2018 Volatility Regime Change
The dominant themes in the second half of the year continued to be the lack of volatility (stock and bond volatility plumbed to record lows) and a loosening of financial conditions, which allowed the Federal Reserve (the Fed) to continue to raise the federal funds target.
Seix Investment Advisors believes there are a number of compelling reasons to invest in leveraged loans. In the current market environment, when most assets are trading near historically high levels, loans remain attractive on a risk-adjusted basis compared to other asset classes.
> The high yield sector delivered another quarter of positive performance against a backdrop of improving fundamentals. At current valuation levels, we believe there is limited potential
for spread tightening. Nevertheless, positive fundamentals for many high yield sectors could be supportive of current spread levels for some time.
> Positive fundamentals and strong technicals have supported leveraged loans. Robust CLO issuance has offset soft retail demand resulting from range-bound Treasury rates.
> A flattening yield curve has dominated markets in the fourth quarter and year. In the investment grade-taxable market, longer-duration assets outperformed shorter-duration assets, and investment grade credit outperformed high yield and bank loans. Changes at the Federal Reserve are prominent on the watch list for 2018.
> The tax-exempt municipal bond market saw record issuance in the fourth quarter as issuers rushed to market on fears they would lose access to the tax-exempt market once final tax reform legislation was passed.
Seix Investment Advisors’ municipal bond team examines potential implications of the tax reform bill.
Featured in Wealth Management’s 2018 Year-End Outlook edition, Seix examines unfunded pension liabilities, a key credit concern across municipal markets, and cautions muni investors to take notice.
Unfunded pension liabilities continue to be a key credit concern for State and Local Governments across the municipal market and municipal investors should take notice. With Fiscal Year 2016 numbers now nearly fully reported, the median funding ratio for states declined to 72%, an 8% decline from 2015 to 2016.
Investment returns averaged below 1% for the year, dramatically underperforming most plans’ projected returns of 7%-8%. Lower investment returns and adjusted assumptions have created wider dispersions between good and bad plans. Not surprising, states with well-publicized poor funding level (Illinois, Kentucky, New Jersey, Pennsylvania and Connecticut) have seen ratings downgrades and generally widening credit spreads. We believe plans with funding levels below 80% have difficult decisions ahead as to how they will address their plans’ funding levels while balancing the broader needs of their constituents.
Cities and counties face many of the same pension issues as states, but have substantially fewer resources to enact a solution. Many states have begun to downstream pension expenses by reducing or eliminating some pension contributions. This decrease in funding creates additional budgetary pressures on smaller cities and counties. In our own research, (reviewing 2,500 plans) we found the average funding level for counties to be 74.8% and 72.3% for cities.
Recently, the Federal Reserve Board estimated the total unfunded liability for state and local plans is an astounding $2.0 trillion, representing just under 11% of US GDP for 2016. In many cases, the growth rate for pension costs exceeds the growth rate for tax revenues creating large budgetary challenges. Going forward, this will only be exacerbated by demographic shifts to an older population, migration challenges for some localities, and declining investment returns. Growing pension liabilities will continue to compete with essential services for the limited pool of tax revenues. Hard choices will need to be made with regard to funding priorities for capital needs, pensions, and debt payments. For these reasons, we closely monitor the funding levels for our general obligation bond holdings and actively seek to limit our exposure to credits with poor funding levels.
Unfunded pension liabilities continue to be a key credit concern for State and Local Governments across the municipal market. With Fiscal Year 2016 numbers now nearly fully reported, the median funding ratio for states declined to 72%, an 8% decline from 2015 to 2016. Investment returns averaged below 1% for the year, dramatically underperforming most plan’s projected returns of 7%-8%. Additionally, contributions in 48 out of 50 states were below the level required to maintain the prior year’s funding level.
Investment returns are typically the largest driver (64%) of a fund’s performance as the assets held in the fund act as the largest lever on overall funding levels. With the implementation of GASB 67 and 68, plans have been required to adjust their Actuarial assumptions to better reflect past performance and current market conditions. This has generally decreased reported funding levels as return assumptions have returned to more reasonable levels (7-8% vs 10-12%).
Seix Quarterly Review
> The third quarter saw a continued lack of market volatility, still-low long-term interest rates, and minimal progress on President Trump’s pro-growth legislative agenda. In the investment grade-taxable market, spread sectors continued to benefit from the insatiable search for yield, producing positive excess returns across both the investment grade and sub-investment grade markets once again.
> In the tax-exempt municipal bond market, limited supply and healthy demand has driven strong performance this year. As issues regarding tax reform are debated, more and more investors may stay on the sidelines until some clarity emerges.
Seix Quarterly Review
> The high yield sector delivered another quarter of strong performance against a backdrop of improving fundamentals. At current valuation levels, there is limited potential for spread tightening.
> Leveraged loans, producing mostly coupon-clipping returns, were also supported by good fundamentals. Retail fund flows have been modestly negative but offset by strong CLO creation, and a high probability of an interest rate hike in December which should be supportive of the asset class.
Over the last month, we have seen three Category 4 hurricanes make landfall in the United States: Hurricane Harvey on the Texas Gulf coast, Hurricane Irma on the Florida Keys and Florida peninsula and Hurricane Maria on Puerto Rico and the US Virgin Islands. This is an unprecedented occurrence and is expected to have far-reaching ramifications to the affected areas, national economy and insurance sector. Thus far however, effects in the municipal market have been relatively minor, though we could see future impacts on a local and national scale.
So far this year we have written several reports on federal policies that could impact the tax exempt asset class and public finance issuers. The reports have discussed tax reform, domestic infrastructure, ACA reform, Medicaid spending, federal fiscal stimulus, and sanctuary cities. This month, we will focus on another federal policy that could impact the municipal asset class, HQLA designation.
Seix Quarterly Review
The last year has been interesting to say the least with the first half of 2017 a continuation of the “expect the unexpected” theme. From Brexit and the Trump election to the snap election in the UK earlier this year...�
George Goudelias and Sarita Jairath of Seix Investment Advisors are featured in WealthManagement’s 2017 Midyear Outlook.
Their article, "Why Invest in Leveraged Loans," features the investment team's perspective on the loan market and why they believe loans are attractive in the current environment.
Municipal green bond issuance has increased significantly over the past four years since Massachusetts became the first state to offer tax exempt bonds designated as ‘green’ in 2013. While only a small part of the municipal market at approximately $19bn...
Tax exempt bonds have had a nice rebound this year after a volatile 2016 and have returned a solid total return of 3.48% YTD. The performance has been primarily technically driven...
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