Wed, 2 Jul 2014
Increasing demand, tightening supply, and expectations for higher rates and inflation should bring better muni returns in the coming years, says Nuveen's John Miller, Puerto Rico notwithstanding.
Steve Pikelny: Hi, I'm Steve Pikelny, coming from the Morningstar Investment Conference. Today, I'm with John Miller, who is a lead portfolio manager at Nuveen. Thanks for joining me, John.
John Miller: Thank you for having me.
Pikelny: John, you manage several open-end funds and closed-end funds, and you focus mainly on high-yield municipal investments. Why don't you just start off and give us a quick overview of where we've been in the muni market over the last 12 months.
Miller: It's been a very interesting 12 months. First of all, going back to 2013, the second half of 2013 was very challenging for municipals, starting with the idea that the Federal Reserve was going to start to taper their bond purchases, not that we thought that was necessarily the end of the world, but the fixed-income markets were rattled by that announcement causing a significant upward movement in interest rates. Under normal circumstances, municipals would tend to hold up relatively well if it was just purely the subject matter of some interest rate increases; munis tend to be fairly resilient in most markets.
In 2013, that actually was not the case. I think that several factors caused munis actually to hold up not as well as normal, and one of those factors was the historic bankruptcy filing of Detroit. We could talk about the implications of that; I think has been a little bit blown out of proportion in terms of what that means for broader munis, even though what that means for Detroit is tough. What that means for broader munis, not as bad in my opinion, but it had a bad impact on the market in 2013. The financial difficulties of Puerto Rico were already there, but they were highlighted more prominently by Barron's and some other sources causing those bonds to trade down sharply.
The combination of the three things had its own impact on muni-fund outflows, which were of historic proportions in the second half of 2013, $71 billion out. If you fast-forward for the first five months of 2014, it's almost a complete reversal. Muni bonds are still a bit cheaper than when we started this whole process, but in trailing 12-month total returns they are positive because of the income generation and because of the bounce back in the municipal market thus far in 2014, There has been little bit better credit news, a little bit better inflows into muni funds, not so much selling pressure. In addition, supply from municipal issuers coming to the market and issuing new bonds, that's down. People have paid their higher tax bills on April 15 of 2014; that may be also stimulating a little bit better demand. So, munis have pretty close to recouped everything that they lost during that tougher period that I just described.
Pikelny: Looking forward, what do you see as some of the big issues that the muni market faces? Like in the last panel, we talked a lot about closed-end funds. So, I think for closed-end funds and leveraged closed-end funds, you have the interest-rate component and the leveraged financing component. So, what are some of the things that you're worried about?
Miller: Well, there is still certainly the expectation that interest rates are going to increase. Now, however, I think most of those expectations are really centered around what the Federal Reserve is going to do and those short-term interest rates. The federal-funds rate is between zero and 25 basis points. Eventually, perhaps third quarter of 2015 being sort of a consensus estimate, that will go up. The Fed will feel comfortable with a self-sustaining recovery and try and normalize that interest rate, again, gradually over the next several years.
Now that doesn't actually tell you where longer-term municipal bonds are going to be trading because longer-term municipal bonds have that expectation embedded in their yield already. The municipal yield curve is steep. It's sharply upwardly sloping. So, as you go out in each year of maturity, you are picking up extra yield. Part of that is the forecast that the federal-funds rate will be higher two or three years from now than it is today.
So, the drivers of longer-term municipal interest rates are expectations for inflation. Those appear to be still around that 2.5% level, even though we're below 2% right now. It's expected that inflation will eventually get back up to 2%, maybe a little bit above 2%. That's also embedded in the yield curve. And then supply and demand and credit issues are also big drivers of municipal yield levels in 10 years, 15 years, 20 years out the curve. Right now, supply has been trending lower, and demand has been trending stronger. So, that has improved both the liquidity and the performance and where munis are trading. I think those trends probably continue because there's still value in the municipal-bond market.
Credit trends are very diverse, but in general they are improving, even though, there's 55,000 different issuers out there and there are some individual situations to watch out for and be cognizant of. There are deteriorating situations, but overall, the muni market credit trends are favorable.
Pikelny: Earlier you mentioned Puerto Rico, as I guess one area of the muni market that is not doing so great from a credit standpoint. I think in 2013, the Puerto Rico Muni Index fell something in the neighborhood of 20%. In the panel we were talking a lot about the problems of Puerto Rico. I know that you actually own some Puerto Rico in your portfolios, so do you mind king of going over some of the pros and cons of Puerto Rico from an investment standpoint?
Miller: Sure. The overall macro environment is very tough. The economy has been shrinking at varying rates for several years. Really, since 2006 the economy has been in a recession. That has not turned. It may be shrinking at a slower pace, but it's still shrinking. Puerto Rican residents are U.S. citizens. There's a migration of the best and brightest from the island of Puerto Rico to the United States where the jobs are being created. That reduces the tax revenue. It reduces industry. It reduces job growth on the island itself. The island has an unsustainably high amount of debt in total.
There are many different credits: general obligation debt, electric power, water and sewer, government development bank and several others. They're somewhat intertwined, though; most of the credits on the island are intertwined. And those fundamental issues that I mentioned has tended to take the paper cheaper over the last 12 months. Overall, we expect that to continue in the sense that for the reasons that even though on the island a couple different issuers have issued $4.2 billion in doubt over the last 11 months, these entities, such as the Electric Power Authority, are still saying that they are running out of liquidity, and their liquidity sources--such as additional lending--are tougher to come by; they're drying up. So we could be heading for a restructuring, meaning, bonds aren't going to get paid in full for several of the different entities on the island.
Overall, it's a concerning outlook for the island of Puerto Rico, a fairly negative outlook for the island of Puerto Rico. Now is it a template for muni credit in the United States? I don't believe so. I think those problems are unique. They are related to the special status of the island. They're related to some tax incentive that boosted industry. That tax incentive actually was repealed in part because they were preparing for statehood, but the repealing of that tax incentive has triggered a recession that they have not gotten out of, and they have just been waiting to get out of that recession. But in the meantime, they've continued to issue more and more debt, and now their debt levels are too high for the long-term ability to service that debt.
Now, for the United States as a whole, though I think the muni market is better-prepared. You can see the pricing of the Puerto Rican bonds reflects the risks. So, the muni market on the United States credits is, I think, generally well-differentiated. You've got Puerto Rican bonds trading in some cases as high as 11% yields, and you have the California General Obligation Bond--sort of a benchmark A rated bond in the municipal market--even at the long end of the yield curve that trades at a 3.7% yield. So those fundamentals of California are very different from the fundamentals of Puerto Rico; one has a 3.7% yield, the other has an 11% yield. So you can see the market is making these distinctions, and that's actually a good thing.
Pikelny: Right. So Puerto Rico might not be the best credit in the world, but at least you're getting paid to hold it to some extent.
Miller: I would put more that the dollar price of the bonds in the marketplace in Puerto Rico reflects the potential for some haircutting going forward. I don't know what the timing of that might be, but it does appear to be inevitable. So as an investor, as a trader in those bonds, you do have to price that in, and those bonds do trade at deep discounts as a result.
Pikelny: Great. Thanks for joining us today, John.
Miller: Thank you very much.