Midterm Elections – The Quick Muni Note

Here’s our first take after the midterm elections.

Market Commentary - Cumberland Advisors - Midterm Elections – The Quick Muni Note

The polls actually got it right, with the Democrats taking the House of Representatives and the Republicans enjoying a slight pickup in the Senate.

Divided government, with different parties in control of the House and Senate, has sometimes led to gridlock.  It also tends to keep spurious legislation from being passed; and so overall, markets are OK with this outcome.

 

Regarding munis, we feel that this election certainly eliminates the concern that a Republican House would have introduced legislation to cut income taxes further.  With the Dems in control of the House, that notion is off the table; and fears that tax-exempt munis would suffer price erosion from lower marginal tax rates should dissipate.

From a spending standpoint, the divided Congress will most likely keep the President’s spending in check, and this may slow the current rise in the deficit (a good thing from our perspective).

We’re still checking final results, but we know that California voters rejected almost $9 billion in bonds for water projects, and Colorado rejected over $3 billion in a transportation bond.  There’s more to come on this issue of bond rejections, but our thought is that the specter of the SALT provisions of last year’s tax bill is forcing voters’ hands. If state income taxes and local property taxes are no longer deductible, anything that raises the level of spending and potentially higher taxes is likely to get a cold shoulder, as people’s EFFECTIVE taxes will rise in any case with SALT provisions.

We do believe that with the current low unemployment level, a national infrastructure program with federal subsidies is not needed and is now more unlikely with divided government.  We have seen large infrastructure bond deals done in the past year in the municipal market, and the issuers have had no problem selling the bonds.

Coming out of the elections, we feel especially constructive about longer-term tax-free bonds. With longer tax-free munis yielding over 4%, and with a taxable equivalent yield of 6.35% and muni/Treasury yield ratios of almost 120%, we feel longer tax-free paper is a real bargain and continue to manage portfolios in a barbell fashion, with longer-maturity bonds being a focal point.

The large December and January reinvestment periods are almost upon us. Supply is running 15% behind last year, and that will be another positive force for the market, along with the core inflation rate, which has been dropping for two months.

More to come.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


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Why the time is ripe for tax swaps

With municipal yields rising more than they have in years, investors should be poised to take advantage of a rare opportunity for tax swapping as the fourth quarter gets underway, municipal experts said.

Cumberland Advisors John Mousseau

Demand for extra yield will be another key theme in the fourth quarter as investors’ expectations have been buoyed by the weakness in Treasurys, according to John Mousseau, president and chief executive officer of Cumberland Advisors.

“We’ve seen rises in longer-term Treasury yields after three quarters of a year of mostly flattening,” he said. On Oct. 2, the 10-year Treasury yielded 3.07%, while the 30-year yielded 3.22% — slightly lower following last month’s record-setting weakness.

With ratios of municipals to Treasurys expensive on the shorter end of the yield curve, and cheaper on the long end, Mousseau expects any additional rise in long-term yields will be more muted in municipals than in Treasurys.

The ratios of municipals to Treasurys ranged from as low as 72.5% in one year to 84.6% in 10 years and 100% in 30 years as of Oct. 2, according to Thomson Reuters data.

“We think part of that is the hangover of supply from earlier in the year and the erosion of the buying base in the longer end, between banks and insurance companies buying less,” Mousseau said.

If you have a subscription, you can read the full article at The Bond Buyer website.


NOTE: Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

 




Q3 2018 Municipal Credit Commentary

Updates, budgets, potential future stresses, state ratings, default study, and last but not least, storms

Market Commentary - Cumberland Advisors - Q3 2018 Municipal Credit Commentary

Last quarter we focused our 2Q 2018 municipal credit commentary on two SCOTUS (Supreme Court of the United States) rulings. One allows states to collect tax on out-of-state internet sales while the other restricts public unions from requiring that non-union public sector employees pay agency fees to contribute to the cost of collective bargaining and other activities through fair-share agreements. We consider both rulings positive for municipal credit (http://www.cumber.com/scotus-two-major-rulings-with-positive-implications-for-municipal-bond-credit-quality/). In particular, the ability to collect online sales taxes should help financial operations. A study by the National Conference of State Legislators (NCSL) and the International Council of Shopping Centers (ICSC) estimates that total U.S. uncollected sales and use taxes increased to almost $26 billion in the year 2015. Of this $26 billion, more than $17 billion in uncollected taxes were projected to be from electronic sales. http://www.ncsl.org/research/fiscal-policy/e-fairness-legislation-overview.aspx

Updates

Regarding the sales tax ruling, some states are working toward collecting sales tax retroactively; however, a bill entitled the Online Sales Simplicity and Small Business Relief Act has been proposed that would ban retroactive imposition of a sales tax on out-of-state internet sales, delay implementation to January 2019, and establish a small-seller exemption for companies with gross annual receipts below $10 million, (compared with the $100,000 threshold or 200 transactions per year in the case of South Dakota). The proposed legislation, if passed, should not be a burden, because states have already been adjusting to the lower collections as internet sales have increased over the years. Regarding the fair-share agreements, it may take some time for the SCOTUS ruling to have an effect on public sector-union coffers and political influence. We noted in our Q1 commentary the abundance of teacher strikes (http://www.cumber.com/q1-2018-municipal-credit/). They continued this quarter, with strikes or threatened strikes in a number of Washington state school districts and a vote by the teachers of Los Angeles Unified School District to strike if state mediation does not result in a satisfactory contract.

Budgets

In addition to the SCOTUS rulings, Q2 was notable because all states passed budgets on time or nearly on time – even the states notorious for passing late budgets, such as Illinois, Connecticut, and Pennsylvania. Common threads for this phenomenon include election-year politics, good revenue growth driven by a generally improved economy, and the acceleration of tax collections in 2017 due to the Tax Cut and Jobs Act.

Future expectations

States

A number of states’ rainy day funds are not up to pre-recession levels, leaving analysts and others to worry what might happen in the next downturn. S&P released a September 2018 report in which they subjected state financial operations to the stresses of moderate and severe recessions and then compared 2018 reserves to expected drawdowns. Only 20 states had reserves sufficient to cover loss of revenue and increased social service spending during a moderate recession, and overall the states showed an average revenue shortfall of 9.9%. S&P went further and made adjustments for dependence on more cyclical revenue streams (capital gains taxes for example), level of social-service spending, and fixed costs including pensions and OPEB. After the adjustments 14 states were considered low risk, 21 moderate, and 14 elevated. S&P contends, however, that states have the capacity to make fiscal adjustments in response to a downturn. S&P also notes, though, that there were 19 state downgrades from the beginning of 2016 through August 2018, compared with just four upgrades, and observes that this ratio is abnormal this far into a recovery. The downgrades could reflect increased reliance on income taxes, eroding tax bases, rising entitlement costs, and liability growth.

 

Cities

The National League of Cities’ annual City Fiscal Conditions report, a survey of 341 of its members, found that while cities’ fiscal health is not yet declining, growth is slowing, and there are cautionary signals that echo previous economic downturns. Cities are facing wage pressure as well as shortfalls in required and/or needed contributions to pensions and healthcare. Although revenues are not in decline, they grew only 1.25% in FY 2017 and are expected to stagnate in FY 2018. Expenditures grew 2.16% in FY 2017, with growth for FY 2018 budgeted at 1.97%. The results are uneven. Communities in the Midwest are faring worse than those in other regions. Smaller cities, too, have a poorer fiscal outlook than their larger counterparts do. The report attributes these differences to population declines and industrial losses that began before the Great Recession but were accelerated by it. And not surprisingly, the report found 35% of finance officers report seeing negative fiscal impacts associated with the elimination of tax-exempt advance refunding bonds. According to the NLC, this critical municipal finance tool saved taxpayers more than $2.5 billion last year.

This picture may sound dire; however, municipal analysts are generally a conservative group. In Moody’s annual US Municipal Bond Defaults and Recoveries, 1970–2017, released in July, the rating agency notes that municipal bankruptcies have become more common in the last decade (think Puerto Rico) but are still rare overall. The five-year municipal default rate since 2008 was 0.18%, compared to 0.09% for the entire study period. This figure compares with the global corporate five-year default rate of 6.6% since 2008. The ten-year municipal default rate is 0.17%, while the corporate default rate is 10.24%.

The Municipal Analysts Group of New York (MAGNY), a constituent group of the National Federation of Municipal Analysts (NFMA) staged a luncheon program at the beginning of summer, in which panelists discussed what the next recession may look like. Their conclusion? It depends. Is weakness going to be on the consumption side and affect sales taxes, or will it be on the employment or stock market fronts and affect income taxes? Recently, oil prices have been predicted to rise, so states that are dependent on energy taxes may benefit from additional revenue.

Given the risk of future revenue declines, it is important to know where the risks could rise to determine whether a municipality is preparing for those risks and striving for structural balance. Are revenues at least equal to expenditures, and are those expenditure needs being realistically addressed? When evaluating an issuer we like to see flexibility in the form of conservative assumptions built into a budget. This prudent practice generally means overestimating expenses and underestimating revenue, so that the entity can end the year with a positive balance, contributing to the buildup of a rainy day fund. Rainy day funds are used to address revenue shortfalls or unexpected expenses. Conservative budgeting and the willingness to cut spending or increase revenues are characteristics of strong financial management. This principle is true for the issuers of general-obligation bonds as well as revenue bonds.

State Ratings

Why do we always have a section on states in our quarterly municipal credit commentaries? States provide funds and services to municipalities and institutions in the state, so what is happening at the state level can have implications at the local level. Additionally, as I mentioned in my inaugural commentary at the firm (http://www.cumber.com/3q2016-municipal-credit-its-never-boring-in-muniland/) – wow, has it been two years already?), state ratings are now more volatile than they were in the past.

Since June 2016 there has been only one quarter that has not seen a state rating change, and that was the first quarter of 2018. Historically, state ratings were fairly stable (with some exceptions, such as California). The variability in the past few years is unusual and is attributable to rising pension costs and OPEB expenses, political gridlock, and/or exposure to energy-related revenues.

Some states’ ratings are naturally more cyclical because those states depend more heavily on a cyclical revenue stream. For example California, which is AA-/Aa3 rated now, has been as high as AAA and as low as A because it is a high tax state with high-income earners, which creates swings in income and budgeting. This history contrasts to that of Georgia, which has been rated Aaa by Moody’s since 1974. Fitch has rated the state’s GOs AAA since 1993, while S&P gave its highest rating to the Peach State in 1997.

State Rating Changes

After no changes in Q1, the changes seemed to accelerate in Q2 and Q3. In Q2 there were three downgrades, one upgrade, and a few improvements in outlooks or trend. In the third quarter all rating actions were positive!

 

Finally, our thoughts are with those in North and South Carolina who are still dealing with the aftermath of Florence. In addition, many around the country and the world were affected by fires, volcanoes, and tsunamis this quarter. The initial costs to communities affected by natural disasters can be great; however in the U.S., after a natural disaster, there is usually a surge of economic activity that continues for an extended period as people and communities rebuild and money (insurance and federal aid) and workers flow into the area, increasing income tax and sales tax revenues to municipalities. That economic flip side, however, is not much immediate comfort for those who have lost homes and other property, pets, livestock, income, and for some, even family members. Our hearts go out to those whose lives have been impacted.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


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On a somber day, muni market endures

While a somber mood fell over Wall Street as the finance industry reflected on the devastating terrorist attack 17 years ago, the municipal market attracted pickup in supply and some cheaper prices on new deals, according to John Mousseau, chief executive officer of Cumberland Advisors.

Cumberland Advisors John Mousseau

“You can get 4% if it’s a new deal, goes out mega long or maybe has an A rating,” Mousseau said Tuesday afternoon, after attending a 9/11 remembrance ceremony in Sarasota, Fla., where Cumberland president David Kotok recalled his memories at the World Trade Center that day.

“The real point is that the long end of the muni market is still dirt cheap, while the front end is ridiculously rich,” he said, calling it “the tale of two ratios.”

If you have a subscription, you can read the full article at The Bond Buyer website.


NOTE: Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

 




Second Quarter 2018 Taxable Bond Market

The second quarter of 2018 saw a continuation of themes apparent in the first quarter. In June the Federal Reserve continued raising rates to a federal funds rate target that now stands at 1.75%–2.00%.

Market-Commentary-Second-Quarter-2018-Taxable-Bond-Market-with-John-Mousseau-&-Daniel-Himelberger

The flattening of the yield curve can be seen in the graph and table below. The 2-year, 10-year, and 30-year US Treasury bond rates continued to increase but at a pace that was measurably slower than in the first quarter.

 

*Data as of 6/26/18  Source: Bloomberg

 


The 2-year note rose the most in the second quarter, followed by the 10-year, with minimal movement in the 30-year Treasury. Thus the Treasury yield curve continues to flatten. Conventional wisdom holds that yield curves become flat in front of a recession, and those who embrace this notion now worry whether yield curve flattening may in fact signal an imminent recession. For now we disagree with that prognosis, for the following reasons:

  1.  (1) The yield curve is flattening, but it is not totally flat yet. In contrast, by the time the Federal Reserve was done hiking in the last cycle of 2004 to 2006, the yield curve looked like this.

 Source: Bloomberg

At that point in time the fed funds rate was slightly higher than the 30-year bond. Contrast that to the situation today, where there is still a 100-basis-point difference between the two.

  1. (2) Long Treasury yields are seeing plenty of demand because they are cheap relative to the rest of the world.

Here’s a recent comparison of US 2-year and 10-year bond yields to those of  other G-7 countries.


Source: Bloomberg


The US yield advantage ranges from 70 basis points to 330 basis points in the  2-year note and (if you exclude Italy at 3 basis points) from 80 to 292 basis points on the 10-year note. It’s hard to argue with the large advantage that US  bond yields offer compared to bond yields in the financially healthy G7 countries and particularly the less healthy ones. As long as the European Central Bank and the Bank of Japan are still in easing mode, the US government bond market should look good to global investors seeking sovereign debt. Call it an over-  demand for longer Treasuries if you will, but global investors have viewed the  US market as a bargain and kept downward pressure on yields.

  1. (3) Inflation has remained low relative to unemployment and relative to where the  Fed thought inflation might be.

Source: Bloomberg

Inflation has remained low – even with the low unemployment rate. Core inflation is lower now than late in 2015 and in 2016. Phillips curve enthusiasts have been frustrated, since the traditional tradeoff is that higher inflation accompanies lower unemployment. Certainly, inflation has stayed low for a number of reasons, including a stronger dollar, as well as the “Amazon effect,” which posits that it is very hard for manufacturers in any and all sectors to move prices meaningfully higher without drastic competition.

But another factor is also at work, and that is the real unemployment rate (U-6), which encompasses workers beyond the standard (U-3) measurement of unemployment. This measure includes people who are not working but not currently looking for work, people who have jobs but are looking for better jobs (think of someone downsized in the recession who now has a job but not at the level they had pre-recession), and people who are working part-time – some because they wish to work part-time and others because they can’t obtain full-time work.


Source: St. Louis Fed

In this graph we see the difference between the narrow measure of unemployment, U3, and the broader measure, U6. The gap – huge at the peak of the recession – has narrowed, but it is still larger than the gap that existed pre-recession. This gap is why the Federal Reserve has undertaken a more patient, slower pace of rate hikes than previous Feds: We think today’s Fed members are sensitive to the broader measures of unemployment, which until recently have been stubbornly high. And the gap is also one of the reasons that inflation has been slow to rise – particularly in the area of wages. The economy needs to lower this gap before wage inflation starts to work its way into higher inflation rates in the general economy.

Finally we have started to see some higher yield spreads on corporate bonds.

Corporate Bond Spread to 10-year Treasury

 Source: Bloomberg

We think some of this is reversion to the mean after two years of narrowing corporate bond yield spreads. But the trend may reflect some of the same jitters caused in the equity markets by the tariff tantrums. We feel this way because the yield ratios on municipal bonds have been narrowing. Part of that narrowing is supply-driven, but the difference between the two is another piece of evidence that the muni credit has dominant powers in many cases (think water, sewer, and transportation) and is not subject to the same profit jitters that affect corporations.

We wish all our readers a happy and healthy Independence Day.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Daniel Himelberger
Portfolio Manager & Fixed Income Analyst
Email | Bio


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Tax Free Munis Continue to Perform

The tax-free bond market has continued to benefit from the drop in supply so far in 2018. To recap, the end of 2017 saw a bulge in supply as issuers tried to beat the tax-cut bill that Congress was still massaging through joint Senate/House committee work.

Cumberland Advisors - Tax Free Munis Continue to Perform

The final results of the bill were an elimination of advance refunding bonds but a continuation of private activity bonds. With the lack of clarity about aspects of the final bill, the supply of both advance refundings as well as private activity bonds mushroomed in early December, leading to a record amount – $63 billion[1] of municipal bond issuance – in the last month of the year.

The offset to the huge uptick in supply in December 2017 has been a drop in supply this year. Through the first five months of the year, new-issue supply has dropped from $161 billion at this time last year, to $126 billion. We have also seen demand pick up, particularly in high-tax states. Many states are seeing an increase in demand because, under the new tax bill, state income taxes as well as local property taxes are no longer deductible on federal taxes; thus the taxable equivalent yield for high-tax state bonds from California, New York, Minnesota, and other high-tax states has risen.

The relative improvement in the tax-free bond market can be seen in the table below.

Cumberland-Advisors-Tax-Free-Munis-Continue-to-Perform-Table01

As the Federal Reserve has continued to hike short-term interest rates, we have seen improvement in the tax-free muni/US Treasury yield ratios. The second quarter so far has continued a trend we saw in the first quarter, with yield ratios in the short end of the curve moving lower. Longer-term yield ratios have also moved lower, but the effect has been a little less dramatic than in the short end.All of this makes a lot of sense in an environment where shorter-term interest rates are moving up because the Federal Reserve is raising rates in the face of an ever-improving economy. If the average tax rate in this country is close to 25%, then only a 75% move in a muni tax-free rate is needed to equal whatever the equivalent rise in Treasury yields is. We believe the longer-maturity muni/Treasury yield ratios will trend lower as the Fed’s hike cycle continues into next year.

In addition, most tax-free yields are NOT on the AAA curve but usually decently above it, with most AA and A-rated bonds trading 40–80 basis points or more above the AAA curve. Thus the longer end of the tax-free bond market still offers superior value in our view. This is why we continue to employ a “barbell” approach to our fixed-income management, particularly on the tax-free side.

Below is a graph showing the US Treasury yield curve and the Bloomberg AA tax-free yield curve:

We can see that the muni yield curve is fairly well behaved from a ratio standpoint out to 7 years, then it cheapens and crosses the Treasury curve and yields continue to rise, even though the Treasury curve is lower – and flatter. One factor here is that longer Treasury yields have stayed lower ever since President Trump was elected. One of the reasons is that inflation has continued to be stubbornly low, and low inflation has been reflected in long Treasury yields, which have also stayed low. Another factor is that US government yields continue to be much higher that sovereign debt yields in other developed countries. In our view, the longer tax-free yields with yield ratios well over 100% provide a safe haven for bond assets if this ratio moves LOWER over time (as it did during the 2004–2006 period – the last time the Fed raised short-term interest rates). Thus we have the two parts of the barbell – on the one hand, owning shorter-term assets that can roll over quickly and be reinvested in higher-yielding short-term bonds as the Fed raises short-term rates. And, on the other hand, owning long-term munis, which provide much higher incremental yield than longer Treasuries do as well as short-term taxfree bonds. In addition, the cheap muni/Treasury yield ratios provide a life jacket to the duration risk of longer bonds. In other words, even if long Treasury yields rise, a return to a more normalized 100%-or-below yield ratio will buffer price erosion of longer tax-free munis.

Finally, a quick word about the Internet Sales Tax Decision announced late last week by the Supreme Court. The Supreme Court found that businesses did not need a physical presence in order for states to levy a sales tax in their respective states. Thus, sales of goods on the internet will now be able to be taxed, generally by the states in which they are purchased. The fact that we have Justices such as Justice Ginsburg and Justice Thomas on the same side of an opinion suggests that common sense prevailed here. Certainly, states that are more highly dependent on sales tax revenues will benefit from this ruling. The fact that the Supreme Court superseded its earlier ruling on this (Quill case) is also refreshing in that the Justices now recognize that technology has changed the original premise of the Court’s thinking. At Cumberland, we think this decision means greater debt service coverage for various sales-tax-backed bonds, and we would expect to see an improvement in their trading values.

And lastly, as we go to press, the US Supreme Court has ruled that government workers who choose not to join unions may not be required to help pay for collective bargaining.  Though this case was decided on First Amendment issues, it has broad positive implications for state and local governments to craft solutions to the pension issues facing them.  We will write more on this important decision in the next few days.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


[1] Figures pulled from Decade of Muni Finance, published by Bond Buyer.

 


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Mousseau takes the helm of Cumberland Advisors

John Mousseau, who has more than three decades in the investment management industry, has been chosen to take the helm of Cumberland Advisors, where he has spent nearly the last 18 years as portfolio manager and director of fixed income.

The Bond Buyer - Mousseau takes the helm of Cumberland Advisors

“The best way to insure the continuous delivery of a high level of quality service to our clients is to execute a well-thought-out succession plan,” Kotok said in a June 11 news release. “Many firms wait too long and become reactive to unfortunate events. At Cumberland, we want to be proactive, not reactive.”

Mousseau told The Bond Buyer on Wednesday that he is responsible for short and long-term investment decisions for the independent registered investment advisory firm that manages fixed income and equity accounts for individuals, institutions, retirement plans, nonprofits, and government entities.

“We have worked on the mechanics for the last six months, putting the pieces in place to make it work,” he said.

“I’m steering the ship and signing off on all trading decisions and making the bigger calls on duration and direction, in addition to the day to day decisions, some more longer term in nature,” he added.

Mousseau said Kotok continues his role as chairman and CIO, focusing on generating revenue and acting as a spokesperson for the firm — apart from the day to day decisions and responsibilities — but no less dedicated.

“He is still heavily involved in the firm and going as strong as ever,” the new president said, calling Kotok a “great model as a boss” due to his work ethic.

At the helm Mousseau has a vision to grow the equity side of the firm as much as it has the bond platform.

“We have developed some very good quantitative models on the equity side,” he explained. “Cumberland manages a majority of assets on the bond side – I would like to see equities grow to a more meaningful level,” he said.

To read the full article: www.bondbuyer.com


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Fed, Employment, Mistake or Correct? Munis?

Albert Einstein was, it turns out, apparently not the person who defined insanity as “doing the same thing over and over again and expecting a different result” (see https://quoteinvestigator.com/2017/03/23/same/); but it’s a good definition just the same.

The definition certainly applies in economics and financial markets when we apply regression analysis to data on the assumption that nothing has changed. Many fail to look for new or unique information or regime changes but rather remain trapped by old ways.

In a brilliant analysis, Philippa Dunne and Doug Henwood published the following insight in their May 3 TLR (formerly The Liscio Report). For information on this first-rate newsletter, which I always read as soon as it arrives, call 518-827-7094 or email Philippa directly: philippa@panix.com. We thank Philippa & Doug for permission to share their superb work with our readers. They wrote:

“Analysts enthusiastically make claims about jobless claims in historical context, but it’s important to remember this: jobless claims are around 62% of flows into unemployment, more than 20 points below the 1990–2007 average of 85%.”

That’s a terrific snippet.

So as we thought about the monthly employment report, we wanted to frame it in this context and not reiterate the headlines that painted the news flow after 8:30 AM on Friday morning.

Let’s wade deeper into TLR for details.

“Much has been made of the low level of first-time unemployment claims. They are low, no doubt about it – 0.16% of employment, a hair above March’s record low of 0.15% and well below the previous record of 0.20% set in March 2000. (You can say similar things about continuing claims.) But, as we’ve noted in the past, the record comes with an asterisk. That asterisk is the declining share of the unemployed who are eligible for benefits. When we last visited this terrain, we noted that the insured unemployment rate was close to 70% of the official rate in the early 1970s; it’s less than half that, around 32%, today. Some readers countered that this could be explained by the rising share of the long-term unemployed in the total. True enough; now, those unemployed 27 weeks or longer account for 26% of the total, which would have been worse than a depth-of-recession neighborhood in the 1970s and 1980s. But the long-termers can’t account for this: initial claims are now around 62% of the flows into unemployment, more than 20 points below the 1990–2007 average of 85%, and had never been below 74% before 2013. Looking beneath the surface, we’d say there are some labor shortages, but the job market is not as tight as claims may suggest.”

Think about that: “not as tight as claims may suggest!”

So are the Fed’s models steering the FOMC in the wrong direction? Is monetary policy succumbing to economic insanity? Do the labor force data changes cited by Philippa and Doug help explain the flattened yield curve?

Former Fed Governor and “almost Fed Chair” Kevin Warsh thinks so.

Politico reported this on May 4, 2018:

“KEVIN WARSH THINKS THE FED IS BUSTED – Former Federal Reserve Governor Kevin Warsh, who nearly became Fed Chair, sat down with a group of reporters in Palo Alto, Calif. on Thursday night for his first on-record comments since the top central bank job went to Jay Powell…. Warsh offered a fairly stark assessment of the Fed, including its reliance on antiquated data sets (including today’s jobs report) and obsession with a 2 percent inflation target that is certainly not precise to the decimal point. Had he gotten the Fed gig, Warsh said he would have harnessed the many big brains inside the central bank to find better data. Warsh: ‘The place is thirsting to be led in new directions … I have the impression … that they are waiting on the payroll number … and they think it’s filled with important insights about the economy.’ He also dismissed the idea that slightly faster wage growth should cause the Fed to panic about inflation. ‘A catch-up in wages would not tell me that “oh my goodness, inflation is coming.” I do not have a 1978 view that unions have bargaining power and that will send us on a wage-plus-price spiral that’s going to lead to inflation.’”

Terrific analysis by TLR and a clear statement from Kevin Warsh are enough to give us pause.

We still wouldn’t buy the Treasury note or long bond. We still prefer spread product in the municipal space. When a very-high-grade tax-free instrument is paying investors a higher yield than the corresponding taxable Treasury security pays, that is a screaming bargain. We will even use the tax-free instruments in taxable fixed-income accounts in lieu of traditional corporate bonds, as the yield may be higher and the cushion against a higher future interest rate is improved by the tax-free nature of the instrument. Only a repeal of the income tax code would change that approach, and we do not believe that is a remote possibility.

The muni sector is offering bargains to those who will do the hard work to find them. Those who are running from that sector are doing so way too soon.

David R Kotok
Chairman & Chief Investment Officer
Email | Bio


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More on Muni Credit

My colleague Patty Healy discussed the muni sector’s credit scoring and status in her recent quarterly commentary. See http://www.cumber.com/q1-2018-municipal-credit/. Readers who missed her missive may want to take a look at it, as it recites lots of evidence of upgrades and downgrades in municipal credit and why they happened. Patty is an expert on municipal credit.

Let me address a market reaction to these credit changes and why that gives separately managed accounts an edge over certain mutual funds and passive muni portfolios. In the latter there are often a set of fairly rigid allocation limits. We know that edge is real from our observation of funds.

When a fund has an allocation method that is rigid, it must watch the weights of its holdings. Thus it may have an allocation to California and another to New Jersey and so forth. Now what happens in the marketplace when California gets a credit upgrade and New Jersey gets a credit downgrade? The market values of California bonds go up while the market values of New Jersey bonds go down.

For a separately managed account this credit shift doesn’t require an allocation change if there are no allocation constraints. The manager can adjust in anticipation and will quite likely use an advanced forecasting credit-scoring system to make those adjustments prior to the actual credit-rating changes. At Cumberland, we try to do that all the time. We want to be ahead of the tsunami.

The passive mutual fund faces a different situation. It is governed by the rules in its prospectus and must comply with them. If it is a state-specific fund, it has to continue to own the New Jersey bond whether it wants to or not. The same is true for a California state-specific fund.

But if it is a national fund, it may encounter a different problem. The fund’s holdings are imbalanced after the credit-rating changes. The New Jersey allocation is down in price while the California allocation is up. Thus the weighting scheme, which is required by the mutual fund’s specific rules, may be out of whack. The fund must make an adjustment, and that usually means the trader has to do something he doesn’t want to do. He has to reduce the position of his higher-rated California bonds because it is now overweight, and he has to increase the position in his lower-rated New Jersey bonds. Additionally, there are usually time limits that govern how long a trader has to make these changes.

Market agents like Cumberland know this and can therefore anticipate that certain bonds may become cheap while other bonds become more richly priced. These distortions affect the entire muni bond market but are not well understood by the retail bond buyer or by the passive-allocation community of family offices and consultants. The nuances are frequently missed. The distortions create market inefficiencies, which can then be seized upon by a separate account manager.

The evidence of these distortions is seen in muni pricing. Remember, this is a freely operating market. The price and yield of any single municipal bond that trades is a direct result of a market transaction between a buyer and a seller. That seller or buyer may be a separate account manager like Cumberland, or it may be an uninformed or unskilled individual, or it may be a passive family office. It makes no difference that the players are diverse or have different levels of skill: It is the price that reveals the market’s inefficiencies.

Here is a recent example:   A very-high-quality housing finance agency bond came to market with a yield above 4%. The bond was secured by a block of mortgages, and most of the collateral had the direct or contingent guarantee of the federal government. At the same time the new issue was coming to market, the US Treasury 30-year bond was trading at about 3%. The housing agency bond became available when the market was experiencing reallocations, so that meant that its pricing was a second-order derivative of the reallocation of other bonds.

Why was the housing bond in excess of 4% tax-free versus the 3% taxable Treasury? On the face of it, this makes no sense at all. But when the muni market is distorted, the ripples of those distortions impact many bonds, and such opportunities to present themselves to those prepared to seize them. At Cumberland we bought the 4% plus tax-free housing bond for our clients. We avoided the 3% long-term US Treasury bond. Note that the actual credit exposure taken by our client was about the same.

Patty has explained the dynamics of muni credit in her quarterly piece. All we want to add to her excellent commentary is that there are market dynamics that allow an active separate account manager to seize opportunities. The bottom line is the same: Dig deep in the weeds and understand the credit and the dynamics of its market pricing. Thorough research works to your advantage.




First-Quarter 2018 Munis: Challenging

The first quarter of 2018 was a wobbly one for municipal bonds. Supply, as we know, was taken from this quarter and moved up to December of 2017 in order to beat the tax bill. Most of this “moved up” issuance was in the form of advance refunding issues (which were not allowed under the new tax law) and private activity bonds (which ended up being allowed). The result was a December with over $65 billion of issuance – a record. It did not hurt markets, as retail and institutional investors snapped up supply, aware that there would be a dearth of offerings come January.

Both Treasury scales and tax-free scales moved higher during the quarter:

 

The rise in yields earlier this year was due in part to the bond market’s catching up to offer competing yields with stock markets, and munis did move up smartly in January. Of the 30-basis-point rise in long yields, half happened in January and the other half in the six weeks since February 1. So the upward movement of yields has slowed down.

We continue to emphasize a “barbell” approach on the muni side because of its relatively steeper yield curve.

 

The muni yield curve has almost always been steeper than the Treasury yield curve. Often it is a function of the different segments of buyers in the muni universe, with banks and insurance companies being segmented in the “belly” of the yield curve and bond funds and individual accounts being traditionally longer-term buyers. We think the longer end has offered an extra yield premium because of the volatility associated with bond funds in the longer end of the market – think the taper tantrum of 2013 and the Trump sell-off in late 2016 as the latest iterations of this volatility. We remain hopeful that muni bonds will be included in the new definition of high-quality liquid assets. (See last week’s commentary: “A Short Note on Bank Muni Holdings” – http://www.cumber.com/a-short-note-on-bank-muni-holdings/). Assuming Congress passes this measure, the development should spur on municipal bond demand in the belly of the curve and potentially longer.

Many bonds in the A and AA categories are trading at yields substantially higher than the corresponding US Treasuries. We believe this cheapness eventually evaporates as short-term yields move higher and the economy continues to return to “normal” – in other words to an economic environment akin to the one we experienced before the financial crisis: a Fed that is raising short-term interest rates because the economy is growing, employment expanding, and companies prospering. In the 2004–2006 period when the Fed raised short-term interest rates, long-muni/Treasury yield ratios declined from over 100% to approximately 85%. We believe this should happen again, partly because only about 75-80% of the rise in a Treasury yield is needed to approximate the same rise in the taxable equivalent yield of a municipal bond, and partly because the drop in supply should eventually work into lower ratios on a long-term basis.

The forward calendar visible supply has moved higher in March, as depicted below.

 Municipal Visible Supply

 

So far 2018 has been marked by a supply drop, with total municipal bond issuance down through the first two months of the year from $59.4 billion in January-February 2017 to $36.5 billion this year. This reduction in supply did not keep prices from being volatile in January. The lack of supply ($17 billion in January 2018 – down from $36 billion last year) meant that most prices (as marked) on municipal bonds were essentially moved down because of the rise in Treasury yields during January. The ten-year Treasury rose from 2.41 to 2.70 during January, and the lack of municipal issuance meant that evaluators used the change in Treasury prices to change muni prices and clearly overreacted. Since that time we have seen municipals perform better as supply has picked up and evaluators have had a sufficient amount of municipal bond trades to be able to base muni pricing on movements in municipal bonds, not Treasury bonds.

John R. Mousseau, CFA
Executive Vice President & Director of Fixed Income
Email | Bio


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