Municipal Bond Podcast 2Q15 (Transcript)

Chris Iovanna: Hello, this is Chris Iovanna. I'm the client portfolio manager here at GW&K, and this is the Q2 Municipal Bond Strategy podcast.

First, we're going to touch on what happened in the market. Overall, we had a challenging quarter in the municipal space with rates rising in each of the months. Ten-year rates were up 32 basis points in total, to finish the quarter at 2.28% and 30-year rates were up 48 basis points to close at 3.28%. We had shorter maturities across the curve, also higher, but not to the extent of the intermediate to long ends. Thus, the curve underwent a bear steepening.

The quarterly loss was the first in two years, and that was -1.14% for the Barclays 10-Year Municipal Index. As is typical when rates back up, munis held on better than Treasuries. We had a slowdown in June issuance, which helped municipals outperform Treasuries and this pushed the muni-to-Treasury ratio lower. We finished the quarter on the 10-year ratio at 98%, and the 30-year ratio at 105% - both of those had been trending higher recently. So what drove rates higher? First of all, there was a rise in European yields, just using the 10-year German Bund as a proxy. The low hit an astounding 7.5 basis points on April 20th. That was after a lot of investors had plowed into European debt, due to the ECB's announced bond buys. Obviously, the trade was pretty crowded and ran pretty far too fast. So the 10-year Bund rocketed up to finish the quarter at about 76 basis points or so; so 7.5 to 7.6, and that was just intra-quarter. We also saw better economic data coming in overseas, somewhat improving data domestically. Employment reports generally trended better.

A little bit of firming in core CPI. The consumer still seems a little bit slow to heal, but they're showing some signs of life. The market is forward-looking, and we are thinking that second half growth will pick up a little bit. We had a rough Q1 with -0.2% growth. Estimates for Q2 GDP are coming in around 2.5% to 2.6%, or so. But the market's expecting growth in the second half to be around 3%. There

So a few reasons behind the increase in rates. Municipal performance is driven by what's going on in the rate market as well as driven by the technicals of its own market. So the demand side, the market has been mostly healthy. It's up around $9 billion in net inflows through the end of Q2. That compares to $21 to $22 billion in net inflows for all of last year, and $60 billion in outflows in 2013. If we remember, that was a negative performance year for municipals. The last handful of weeks, we did see some net outflows, but mostly around that $400 million mark. So it's been digested by the market pretty well. A good chunk of those outflows were in the long and high-yield space.

Basically, supply was the bigger story, new issuance year to date is up 40% over last year. That was driven basically by a large number of re-fundings, about an 86% increase there. New money issuance actually declined by 1%. Supply, as I mentioned before, was actually down 3.9% in June. That was the first negative supply we saw in 10 months, which goes to show how much the market has had to absorb recently.

Regarding credit spreads, they were mostly unchanged. AAA to AA spreads narrowed a couple of basis points, while AAA to single-A spreads widened a couple, so not a lot of change there.

As far as market headlines were concerned, the municipal market was pretty busy in Q2. You had the Illinois Supreme Court striking down pension reform, it was a unanimous decision. They rejected the state's argument that they could exercise police powers to cut retirement benefits. Chicago was down-rated to junk. That was based on the Illinois pension ruling. Moody's cut the city's rating to not just Ba1, while the Board of Education was dropped three notches to Ba3. The other rating agency followed up: S&P cut the rating two notches to A-. Fitch dropped it one notch to BBB+.

On the other side, New Jersey's Supreme Court allowed pension cuts. They ruled that Governor Christie didn't violate the state constitution when he cut about $1.6 billion in payments to the underfunded pension system for fiscal year 2015. That was a short-term positive for the state.

Puerto Rico, obviously in the news, announcing a restructuring. Governor Padilla, just before month-end said that Puerto Rico debt, including the GOs, would have to be restructured. "It's not politics, it's math." So the GO bonds traded down approximately 10 points, and the 8% coupon of 2,035 were around $0.67 on the dollar.

Moving on to our Strategy, as far as the intermediate portfolio is concerned, recently, we've determined a lot of the pension systems are underfunded. That hadn't really been priced into the market. So in past quarters, we've liquidated our holdings in states such as Pennsylvania, Connecticut, Kansas; we've lightened up in New Jersey, we sold out of Louisiana and that economy is pretty energy-dependent. This past quarter, though, we added two states to those liquidations and we sold out a small amount of Kentucky and New Hampshire GOs that we owned. Again, unattractive debt, unattractive pension funding levels. Spreads on all these bonds have widened out since our sales. This really speaks to our credit research and why we are active managers, in that it makes sense to be active in the municipal space.

Normally, we have to sell out of our shorter bonds and extend out on the curve, just to keep duration from coming in too far. That would happen with a normal maturation of the portfolio. However, coming into the summer where we expect a good technical backdrop, we pushed duration out a little further. We don't want to get too long, but in knowing the seasonality of the municipal market, we can adjust portfolio positioning ahead of time. So we bumped up duration to 5.8 years from 5.6 years at the end of Q1. The uptick is due to us buying in the 10 to 15-year area. Rates had sold off, and again, getting ready for the expected summer tailwind. We've picked up about 100 to 150 basis points in yield by selling out of our 5-year paper and buying into the 10 to 15-year part of the curve.

We've also increased credit quality somewhat over the quarter. Single-As in the portfolio are down to 12%. They were 12.8% at the end of Q1, and they were 14.1% when we started the year. We still have approximately 50% of our bonds in shorter than benchmark maturities. That, we believe, should serve as dry powder if we continue to see pressure on rates.

As far as performance is concerned, our intermediate municipal Strategy outperformed the Barclays 10-Year Muni Index for the quarter. It's also ahead slightly year to date. For Q2, positive contributors included our underweight to New Jersey and Illinois debt, spreads ahead widened out in those states. Our overweight to the 5 to 8-year area of the curve also helped. A couple detractors I'll mention, our lower yield than the Index and our underweight to BBBs, which outperformed in the 10-Year Index.

Looking ahead, we should be entering a positive technical environment for munis. Supply should moderate as we enter the slower summer months. We think demand should be steady, investors are going to be putting recent coupon payments, and maturities back to work in the market. If you add this to the larger macro themes of increasing baby boomer retirees needing income, and higher tax rates, what you have there is a solid backdrop for the asset class in our opinion.

Muni-to-Treasury ratios, as of July 15th, were 99% for the 10-year and 104% for the 30-year. Both of these remain above their historical average and, we think, are attractive. We started the quarter with the yield to worst for the portfolio of 1.78%. But we're at more attractive levels now at 2.11%. If you gross that up for a taxable equivalent, that gets you to 3.72%. Add in about 110 basis points in bond roll that we think is available and you have an all-in yield of 4.82%.

I hope that was helpful, and this concludes the Q2 2015 Municipal podcast. Thanks for listening, and we look forward to speaking with you next quarter.

This represents the views and opinions of GW&K Investment Management and does not constitute investment advice, nor should it be considered predictive of any future market performance. Data is from what we believe to be reliable sources, but it cannot be guaranteed. Opinions expressed are subject to change. Past performance is not indicative of future results.