Municipal fixed income markets: First quarter review
March 31, 2013
Notes: Market activity cited throughout this commentary is supported by data published by sources that include Barclays, Bloomberg, Municipal Bond Buyer, and Thomson Municipal Market Data (MMD).
As the first quarter drew to a close, substantial fiscal policy issues remained unresolved in Washington, D.C. We remind readers that legislative changes can happen quickly, often with ramifications for financial markets. The material in this commentary reflects legislative information available as of March 31, 2013.
Broad market overview
On Jan. 1, 2013, an agreement was reached in Washington known as The American Taxpayer Relief Act of 2012. The deal averted tax hikes for most taxpayers and delayed the effects of the sequestration cuts for two months. However, it also left many other fiscal policy decisions unresolved, with questions to be answered in the near future. The good news for municipal market demand was that the deal did not include a 28% cap on the municipal exemption, as had been proposed at one time, and that taxes were raised only for those in the highest income brackets. While most American’s tax rates remained the same, individuals earning more than $400,000 and married couples earning more than $450,000 saw tax rates increase from 35% to 39.6%. In addition, a new Medicare tax commenced on Jan. 1, 2013, adding a 3.8% tax on unearned income above $250,000. The lack of a cap on the exemption combined with higher tax rates for certain investors was supportive in January of a municipal market that had posted negative returns in December. However, these supportive technical factors eventually gave way as the quarter progressed and as markets traded more on fundamental factors that resulted in rising yields.
Municipal bond yields rose during the first quarter of 2013 from 3 to 36 basis points for bonds with maturities of five years or longer, with the largest rise coming in the 15 year range. Yields on the short end of the curve were largely unchanged (Source: MMD). This was against the backdrop of rising U.S. Treasury yields and a domestic stock market that rallied approximately 10% for the quarter. As mentioned above, the deal to avert the fiscal cliff provided municipal bonds with strong technical support in January. Avoiding a cap on exemptions seemed to unleash pent up cash that had moved to the sidelines in December. The higher taxes also seemed additive to demand. As the quarter progressed, however, a combination of stronger domestic economic data, the avoidance of various fiscal deadlines and relative quiet from Europe resulted in higher interest rates and a rallying stock market. This was finally disrupted in late March when problems arose with the banking system in Cyprus.
After the technically driven rally of the first few weeks of January, municipal yields started to rise as the market digested better economic data along with news of the Federal Reserve reiterating its support for the markets. Better-than-expected payroll numbers throughout the quarter, a stronger housing market, solid auto sales and a resilient consumer contributed to expectations for higher than anticipated GDP for the first quarter. The January release of the December Federal Reserve meeting minutes did lead to some market doubts about the duration of the QE3 program (the monthly purchase of $85 billion of Treasurys and Mortgage-backed securities). However, public comments by the Federal Reserve over the remainder of the quarter gave comfort to the market that asset purchases would continue throughout 2013. Treasury bonds rallied in mid-March as the European Finance Ministers and European Central Bank threatened to not renew Cyprus’s loans unless they took some dramatic banking measures to raise funds internally. This crisis continued for approximately 10 days resulting in a stronger dollar and declining Treasury rates.
The American Taxpayer Relief Act of 2012 left many of the pending fiscal issues unresolved and on the docket for the first quarter of 2013. There were market concerns coming into the quarter over the debt ceiling, sequestration cuts and the continuing budget resolution. However, Congress suspended the debt ceiling for three months on January 23rd, allowed the sequestration cuts to go into effect on March 1st and passed an ongoing budget resolution for the remainder of the fiscal year in March. For the time being these were considered neutral to mildly positive for the financial markets. However, the sequestration cuts have not been fully felt by the economy yet and nothing has been done to address long-term deficit reduction, something the rating agencies are watching carefully. The ultimate goal, although perhaps not attainable, would be to achieve significant long-term deficit reduction and tax reform. At the moment, however, the issue of the 28% cap on the municipal exemption remains unresolved. While it is believed that this cap almost became part of a grand deal in December, since then, market participants have done a good job of defending the full (uncapped) tax exemption. Members of Congress seem supportive but unfortunately have remained noncommittal on the issue, leaving it on the table for the foreseeable future until deficit reduction and/or tax reform are more fully addressed.
The municipal bond market followed historical seasonal patterns in the first quarter of 2013. It was driven in January by good demand from both mutual fund flows and maturing/called bonds while experiencing light new-issue supply. In early January it rallied even while Treasury rates moved higher, resulting in lower ratios as a percentage of Treasurys. Strong demand began to trail off in February and the market followed interest rate movements more closely. In March, positive mutual fund flows turned negative as quarter end and tax time approached, while new issue supply was increasing. Due to these end-of-quarter pressures, the municipal market did not rally along with Treasurys during the Cyprus crisis. As a result, municipal bond yields rose more than Treasury yields for the quarter. The yield curve steepened as long yields rose more than short yields, but credit (BBB-rated and high yield municipal securities) outperformed bonds rated AAA. As a result of this, the Barclays Municipal Bond Index rose only 0.29% during the quarter, as income barely overcame negative price performance.
A note on Puerto Rico debt
Puerto Rico related debt experienced volatility beginning late in the fourth quarter of 2012 when it was downgraded to Baa3 by Moody’s. After December’s sharp sell-off, Puerto Rico was the strongest performing state/territory during the first two months of 2013. However, additional downgrades to weak BBB by Fitch and Standard & Poor’s left the Commonwealth one notch above a non-investment grade rating by all three rating agencies. Also, all three agencies maintained their negative outlooks on the debt. A weak economy, significant unfunded pension obligations, and an unbalanced budget leave a new administration challenged going forward. However, as Puerto Rico traded off the broader market actually rallied the last week of the quarter.
For the sake of comparison, listed below are the returns posted by major fixed income and equity indices for the first quarter of 2013:
|Major fixed income and equity indices
|Barclays Municipal Bond Index
|Barclays U.S. Treasury Index
|Barclays U.S. Aggregate Index
|Baclays U.S. Government/Credit Index
|Barclays U.S. Corporate High-Yield Index
|Dow Jones Industrial Average
(Data: Barclays; Bloomberg. Accessed on or about April 2, 2013. Index performance reflects past performance and does not guarantee future results.)
Municipal markets: Statistics
Treasury yields on 5-, 10-, and 30-year bonds increased by 5, 12, and 19 basis points, respectively, during the first quarter of 2013. Municipal yields also increased over the 5-, 10-, and 30-year periods by 3, 19, and 26 basis points, respectively. This resulted in underperformance of municipal securities versus U.S. Treasurys for the 10- and 30-year periods and outperformance for the 5-year period, as demonstrated by the chart below:
|AAA MMD/U.S. Treasury ratios
(Data: Thomson Municipal Market Data, accessed on or about April 2, 2013. Index performance reflects past performance and does not guarantee future results.)
Other developments during the quarter included:
- The municipal curve steepened by 26 bps to 278 bps as measured by the spread between 2- and 30-year MMD AAA yields. 2-year high-grade tax exempt bond yields remained unchanged for the period while 30-year high-grade tax-exempt yields increased by 26 basis points. (Data: Thomson Reuters.)
- The Barclays Municipal Bond Index returned 0.29% for the quarter. The strongest performing maturity segment was the 5-year Index (bonds within 4 to 6 year maturities), which generated a 0.84% return; the weakest performing maturity segment was the 15-year Index (12 to 17 year maturities), which returned -0.11%. (Data: Barclays.)
- BBB-rated securities provided the strongest return during the first quarter of 2013. Credit spreads, as measured by MMD yields on 30-year BBB GO securities minus 30-year AAA GO securities, flattened slightly. At the end of the first quarter, the spread was 130 basis points.
For the third quarter of 2013, the total return within the Barclays Municipal Bond Index by rating, as well as the Barclays High-Yield Municipal Bond Index (representing noninvestment grade bonds) was as follows:
|Barclays High-Yield Municipal Bond Index
(Data: Barclays, accessed on or about April 2, 2013. Index performance reflects past performance and does not guarantee future results.)
Leading the investment grade sector were bonds classified as industrial development revenue bonds (IDRs) and pollution control revenue bonds (PCRs). They returned 0.90% for the period and were followed by Resource Recovery (0.87%) and Housing (0.81%). High Yield Tobacco was the strongest overall performing sector for the period, returning 2.49% for the quarter.
Supply for the first quarter of 2013 was $81 billion, representing a 2% increase as compared to the same period last year. (Source: Municipal Bond Buyer.)
We are aware that as always there are many moving parts to the market. We are closely watching the fiscal negotiations in Washington in regards to both the cap on exemptions and the effect of sequestration or any replacement budget cuts on municipal finance. We are also closely watching the domestic economy as well as the developments in Europe and other global economies. In addition, we are following the developments in Puerto Rico and we continue to be diligent on our credit surveillance.
We took a more cautious approach to the first quarter, allowing our security selection and focus on income to help drive performance. We must now evaluate the ability of these lower-rated securities to potentially outperform if yields keep rising. We believe credit can still outperform if rates rise modestly and in an orderly fashion. We also believe credit can outperform due to its income feature if rates stay range bound. We currently favor credit exposure over yield curve exposure. During the late fourth quarter of 2012 and early first quarter of 2013, we reduced some of our yield curve exposure, which was beneficial to performance. At this time, we do not anticipate adding curve exposure back to the portfolios.
Additional statistics at the state level, briefly noted
(State-specific developments noted below are based on information published by each state’s respective budget authorities and supplemented by sources that include Standard & Poor’s, the National Conference of State Legislatures, the U.S. Labor Department, and the National Association of State Budget Officers.)
- Idaho’s unemployment rate declined in recent months, reaching 6.2% in February 2013, lower than the U.S. national rate. The governor signed a $2.7 billion 2013 General Fund budget into law in April 2012. For the first nine months of fiscal 2013, general fund revenues totaled $1.84 billion. This is 3.6% above the prior year and 1.2% more than projected. Individual income taxes were on budget while corporate and sales taxes were 3.8% and 1.6%, respectively, above estimates.
- Although down from its prior highs, Arizona’s unemployment rate increased slightly to 7.9% in February 2013. The fiscal 2013 $8.57 billion General Fund Budget represents a 0.6% increase from fiscal 2012. For the first eight months of fiscal 2013, General Fund revenues totaled $5.7 billion. This is 4.4% above the prior year and 0.3% above forecast. Year to date, sales taxes are 4.5% higher than the prior year and 0.3% above projections. Personal income taxes are 8.4% higher than the prior year and 0.5% above estimates. Corporate taxes are down 10.5% and are 2.9% below forecast.
- Minnesota’s unemployment rate was 5.5% in February 2013, significantly lower than the national rate. According to the state’s February forecast, general fund revenues for the 2012-2013 biennium are expected to exceed November estimates by $217 million. General Fund spending is projected to be $63 million below earlier estimates. This improvement reflects gains from fiscal 2012 and spending savings in K–12 education, debt service, and property tax aid. These forecast changes produce a $295 million balance for the end of the biennium. This will be allocated to buy back some of the outstanding school aid payment shifts amounting to $1.1 billion. After this buyback, $801 million of school aid shifts will remain. The state’s November forecast for a $1.09 billion deficit for the 2014–15 biennium has been reduced to $627 million. Revenues are now forecast to be $36.1 billion, 0.9% more than earlier estimates and spending is expected to be reduced by $117 million (0.3%) to $36.74 billion.
- The unemployment rate in Colorado has continued to improve in recent months to 7.2% in February 2013. According to the March economic update, General Fund revenue for the current fiscal year is expected to be 2.8% higher than forecasted in December. Overall, general fund revenue is expected to grow 7.1% in fiscal 2013. After accounting for a one percent increase in the reserve level, the state will have excess reserves of $959.3 million. All excess reserves will be transferred to the State Education Fund.
- New York’s unemployment rate totaled 8.4% in February, higher than the national rate of 7.7%. Lawmakers signed off on a $135.1 billion All Funds Fiscal 2014 Budget that closed a $1.3 billion gap with no new taxes or fees and actually cut taxes for businesses. It contains cost-control measures to keep agency operations spending on par with fiscal 2013 and benefits from some favorable trends in healthcare costs. Fiscal 2013 (ended March 31st) revenues are expected to be $226 million less than projected but 3.1% greater than fiscal 2012. Local assistance and other expenses are greater than expected but debt service savings, reduction in capital spending and a large settlement with Standard Chartered Bank should offset these negative developments.
- In California, the unemployment rate totaled 9.6% in February but continues to improve month over month. Governor Brown signed a $91.3 billion 2013 General Fund Budget into law on time that closed a $15.7 billion budget gap through revenue increases and expenditure cuts. Revenues for the first nine months of fiscal 2013 are currently running 15.5% above the prior year figures and 7.8% above budget. Part of this is due to the temporary increases in personal income and sales taxes. Individual income taxes are coming in 28.7% higher than the prior year and 12% above budget estimates. Sales taxes are similar to last year but 2.4% below expectations. Additionally, spending is running 1.2% below estimates. The nine-month cash deficit now stands at $5.6 billion versus the $11.4 billion projections.
- The unemployment rate in Pennsylvania increased slightly in February to total 8.1%. Governor Corbett signed the Fiscal 2013 $27.7 billion budget on June 30, 2012. Through the first nine months of fiscal 2013, General Fund revenues are 0.2% above estimates due to strong corporate taxes. Individual income taxes are currently tracking on budget. Sales tax collections remain weak, coming in 3.6% less than anticipated.
- Puerto Rico’s unemployment rate weakened to 14.5% in February. The Commonwealth has struggled to come out of its recession that started in 2006. It is plagued with large budget deficits, weak revenues, high debt levels, extremely weak pension systems, and a lack of sustainable economic growth. Standard & Poor’s downgraded the territory’s general obligation (GO) bonds to BBB- based on these concerns. Now all three major ratings agencies have the GO bonds rated weakly. A new governor has taken office and has already implemented some changes; on the pension front, for instance, a pension reform plan was signed into law. The new bill calls for higher retirement ages, as well as a nearly 2% increase in worker contributions and reduced special benefits. It also transfers future benefits to a defined contribution plan, which will be paid through a lifetime annuity. While funding levels will remain near zero, the plan will eliminate annual cash flow deficits and in essence become a pay-as-you-go plan. The new administration is currently working on solutions to bridge the estimated $1.87 billion 2013 budget gap, including raising revenue through the elimination of sales tax exemptions and better collection measures. Other solutions include expense reductions, COFINA financing and debt restructuring. The goal of the administration is to achieve structural budget balance by 2015.
The views expressed represent the Manager’s assessment of the market environment as of March 31, 2013, are subject to change, and may not reflect the manager’s current views. Views should not be considered as recommendations to buy, hold, or sell any security, and should not be relied on as research or investment advice. Please see important disclosures and definitions at the end of the document.
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Unless otherwise noted, the sources of statistical information in this document are Bloomberg, Municipal Bond Buyer, Barclays, and Thomson Municipal Market Data. Data were originally accessed on or about April. 2, 2013.
The information is provided with the understanding that Delaware Investments is not engaged in rendering accounting, legal, or other professional services. Seek the services of a competent professional if legal advice or other expert assistance is needed.
Advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.
Joseph R. Baxter and Stephen J. Czepiel are officers of Delaware Management Company, a series of Delaware Management Business Trust and a registered investment advisor.
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This document may mention bond ratings published by Moody’s, a nationally recognized statistical ratings organization. Bonds rated Aaa are rated as having the highest quality and are generally considered to have the lowest degree of investment risk. Bonds rated Aa2 are considered to be of high quality, but with a slightly higher degree of risk than bonds rated Aaa. Bonds rated A2 are considered to have many favorable investment qualities, though they are somewhat more susceptible to adverse economic conditions. Bonds rated Baa3 are believed to be of medium-grade quality and generally riskier over the long term.
This document may mention bond ratings published by Fitch, a nationally recognized statistical ratings organization. Bonds rated AAA are rated as having the highest quality and are generally considered to have the lowest degree of investment risk. Bonds rated AA are considered to be of high quality, but with a slightly higher degree of risk than bonds rated AAA. Bonds rated A are considered to have many favorable investment qualities, though they are somewhat more susceptible to adverse economic conditions. Bonds rated BBB are believed to be of medium-grade quality and generally riskier over the long term.
The Barclays Municipal Bond Index measures the total return performance of the long-term investment grade tax-exempt bond market.
The Barclays High-Yield Municipal Bond Index measures the total return performance of the long-term, noninvestment grade tax-exempt bond market.
The Barclays U.S. Aggregate Index is a broad composite that tracks the investments grade domestic bond market.
The Barclays U.S. Corporate High-Yield Index is composed of U.S. dollar–denominated, noninvestment grade corporate bonds for which the middle rating among Moody’s Investors Service, Inc., Fitch, Inc., and Standard & Poor’s is Ba1/BB+/BB+ or below.
The Barclays U.S. Treasury Index measures the performance of U.S. Treasury bonds and notes that have at least one year to maturity.
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