STATE BUDGETS
Distribution of Medicaid, education, and all other spending from total state budgets versus state-funded state budgets for state fiscal year 2014
Medicaid
15.3%
Medicaid 25.6%
(10.7% state,
14.9% federal)
All other
44.0%
(33.1% state,
10.9% federal)
Total state
budgets
$1.7 trillion
Higher education 10.5%
(9.3% state, 1.2% federal)
All other
47.4%
Elementary
and
secondary
education
19.8%
(16.8% state,
3.0% federal)
Total statefunded budgets
$1.2 trillion
Elementary
and
secondary
education
24.1%
Higher education
13.2%
Source: MACPAC 2016 analysis of NASBO 2015.
Note: Total state budgets include all state funds (solid segments) and federal funds (dotted segments). State-funded state budgets include all non-federal funds, and consist
of state general funds (expenditures from revenues raised through income, sales, and other broad-based state taxes), other state funds (expenditures from revenue sources
that are restricted by law for particular government functions or activities, which for Medicaid includes provider taxes and local funds), and bonds (expenditures from the sale
of bonds, generally for capital projects).
IMPACT ON HOSPITALS
In spite of these outcomes and the resulting coverage losses, more and more states are likely to implement similar measures. The new
administrator of the Centers for Medicare and Medicaid Services, Seema Verma, is credited with designing Indiana’s waiver program and
has helped other states roll out similar models. Under Verma and the new administration, we could see the addition of first-ever obligations for Medicaid beneficiaries, such as work search or work requirements, drug testing, or lifetime limits on benefits. A waiver proposal
in Wisconsin, for example, would place a lifetime four-year limit on coverage, while Maine would implement a five-year limit and a work
requirement and Kentucky would add coverage lock-outs for premium non payment and add high-deductible HSAs.
Such changes to states’ Medicaid programs will have a negative effect on many hospitals. To the extent beneficiaries lose coverage
due to unaffordable premiums or copays, lifetime caps on coverage, or an inability to meet a work requirement, these individuals
likely will turn to the emergency room for care, driving up hospitals’ uncompensated care costs. To offset these pressures, many
hospitals will need to increase their capture of commercially insured patients by adding key service lines, expanding physician
networks, and growing their outpatient presence. As we noted earlier, we believe that most healthcare systems will successfully meet
the challenges posed by the potential Medicaid changes. Still, the success of these efforts, and their effect on hospitals’ credit profiles,
will bear close watching.
COFINA (Corporacion del Fondo de Interes Apremiante, the
Puerto Rico Sales Tax Financing Corporation), whose debt is
backed by sales-tax revenue. The GO bondholders’ group
considers their debt to have priority over all other obligations.
The litigation led to discussions between GO bondholders,
COFINA bondholders and the Puerto Rican government under
the supervision of a mediator in April.
GETTING UP TO SPEED
ON PUERTO RICO
by Derek Gabrish, Research Analyst
As expected, things are beginning to heat up again in Puerto
Rico, with several bondholder groups meeting with government
officials to discuss a potential restructuring of Puerto Rico’s debt
prior to a May 1st deadline. In March, a federal appeals court
temporarily denied the general obligation (GO) bondholders’
effort to stop the island’s government from making payments on
Puerto Rico bonds became a large component of the U.S.
high-yield municipal bond market when they were downgraded
below investment grade in 2014. Currently, their bonds are trading
at prices, which could present value under a variety of outcomes
for portfolios that have mandates to invest in the high-yield
portion of the municipal bond market. Since the situation in
Puerto Rico remains fluid, we thought it would be helpful to bring
everyone up to date about the important facts.
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A LOOK BACK
Over the past 10 years, the U.S. territory of Puerto Rico has
run multibillion-dollar annual deficits and more than doubled its
total debt since 2004—all the while facing an economy that has
grown during only one year since 2007. Not surprisingly, with
high unemployment and limited job prospects for its residents,
Puerto Rico experienced an exodus of nearly 7% of its population from 2010–15. Moreover, the island’s credit rating has
steadily declined, dropping to below investment grade in 2014,
and then to default in 2016. The commonwealth’s last demonstrated market access occurred with the 2014 issuance of GO
bonds that carried an 8% coupon.
Shortly after the 2014 issuance, then-Governor Alejandro
García Padilla indicated that the island’s debt was not payable—
a pronouncement that effectively closed the door on future
financings, and left the government in the position where it would
have to drain virtually all of its remaining cash. The relationship
between the island’s administration and its bondholders subsequently deteriorated. Current federal law did not permit Puerto
Rico and other U.S. territories to restructure their debts through
bankruptcy, so the only path toward a resolution was for them to
negotiate with creditors unless the federal government took action.
If Congress provides additional healthcare funds for
Puerto Rico, more funds could ultimately be freed
up for bondholders of the roughly $70 billion in
commonwealth debt outstanding.
AN OVERSIGHT BOARD FOR DEBT RESTRUCTURING
In June 2016, President Obama signed into law Congress’s
potential fix for Puerto Rico, the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA). PROMESA
created an oversight board with debt-restructuring powers, and
gave the commonwealth the ability to avoid litigation through a
“stay” for a period of time and bind non-consenting creditors in a
potential debt restructuring. Under the protection of PROMESA,
the commonwealth defaulted on its constitutionally guaranteed
debt on July 1, 2016.
Since the passage of PROMESA, a fiscal oversight board has
been appointed and bylaws and directives have been adopted. In
the fall of 2016, Padilla was charged with submitting an initial
draft of a fiscal plan for the Puerto Rican government, as required
under the law. He presented his draft in December, but it was
rejected by the oversight board for many reasons, such as not
setting aside any funds for debt service after paying operating
expenses. The board’s request for revision was refused by Padilla.
NEW GOVERNOR RENEWS HOPE
In January 2017, the power of the Puerto Rican government
shifted to another political party, as the new governor, Ricardo
Rosselló, took office. Burdened with a short time frame to craft a
revised fiscal plan, the oversight board provided the newly
elected governor with some relief by extending the litigation stay
until May 1 and pushing back the plan deadline. On March 13,
the board amended and certified the new administration’s fiscal
plan, with a baseline projection of a $66.9 billion 10-year deficit
and recommended fiscal adjustments.
Approving a fiscal plan was a step in the right direction for the
island, but the plan is facing scrutiny because it failed to address
two important issues for bondholders: the legal priority of debt
service in the government’s flow of funds and the potential for
additional healthcare funding from the federal government. The
approved fiscal plan leaves bondholders with only $7.8 billion
over the next 10 years for debt service (after expenditures), which
is well below what is needed. Unfortunately, the plan is attempting
to pay bondholders only after other government expenditures
have been funded. This likely will lead to litigation, given the legal
provisions set up for bondholders prior to initiating the bond
deals, which included a first priority of payments from commonwealth revenues before paying any other expenses.
In addition, the island previously attempted to expand
Medicaid under the Affordable Care Act (ACA), despite its
funding being limited by a federal funding cap, which led to
insufficient cash for the island’s healthcare programs. To offset
this gap, the federal government previously gave the island $6.4
billion in additional funding to be spent through 2019. Yet, that
funding is projected to be depleted by 2018. The commonwealth
government believes that it is owed more money for health care,
and it is waiting for the U.S. Congress to respond. If Congress
provides additional healthcare funds for Puerto Rico, more funds
could, ultimately, be freed up for bondholders of the roughly $70
billion in commonwealth debt outstanding.
COFINA VERSUS GO BONDHOLDERS
The commonwealth has issued debt under a variety of securities,
which has led to complexity for a comprehensive debt restructuring and the ability to design a hierarchy to the payment priority of
the island’s issuers. Among the two largest debt groups are
commonwealth GOs and COFINA. (GO debt includes constitutionally guaranteed obligations.) These two types of obligations
each represent roughly $17 billion in par amount outstanding and
69% of the island’s tax-supported debt in total, according to the
Puerto Rico Fiscal Agency and Financial Advisory Authority.
Bondholders of each group currently are in a legal battle to
determine who has claim over the sales tax revenues supporting
the COFINA bonds. A group of hedge funds holding GO debt
is arguing that pledged revenues are actually the property of
GO bondholders and that the COFINA debt structure is
potentially illegal. COFINA bondholders say that the security
supporting their bonds was approved by several previous
attorney generals and that it was structured to create a dedicated
and clear revenue stream to support the separate bond issue. As
of April 2017, COFINA bondholders have continued to receive
their debt payments without interruption, while GO bonds
have been in default since July 2016. COFINA bondholders
continue to defend their rights to the sales tax revenue stream
and the case has been temporarily halted by the PROMESA
stay. The outcome of this case or a resulting settlement could
have a material effect on the ultimate recovery rate for each
group of bonds in a restructuring.
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GOOD FAITH NEGOTIATIONS
The Puerto Rican administration and the fiscal oversight board have indicated a preference for pursuing good faith negotiations
under Title VI of PROMESA, which could result in a consensual debt restructuring. Should good faith negotiations fail, however,
an alternative for the board would be to file a Title III restructuring under PROMESA, which would be a court-driven bankruptcy
proceeding. Negotiations are only in the very early stages, despite a May 1st deadline looming from the PROMESA stay expiration.
The commonwealth has requested an extension of the litigation stay, from May 1, 2017, until year-end, so that it may further pursue
negotiations with creditors. More important, an extension of the stay through year-end would require action by the U.S. Congress,
which, so far, has not indicated any interest in granting an extension, further increasing the potential for a Title III filing in May.
Lawsuits are likely to continue regardless of the outcome.
With the deadline closing in, there do not appear to be any indications that an agreement between the government officials and
creditors is imminent. The probability is low that there can be a final agreement with so many creditors having different levels of
security on their bonds. The next key actions to watch will be how stakeholders respond should the May 1st deadline pass without an
agreement and what directions the discussions will turn given a variety of outcomes.
The only Puerto Rican entity so far that had reached a restructuring deal with creditors was the island’s public power utility, the
Puerto Rico Electric Power Authority (PREPA). That December 2015 agreement, which included a 15% haircut to uninsured bondholders, recently had been rescinded, with the new governor seeking additional concessions from creditors. As a result, negotiations
resumed for this issuer and a new resolution is pending final approvals.
We expect more news to come from the island in the coming months, and we will keep you informed.
INTERNATIONAL STUDENT-ENROLLMENT GROWTH HAS BEEN
A DOUBLE-EDGED SWORD FOR U.S. UNIVERSITIES
Tough immigration policies could hurt schools that invested heavily in attracting overseas applicants.
by Eric Friedland, Director of Municipal Bond Research
The headwinds faced by many U.S. universities have
increased, particularly for those without strong international
brands. This is due to challenging demographics, higher tuition
discounting, declining endowment returns, and lower state
funding for public universities. To offset potential declines in
enrollment, administrators have been actively recruiting foreign
students who pay full nonresident tuition. Many universities
currently have offices in India and China, and several university
presidents have accompanied their state governors on trade
delegations abroad. Although these universities have benefited
from the influx, they also have become exposed to unique fiscal
risks that may be beyond their control. The current administration’s tough immigration stance has not been helpful. Although
most U.S. universities are well positioned to capitalize on
WHERE ARE INTERNATIONAL STUDENTS COMING FROM?
Number of Students
Top countries sending students to U.S. colleges and universities for the school years 2011/12– 2015/16
350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
2011-2012
2012-2013
China
India
2013-2014
South Korea
2014-2015
Saudi Arabia
2015-2016
Canada
Source: Institute of International Education, Open Doors Report on International Educational Exchange.
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Due to the shift in immigration policy, nearly 40%
of colleges in a recent survey are reporting overall
declines in applications from international students.
opportunities, those that have relied most on international
student-enrollment growth will require more credit diligence.
The growth in foreign students studying in the United States
has been significant. In 2015, for example, there were 1.13 million
foreign students in U.S. colleges and universities. This represents a
14% increase over 2014, and was 50% higher compared with 2010
and 85% higher compared with 2005. The group of countries from
which these students originate is fairly concentrated, with China
by far being the biggest source, accounting for 29%. India
accounted for 18%, and South Korea for 10%. Saudi Arabia, at
7%, saw rapid gains, as the number of students increased, from
5,000 in 2001 to 81,000 in 2015.
While there was only one university in 2000 for which international students accounted for more than 20% of enrollment, in
2014, that number rose to 14. The largest five were the New School
(30%), Mount Holyoke College (28%), Bryn Mawr College
(28%), University of Rochester (26%), and Brandeis (24%).1
THE LURE OF U.S. COLLEGES
The reasons vary as to why international students enroll in
U.S. universities. For Chinese students, they seek alternatives to
a domestic higher education system that has been described as
uninspiring and where cheating is pervasive. There is fierce
competition to get admitted into the few reputable Chinese
universities, and the entrance exams are extraordinarily difficult.
The experience for Chinese students is regimented, as they are
assigned to universities based on scores, and majors are preassigned. For those from India, it is primarily graduate students
seeking to study abroad, as the quality of those programs is
significantly weaker than that of the domestic undergraduate
programs. And because legal restrictions are more severe in the
other English-speaking nations of the United Kingdom and
Australia, international students are drawn to the United States.
The use of consultants has become more prevalent and
problematic, particularly for those colleges that do not have
an international brand. The consultants assemble candidates’
documents and guide the students toward specific schools.
Once successful, the consultants are paid a portion of first-year
students’ tuition, typically 20–30%. This practice puts colleges
at risk, as it has been reported that many admissions packages
derived from consultants (particularly those from China) have
included falsified transcripts, recommendations, and test scores,
and ghost-written essays. With the potential for lower graduation rates, these schools are exposed to sanctions and the
potential loss of accreditation. Further, the consultants have no
allegiance to a particular school, so they may shift where they
send their clients, resulting in enrollment volatility for those
colleges that received international students in prior years.
IMMIGRATION POLICY AND OTHER RISKS
To continue attracting international students, some schools
have committed significant capital by expanding facilities. This has
put their balance sheets at risk, because the international student
base can be volatile. Further, due to shifting U.S. immigration
policy, nearly 40% of colleges are reporting overall declines in
applications from international students, according to a survey of
250 college and universities, which recently was released by the
American Association of Collegiate Registrars and Admissions
Officers. In addition, enrollment is being affected by international
events well beyond the universities’ control, which include
geopolitical, foreign currency, and commodity fluctuations.
Meanwhile, China is building up its own higher education
infrastructure, while the Chinese student population in the
United States grew by only 10.8% last year, the smallest increase
in a decade. Shrinking oil revenue in Saudi Arabia has resulted in
the kingdom granting fewer awards for students to study abroad,
and has reversed the steady double-digit annual percentage
growth. The increasing value of the U.S. dollar has reduced the
number of students from Brazil, as only 34 grants were awarded
to U.S.-bound students last year, versus 5,745 in 2015. Finally,
the government-induced currency shortage in India has limited
the ability of many students to fund their education.
It is clear, then, that as international student tuition has helped
many U.S. universities maintain their bottom line, such revenues
have proven to be volatile. Those universities that have been
most reliant on these students, and do not have a strong international brand, will be most exposed to credit pressure.
Overall, the higher education sector has performed well, and
we will continue to invest in those universities that demonstrate
steady student demand and enrollment growth, strong balance
sheet resources, and good liquidity.
Enrollment data referenced herein are from the Institute of International Education.
1
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TEXAS TWO-STEP: WHAT DALLAS AND HOUSTON TEACH US
ABOUT MUNI CREDIT RISK
Both cities are struggling with large pension liabilities because investment returns were below
rosy predictions.
by Josh Levine, Research Analyst
According to Moody’s Investors Service, U.S. local government pension liabilities will
rise again in fiscal 2017. While we believe that most pension plans are adequately
managing the risk associated with these liabilities, the few plans that are performing very
poorly are catching many of the headlines. These weak plans struggle due to deferred
annual contributions, rosy investment assumptions, unsustainable promises, or all of the
above. There are local governments, including large cities with strong economies, that
could experience budgetary pressure and credit ratings agency downgrades due to pension
risk (see accompanying table). With negative headlines dominating the national discourse
on pensions, this discussion sets the backdrop for an important question: how can
investors identify the entities most affected by underfunded pension plans?
Pension risk is among the most opaque credit factors that influence muni bond pricing.
Pensions are long-term liabilities, whose size and immediacy depend on individual plan
assumptions, returns on investment portfolios, and structural elements that govern how
benefits are accrued by pensioners and paid out by the sponsoring entities. In short, a variety
of technical factors make comparing pension risk across a credit portfolio very challenging
without a substantial standardization effort. What we can do more easily is break down some
essential elements about pensions and use them to identify municipalities that face the most
significant pressure from pension liabilities.
The way municipalities choose to pay pension benefits has a large impact on the pension
liability numbers reported in their audited financial statements. Because most pension plan
benefits are guaranteed, municipalities can anticipate how much they will have to pay out to
retired/retiring employees over time. However, rather than just paying out benefits after
employees retire, plans are funded while people are still working, through annual contributions from both employees and employers. Some of these contributions go toward paying
current-year benefits, while the rest is invested for the payout of future benefits. By assuming
that already-invested pension assets will generate investment income that can go toward
paying future benefits, municipalities contribute less than they would if benefits were simply
paid in the year they were due. This means that the amount a municipality needs to contribute annually for its pension program depends on both the size of the liability (benefits owed)
and how much money it believes it will make off of its existing investments.
This is where municipalities get into trouble: In order to keep current-year contributions
into the pension plan low, they have an incentive to assume that investment returns on an
existing portfolio will be strong. While strong returns do happen, aggressive rate-of-return
assumptions inevitably encourage pension fund managers to invest existing assets in riskier,
but higher-yielding securities in order to meet the targets outlined by the plans.
In years when benefits owed to employees go up while investment returns are weak,
funding shortfalls emerge that cause pension liabilities to grow. This in turn requires larger and
larger contributions to the plan just to maintain the same funded level. Without reforms to
benefits, investment return assumptions, or contribution rates, rising pension costs can create
significant budgetary pressure that threatens to crowd out other expenses. These include
public safety, infrastructure, and (in the case of the most pressured entities) debt service.
City
Liability as
% of annual
operating
revenues
Chicago, IL
719%
Dallas, TX
549%
Phoenix, AZ
434%
Houston, TX
414%
Los Angeles, CA
407%
Jacksonville, FL
369%
Detroit, MI
364%
Columbus, OH
278%
Austin, TX
267%
Philadelphia, PA
223%
Honolulu, HI
(city and county)
221%
San Antonio, TX
188%
Kansas City, MO
175%
Memphis, TN
167%
San Francisco, CA
(city and county)
151%
Source: Moody’s.
Without reforms to benefits,
investment return assumptions, or contribution rates,
significant budgetary
pressure could crowd out
other expenses. These
include public safety,
infrastructure, and (in the
case of the most pressured
entities) debt service.
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PENSION TENSION IN DALLAS AND HOUSTON
Dallas and Houston are struggling with the exact problem
described above, leading to budgetary stress. While both cities
maintain high investment-grade ratings, they have experienced
recent downgrades from credit rating agencies. In both cases,
investment returns were below rosy assumptions, leading to
growing liabilities. However, risk levels in Dallas and Houston
are elevated for two key state/plan-specific reasons:
1. Unlike most state and local government pension plans,
Dallas and Houston have local pension boards with the authority to make benefits more generous, but need state legislative
approval to increase contributions or change the structure of the
offered benefits. This arrangement makes negotiations between
the key parties more difficult because policy options for
reforming plans are not available without legislative action.
Their reliance on the state legislature also creates political risk,
as reform packages must go through a lengthy and complex
lawmaking process designed to limit changes to state laws.
2. For Dallas in particular, an element of its Police and Fire
Pension Plan (75% of the unfunded liability) adds significant
risk. This element is called the Deferred Retirement Option
Program (DROP), which allows participants to withdraw
pension benefits while they continue to work and guarantees a
very high rate of return on withdrawable investments. As the
plan’s growing pension liability made headlines, nervous
pensioners started to withdraw their savings from DROP
accounts at a faster-than-expected rate, reducing total plan
assets by $500 million (a bit less than 25%) in the second half
of 2016. These withdrawals not only affected the size of the
investment portfolio in the current year but they also compounded the problems with the funded ratio because the plan
was depending on generating investment returns of 8.5% on
those assets to pay down the pension liability.
HOW DALLAS, HOUSTON, AND THE TEXAS LEGISLATURE
ARE RESPONDING
Texas state representative Dan Flynn (R) filed bills with the
state legislature to address the underfunded pension plans in
both cities. As the lawmaking process moves forward, any
solution that both improves the sustainability of the plans and
avoids placing a substantial burden on the cities’ finances will
have to forge a delicate compromise among city officials, plan
administrators, employee groups, and the legislature.
In Dallas, the city and pension boards have not been able to
agree on how to reform the Police and Fire Pension Plan, with
the city looking to claw back certain benefits and the board
wanting the city to pay more. Representative Flynn’s legislation (as of this writing) restructures the pension plan board,
reduces cost-of-living adjustments (COLAs), limits payouts
from DROP, raises the retirement age, and increases the
statutory maximum contribution for the city. There also is a
provision that requires the board to consider benefit clawbacks.
While these changes would be credit positive, we don’t believe
they completely mitigate pension risk. The suggested reforms
still will require the city and pension board to figure out a way
to pay for increased contributions.
Houston faces fewer acute challenges than Dallas, owing to its
less-generous guaranteed investment returns for DROP participants
and more coordination among its key constituents. Houston mayor
Sylvester Turner (D) was able to broker a pension-funding
compromise ahead of the legislative session, and Representative
Flynn will present a version of this compromise to the legislature.
The bill will include reduced COLAs, the phasing out of DROP
benefits, and the implementation of a “cost corridor” that will
index the city’s contribution rates to current-year investment
returns. An additional component of the plan is a $1 billion
pension obligation bond (POB) issuance, whereby proceeds will
be added to existing investments in order to improve current-year
funded ratios.
While Houston’s solution is more solidified than Dallas’,
we think that the use of POBs turns an adjustable long-term
liability (pensions) into a more rigid liability (bonded debt)
that reduces the city’s flexibility and creates additional challenges if the invested bond proceeds don’t generate sufficient
investment returns.
Overall, these examples illustrate how legal limitations and
technical components of specific pension plans add to risk, in
this case forcing Dallas and Houston to engage in an uncertain
political process to gain the authority to address their respective
liabilities. During the sensitive time frame when compromise bills
to fix the cities’ pension plans have not yet been passed, a political
or legislative disruption to the process could force both Dallas
and Houston to go back to square one.
Want to learn more about our municipal bond strategies?
Contact the Lord Abbett Advisor Solutions Team at 888-522-2388 or email us at [email protected]
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MUNI MARKET MONITOR
For the quarter ended March 31, 2017
RETURNS FOR BLOOMBERG BARCLAYS MUNICIPAL BOND INDEXES, AS OF MARCH 31, 2017
Benchmark*
1Q 2017 Returns (%)
3-Year Annualized Returns (%)
Municipal Index
1.57%
3.67%
Municipal Index GO Bond Index
1.63%
3.12%
Municipal Index Revenue Bond Index
1.63%
4.11%
Municipal Index High Yield
4.05%
5.76%
Municipal Index 1-5 Year
1.21%
1.15%
Municipal Index 1-15 Year
1.55%
2.79%
Municipal Index Long Bond (22+ Years)
1.74%
5.65%
Municipal Index California Tax Exempt
1.57%
3.75%
Municipal Index New Jersey Tax Exempt
1.80%
3.27%
Municipal Index New York Tax Exempt
1.48%
3.72%
Source: Bloomberg.
*As represented by Bloomberg Barclays indexes for each category (see “Important Information” below).
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For
illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the
deduction of fees or expenses and expenses, and are not available for direct investment.
n Municipal
bond returns were off to a good start in the first quarter of 2017, with positive returns reported for all categories.
n Macro
factors, such as uncertainty regarding U.S. budget policy proposals and elections in Europe, supported a rally in the
general rates market and drew investors to haven assets.
n The
Bloomberg Barclays Municipal Bond Index returned 1.57%, its highest quarterly return since the second quarter of 2016.
n The
Bloomberg Barclays High Yield Municipal Bond Index returned 4.05%, due to the longer duration profile of bonds within
the index and the outperformance of the tobacco sector.
YIELD CURVE CHANGES FOR ‘AAA’ RATED GENERAL OBLIGATION BONDS
3.5
03/30/2017
12/31/2016
03/30/2016
3.0
Yield (%)
2.5
2.0
1.5
1.0
0.5
0.0
1
2
3
4
Source: Thomson Reuters MMD.
5
6
7
8
9
10 11
12 13 14 15 16
Maturity (Yrs.)
17 18 19 20
21 22 23 24
25 26 27 28
29 30
n In the face of a 25 basis-point rate hike by the U.S. Federal Reserve in March, short-term U.S. Treasury yields rose, while longer-term
yields were relatively stable, resulting in a modest flattening of the Treasury curve.
n Within
the municipal bond market, short-term yields declined, while longer-term yields were relatively stable, leading to a modest
steepening of the muni yield curve.
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Net Investment Flows ($ in mil.)
MONTHLY INVESTMENT FLOWS INTO MUNICIPAL BOND MUTUAL FUNDS, MARCH 2016–MARCH 2017
9000
6750
4500
5,100
5,494
7,455
6,482
6,154
6,783
3,936
3,934
1,402
2250
2,148
866
0
-2250
-4500
-6750
-9000
-11250
(10,456)
-13500
-15750
(17,554)
-18000
Mar-16
Apr-16
May-16
Jun-16
Jul-16
Aug-16
Sep-16
Oct-16
Nov-16
Dec-16
Jan-17
Feb-17
Mar-17
Source: J.P. Morgan.
n Municipal
bond fund flows turned positive in the first quarter, reversing the sizable outflows that resulted from the post-election
rate spikes.
n The
largest share of the positive flows was derived from the high-yield segment of the market, followed by the intermediateterm category.
MUNICIPAL BOND YIELD RATIOS VERSUS U.S. TREASURIES OF COMPARABLE MATURITY
Maturity
3/30/2017
12/30/2016
1Q17
High
1Q17
Low
5-Year
Average
5-Year
High
5-Year
Low
2-yr
81.0%
100.8%
100.9%
75.7%
95.5%
147.6%
55.4%
5-yr
80.3%
92.7%
92.7%
76.5%
86.2%
122.6%
62.8%
10-yr
93.3%
94.3%
98.7%
89.7%
96.2%
119.9%
81.3%
30-yr
100.7%
99.3%
103.2%
95.7%
102.4%
120.6%
85.8%
Source: Thomson Reuters MMD.
n Short- and intermediate-term AAA Muni/Treasury ratios declined as municipals outperformed Treasuries in the first quarter.
The 30-year AAA Muni/Treasury ratio was modestly higher.
n The outperformance was supported by lower new municipal issuance and positive flows.
n In our view, the ratios indicate that municipal bond yields are at fair value relative to Treasury yields at all maturities
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INVESTMENT-LED. INVESTOR-FOCUSED.
IMPORTANT INFORMATION
These commentaries may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those
assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy.
References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The examples
provided are hypothetical, are for illustrative purposes only, and are not indicative of any particular investor situation.
A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to
rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by
unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality.
Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the
market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject
to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional
factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.
There is no guarantee that markets will perform in a similar manner under similar conditions in the future.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond’s market price. Spread is the difference in yield between two different investments.
Yield Curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month,
two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in
economic output and growth.
The Bloomberg Barclays Municipal Bond Index a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. Bonds must be rated investment-grade (Baa3/BBB- or
higher) by at least two ratings agencies. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a
dated-date after December 31, 1990, and must be at least one year from their maturity date.
The Bloomberg Barclays California Tax Exempt Municipal Bond Index, Bloomberg Barclays New Jersey Tax Exempt Municipal Bond Index, and Bloomberg Barclays New York Tax Exempt Municipal Bond Index are state-specific subgroups of the Bloomberg Barclays Municipal Bond Index.
The Bloomberg Barclays General Obligation Municipal Bond Index and Bloomberg Barclays Revenue Bond Municipal Bond Index are category-specific subgroups of the Bloomberg Barclays Municipal
Bond Index.
The Bloomberg Barclays Municipal Bond Short 1-5 Year Index is the Muni Short 1-5 year component of the Bloomberg Barclays Municipal Bond index.
The Bloomberg Barclays Municipal 3-15 Year Blend A or Better Index is a component of the Bloomberg Barclays Municipal Bond Index. Bonds included in the index have remaining years to maturity
between 2 and 16.9999, and for each of the 3 rating agencies (S&P, Moody’s Fitch) having a rating of either A3 or better, or not rated.
The Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.
The Bloomberg Barclays Long Current Coupon Municipal Bond Index is a total return benchmark designed for long-term municipal assets. The index includes bonds with a minimum credit rating of
BAA3, issued as part of a deal of at least $50 million, with an amount outstanding of at least $5 million and a maturity of 22 years or greater, with a dollar price of $96 to $104, and issued after December
31, 1990.
The Thomson Reuters Municipal Market Data (MMD) AAA Curve is a proprietary yield curve that provides the offer-side of “AAA” rated state general obligation bonds, as determined by the MMD
analyst team. The “AAA” scale (MMD Scale), is published by Municipal Market Data every day at 3:00 p.m. eastern standard time with earlier indications of market movement provided throughout the trading
day. The MMD AAA curve represents the MMD analyst team’s opinion of AAA valuation, based on institutional block size ($2 million+) market activity in both the primary and secondary municipal bond
market. In the interest of transparency, MMD publishes extensive yield curve assumptions relating to various structural criteria which are used in filtering market information for the purpose of benchmark
yield curve creation.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s
creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds).
High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.
The opinions in The Muni Quarterly are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not
intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or
depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including
possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors
should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett Funds. This and other important information is contained
in the Fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment
professional, Lord Abbett Distributor LLC at 888-522-2388 or visit us at lordabbett.com. Read the prospectus carefully before you invest.
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10
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MUNI-QUARTERLY-0417