> Rising interest rates dampened total returns in the investment grade-taxable market in the third quarter as the yield curve continued to flatten. Volatility has returned to global markets and is likely to remain, given tightening global liquidity conditions.
> The investment grade municipal bond market continued to feel the effects of the 2017 tax law, as the elimination of advance refundings reduced supply, and banks and insurance companies continued to reduce their holdings, primarily at the long end of the curve.
> The high yield market advanced 2.44% during the quarter, according to the ICE BofAML High Yield Index, with CCC-rated issues leading. Despite some outflows from mutual funds, technical factors, on balance, provided support to the market, as issuance declined during the quarter and the market continued to shrink.
> The leveraged loan market posted positive returns for the quarter, gaining 2.00% and building on the previous two quarters. It was the strongest quarterly performance for loans since fourth quarter 2016. Gains occurred across all sectors, with Retail and Metals & Mining leading the way, and Diversified Media and Utilities lagging. There were no new defaults this quarter, signaling a reduction in forward looking projections.
> Rising short-term rates dampened total returns in the investment grade-taxable market in the second quarter as the yield curve continued to flatten. A flatter curve does not mean that recession is imminent, though so-called “synchronized global growth” appears to be at an end.
> The tax-exempt municipal bond market continues to digest the effects of the new tax law as banks and insurance companies became active sellers, and the elimination of advance refundings resulted in diminished supply.
The high yield market eked out a positive return in the second quarter while issuance continued to decline and flows to mutual funds and ETFs remained negative. Defaults remained about even with last year, at 2.06%, while credit quality continued to improve.
The leveraged loan market posted a return of 0.78% for the quarter, continuing the trend of the first quarter. Issuance continued to be robust, hitting the second-highest level on record, and demand remained strong.
The high yield sector posted a negative return for the first quarter driven by rising U.S. Treasury rates. At current valuation levels, we believe there is limited potential for spread tightening. Our focus is on quality over yield though we will take advantage of market volatility to seek potential opportunities for incremental yield.
Leveraged loans delivered a positive return in the first quarter. Loans are performing as expected in the current market environment – protecting investors from rising interest rates.
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.
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.
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...�
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...
After focusing on tax reform in January’s report, this month we will explore Trump’s infrastructure plan and the possible implications for tax exempt bonds.
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