Municipal Bond Podcast 4Q15 (Transcript)

Chris Iovanna: Hello, this is Chris Iovanna, Client Portfolio Manager at GW&K. This is the Q4 2015 Municipal Bond Podcast.

Let's take a look at the past quarter, and then we will look forward to what we expect for municipals in the upcoming year.

The past quarter was pretty interesting from the municipal market perspective. Muni yields were down while Treasury yields were higher. If you look at the 10-year AAA G.O. on the muni side, the yield fell 11 basis points for the quarter. The 30-year bond yield fell 22 basis points.

Going to the Treasury market, the 10-year Treasury yield was up 23 basis points. The 30-year yield was up 16 basis points. It was definitely a surprise from a rate perspective that both of those markets would move in the opposite direction, but really what was going on in municipals was driven by the technical side.

From a technical basis, there's supply and demand. Supply was down 24% for the fourth quarter. That's year over year, so compared to Q4 of 2014 there was a 45% drop in refunding that really drove the lower supply that you saw on the market. As far as demand was concerned, the net inflows into muni ETFs and funds for 2015 was over $13 billion. That compares to $22 billion or so from 2014. Both were up years in the municipal market. Regarding demand for the quarter, it was solid. We saw positive flows every week of the quarter. The supply and demand dynamics were positive. That really helped drive returns.

We started the quarter with muni-to-Treasury ratios pretty attractive. On the 10-year side, the muni-to-Treasury ratio was 100%. On the 30-year side it was 107%. As we finished up the quarter, those moved down to about 85% and 93% or so for the 30-year. Munis richened up to Treasuries over the quarter.

We'll talk about some of the economic happenings during the quarter, just to give a little bit of background there. The U.S. and the globe were continually concerned with lack of growth, especially in China. Although China has been growing around 7% or so, it had been growing at +10% over the past few years. It seems like the world is concerned that some of the shine is off of China.

We've also had a real big loss in the commodity space. For 2015 alone, we've seen a 32% plunge in a broad commodities based index which has definitely spooked the market. Oil finished the quarter at $37 a barrel. That was down from where it started the quarter in the mid- to high-$40s.

We've also had low inflation. That has been generally a positive for municipals, and generally a positive for Treasuries, although again Treasuries did not do too well this past quarter. They were down 0.94% and didn't even earn their coupon.

Treasuries were really hurt because of the first Fed rate hike, which took place in December. This was the first Fed rate hike since 2006. The market was expecting that. Before the rate hike went into effect, Fed futures were indicating well over a 70% chance that they would hike rates after FOMC members were sure to say that they expected the interest rate path higher would be gradual. The median forecast for 2016 for rate hikes from the Fed side was four 25 basis point rate hikes. The market doesn't expect that. The market's more dovish. At this point in time there's only a 22% chance of a Fed rate hike in March according to the market. The market is pricing in less than two rate hikes for all of 2016, which is definitely dovish and definitely differs from what the Fed has been saying.

Getting back to the municipal market, the municipal curve ended up flattening for the quarter. Again, we had a good technical environment, cheap muni-to-Treasury ratios entering the quarter. We continued to see good state finances. They've been helped by a jump in employment. There's also been an increase in personal income taxes. There's been a recovery in the housing market. If you look at the past 15 quarters, we've seen revenue growth from the states. That's been positive.

Another positive I'll mention is that the troubles in Puerto Rico have generally been confined to that island. They had their first payment default. There's also been quite a few talks that have been happening with their creditors, as far as restructuring is concerned. The general market has not had any issues there.

Going forward into 2016, we see gross supply being around the $390 billion mark. Last year it was around $398 billion. Somewhat level. Net supply should be about $4 billion, give or take this year. So far, we don't see any issues with investors taking that down, that increase in supply. If you remember back toward last year, a lot of the supply was front loaded into the beginning of the year as municipalities wanted to get that cheaper financing in before the second half of the year. They were forecasting that the Fed was going to get going during the second half of the year. We had some supply frontloaded into the beginning of 2015 dry up in the second half of 2015. It should resume to a more normal pace as we kick off 2016 here. Demand should stay solid. Supply should be reasonable.

A couple other big macro tailwinds that we've been talking about for a while:

The first tailwind is higher tax rates. If you add in the Affordable Care Act tax to the highest federal bracket you're going to get about 43.4%. That doesn't even take into consideration any state tax advantage municipals may provide.

The other tailwind is that there's the continual retirement of the boomer population. Something along the lines of 10,000 people turn 65 every day. They're going to continue to need diversification within their portfolio, tax-free income, and the relative safety that municipal bonds provide.

Demand should still stay robust, especially if rates start increasing in muni land. Generally they've been on the lower side because of the strong performance. If there is anybody sitting on the sidelines, they may come in as rates tick higher and eventually keep a cap on where rates are.

Regarding performance, munis had a good quarter, up 1.60% for the Barclays 10-Year Muni Index. For the year, the index was up 3.76%.

As far as our Strategy is concerned, we have had better call protection. We've had an underexposure to Illinois and New Jersey bonds where spreads have generally been wider. Those are a couple positive contributors to returns.

The biggest negatives would be that we were overweight maturities in the 5 to 8 year area of the curve. That lagged due to the bull flattening. We've had a lower yield than the index because we are a little bit higher quality so we don't have any BBBs in the portfolio.

Where we started the quarter, from a duration standpoint, to where we ended it there has not been much change. Our duration was 5.70 years to start the quarter and we are at 5.69 years as of the end of the quarter.

As we move into 2016, we'll note that there are a couple technical headwinds that we may be dealing with. One is that typically supply can pick up at the end of January. That's a little more paper for the market to digest. Then as we get in toward tax season, municipal bonds can be used to raise money for individuals to pay their tax bills. March is typically a weaker month in the municipal bond market.

As far as returns are concerned, what we expect for 2016, probably something similar to what we saw last year. If we're thinking that the portfolio is yielding in the mid to high 1s and you gross that up for a taxable equivalent basis, and you add in about 80 to 90 basis points of bond roll, you're looking at a taxable equivalent return in the mid-3s or so.

The municipal bond market isn't cheap at this point. Muni-to-Treasury ratios have come down. We're going to deal with some technical near-term headwinds but they should be able to supply the high quality tax-free returns that you would expect and offer diversification for investors' portfolios.

In this low yield environment, having total returns in the mid-3s for a liquid, high quality portfolio, we think is good.

We still have approximately 50% of our portfolio in below benchmark maturities, which should serve as dry powder if rates rise. We've also been avoiding states over the past year plus that have had debt issues or pension issues. Examples would be Pennsylvania, Connecticut, Kansas, Kentucky, and New Hampshire.

A lot of our purchases have been in the essential service revenue bond area. It's about a 75/25 split in favor of essential service revenue bonds to state G.O.s.

That concludes our Q4 2015 Muni Podcast. I look forward to speaking with everybody the 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.