Tax-Free Yield: Finding Opportunity, Avoiding Potholes
Puerto Rico, Illinois, and tobacco continue to polarize, but opportunity remains in the muni market.
This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference.
While U.S. municipal bonds are often thought of as constituents of a sleepy sector, the events and market moves of the last 18 months have riled up uncertainty and left many investors asking what lies ahead for their municipal bond allocations. Elizabeth Foos, Morningstar's lead on municipal bond fund coverage, hosted a discussion at the Morningstar Investment Conference around many of these themes, including the broad municipal bond outlook post tax-reform, headline-familiar names, and the nascent role of indexing within the space. Panelists included Jim Murphy, portfolio manager on Gold-rated T. Rowe Price Tax-Free High Yield fund; Melissa Haskell, director of fixed-income research North America at MFS; and Chris Alwine, a principal at Vanguard who spent a decade as head of the firm's municipal bond group.
Implications of Tax Reform Legislation
Once tax reform passed in late 2017, all three panelists described a glut of issuance that was rushed to market in anticipation of changes to the landscape. Ultimately, December delivered a deluge of supply accompanied by long hours in the office for municipal credit analysts tasked with wading through the resulting pool of options. Haskell estimated that the record 400 billion of issuance in 2017 would drop by roughly 25% in the coming year. Murphy pointed out that in January, the rates sell-off further hindered municipal performance, but broadly speaking, the market hasn't been terribly shaken. There was a bit of demand fall-off from banks and a bit of supply fall-off at the start of the year, but the market has traded pretty well since.
Alwine added that many of the bonds brought to market were further out the curve and extended duration in portfolios. Even if these longer municipal securities were hedged to U.S. Treasuries, with rates rising at a clip, basis risk remained a very real concern for actively managed portfolios.
Puerto Rico, Illinois, and Tobacco
Within the pool of municipal securities, a number of specific bond sectors and names regularly surface as polarizing credits. One of those is bonds associated with Puerto Rico, which many investors shun given the island government's weak sources of cash flows and precarious financial position. Haskell's team owns Puerto Rico, but only insured bonds, having engaged in thorough due diligence on the underlying insurers, complete with sensitivity analysis, to reach a level of comfort that the bonds would eventually pay out. Murphy echoed Haskell in viewing some of Puerto Rico's insured bonds as attractive, depending on the strength of a bond's underlying insurer as well as the initial price level that the bond is introduced into the portfolio. Regardless of haircuts, if the bond was bought at a bargain price and appreciates modestly, there is return to claim.
Haskell, Murphy, and Alwine all cited improvements in the outlook for Illinois GO debt and credits associated with the city of Chicago, but with healthy reservations. When it comes to these heavily politically dependent credits, all three panelists described monitoring a variety of factors, including: the existence of a unified government, the ability to raise cash flows through taxes, and a desire to move in a more fiscally responsible direction. Relative to a few years prior, the pressure to remedy the situation in Illinois has improved, and history isn’t without examples of turnaround situations. Alwine points out that California once traded at wide spreads, but strong leadership and an improved economy turned that into a success story.
Opinions around allocating to tobacco bonds often split market participants, and the panelists were no exception. Haskell and Murphy outlined softening fundamentals for the bonds, underpinned by lower rates of smoking and various policies, such as minimizing the nicotine content of cigarettes and the adoption of vaping. Neither view the sector with particular enthusiasm going forward, but while Alwine agrees with this analysis, he also mentions that it depends upon the price at which the securitized structures are acquired. Though these tobacco bonds will default eventually given deteriorating fundamentals, if the cash flows are reasonable for a period of time, the IRRs on the securities may remain attractive.
Reasons for Optimism
While the swift pace of challenges to the municipal markets have been fueled by new legislation, political pressures for fiscal reform, and an environment of rising rates, all three panelists emphasize that this also generates opportunity. For example, Alwine mentioned that this situation was impetus for the active municipal team at Vanguard to further develop better systems to track and to manage risk within municipals, and they have since employed these sharpened tools to provide a high-quality and diversified passive municipal vehicle--an offering that was once considered impossible given liquidity concerns and tracking requirements. Furthermore, stress in the municipal markets is necessary for active managers to put their research and discretion to work--a perspective shared by all three panelists. According to Haskell, the "opportunities are out there every day."