Senior Manager | CAPTRUST Consulting Research Group
With dour market prognostications from notable pundits like Meredith Whitney failing to materialize thus far, many investors are left guessing about the municipal market’s overall health and direction. As investment consultants, we spend a great deal of time talking directly to investment managers as part of our due diligence process. This quarter we bring one of those conversations directly to Clients with the goal of helping to answer their questions on municipal Fixed Income. Peter Coffin, President and founder of Breckinridge Capital Advisors, a $14 billion registered investment advisor based in Boston specializing in municipal bonds, joined me to provide an update on issues within the muni market and to share his take as an investor.
Q: What is your assessment of state and local credit fundamentals as we begin the year?
Coffin: Fundamentals, while somewhat improved with better sales and income tax receipts, remain strained with problematic long-term structural imbalances. Pension and healthcare associated costs are particular challenges. On the plus side, many states and municipalities have made significant progress in pension reform. Debt levels are also quite manageable for the vast majority of state and local governments. In sum, we expect all but a few municipalities to continue to meet their obligations.
Q: What does current debt supply and demand look like in the municipal market?
Coffin: Supply of tax-exempt municipal debt is running at a moderate pace, ahead of last year, but below issuance in previous years. We expect total annual supply at slightly over $325 billion for the year. Demand has been relatively strong as evidenced by inflows into mutual funds. Supporting demand has been fewer negative headlines about municipal credit quality and the reinvestment needs resulting from significant maturities and redemptions of outstanding municipal bonds.
Q: What is the probability that policy makers would reinstate a program similar to the Build America Bond (BAB) program, and what effect would that have on the municipal market?
Coffin: I believe there is a high probability that a similar program will be reintroduced, although with a substantially lower subsidy. The current Administration continues to advocate bringing back BABs and there is strong support throughout the Treasury Department. The municipal market needs a broader base of demand that extends beyond retail investors. BABs allow issuers to tap into that demand and thus has proven a far more efficient form of subsidy for municipal borrowing costs. As pressure mounts to properly maintain and restore our nation’s infrastructure, BABs will increasingly be viewed as a necessary element in achieving that objective. Reintroduction of the BAB program would have a positive impact on the tax-exempt municipal market as a more limited supply would improve prices. For taxable municipal bonds, I think the impact would be positive as well, as more investors would focus attention on taxable municipals with greater confidence that the market will grow.
Q: How did munis react to the initial move higher in Treasury yields in the first quarter?
Coffin: Municipal yields rose across the curve with the most pronounced spike in the ten-year range. The rise in Treasury yields coincided with a pickup in new issue volume for the municipal market. The heavier supply made the market susceptible to the broader sell-off in Fixed Income. As we end the first quarter, muni yields are about 50 bps higher than their lows in mid-January. This seems to have attracted sufficient demand and recently prices have firmed somewhat.
Q: Are you seeing any reversal in the flight to quality that benefitted taxable munis in 2011?
Coffin: There has been no meaningful change in that trend. Taxable municipal yields have narrowed with the flight to quality, as have very high-grade non-financial corporate bond spreads. Taxable municipals maintain an attractive yield relationship to corporate and other Fixed Income sectors. We expect this advantage for taxable municipals to continue due to mostly technical factors such as issue size.
Q: If overall rates continue to rise, how would you expect munis to perform? Should investors continue to invest in municipal Fixed Income?
Coffin: A gradual rise in yields should bode well for relative municipal performance as retail demand would ultimately be stronger. Also, new issue supply would moderate with the diminished potential with fewer refundings. An abrupt rise in rates could prove problematic however, particularly if it causes a significant increase in mutual fund redemptions. For investors in separate accounts, any market dislocation during a period of redemptions would represent a great opportunity to add longer duration municipal exposure.
Q: What is currently the biggest risk factor for the municipal market as you see it?
Coffin: For the market as a whole, my biggest concern is that mutual funds have far outgrown the capacity of dealers to provide liquidity during a prolonged period of redemptions. Previous experience has shown that it is difficult for the market to break out of the “negative feedback loop” when redemptions accelerate. The most likely catalyst would be a spike in rates, but a large credit event from an issuer such as Puerto Rico could prompt redemptions as well.
For Breckinridge tax-free portfolios, my biggest concern is tax reform and the risk of a significant curtailment in supply of tax-exempt bonds in the future.
Q: What is your outlook for the rest of the year?
Coffin: Our expectations for the coming year are for relatively modest returns. We expect yields to trend slowly upward as the economy gains traction. Mitigating this risk somewhat is the steep slope of the curve, which provides a modest positive bias in returns as bonds roll down the curve moving toward maturity. Also moderating risk is the relative attractiveness of municipals relative to taxable Fixed Income alternatives.
While we expect modest returns in the neighborhood of 2.5 to 3.5% on a non-tax-adjusted basis, there remains considerable risk and uncertainty, which is why we believe a high-grade intermediate-term municipal bond portfolio has a good balance in terms of maturity structure. Also, maintaining focus on very high-quality bonds is paramount given the fiscal stress and structural imbalances for many local governments.