Diverging fund flows are reflected in fixed income performance

Capital is returning to certain fixed income sectors. Fund flows are quite uneven however, with the corporate sector remaining investors' favorite. In particular, high yield bonds have recouped a great deal of the recent outflows.

Source: Goldman Sachs

In contrast, mumi bonds have seen almost no new net inflows. The little problem in Detroit is not helping the situation (see story) and the SEC going after the city of Miami (see story) has made the sector look quite unappealing.

Source: Goldman Sachs

Outside of treasuries, fixed income performance these days is extremely sensitive to fund flows. And the returns over the past month (June 20th - July 19th) fully reflect these dynamics in mutual funds and ETFs.

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From our sponsor:

Retail fixed income investor capitulation

Spooked retail investors are exhibiting complete capitulation in their bond portfolios. They have been dumping fixed income assets, particularly munis, in record amounts.

Source: DB

And the proceeds are ending up in money market funds - while institutions are reducing their overall money market funds holdings.

$mm (source ICI)

Are US retail investors overreacting to "taper" talk? For those who like to take contrarian bets, this looks like an opportunity.

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Munis dumped below market levels via ETFs

Muni ETFs have taken tremendous hits in the last few days. SPDR New York and California municipal bond ETFs in particular have underperformed the overall muni market.

Source: Ycharts

Surprisingly these NY and CA ETFs now trade with a 4-5% discount to NAV (ETFs' value is lower than the value of the underlying portfolio). That discount explains a portion of the underperformance (the index ETF discount is about 1%). But these are not closed-end funds and over time the ETF discount should disappear. Given this is not driven by credit concerns (for now), one could make money going long these state ETFs and shorting the overall index or treasuries to "lock in" the discount.

It's just amazing to see investors dumping munis indiscriminately, even if they end up selling below market levels (via ETFs at discount to NAV). Many of the higher rated (particularly longer dated) munis yield more than the equivalent treasuries on a pre-tax basis. The fear of fixed income product is outweighing the attractiveness of post-tax yields.

From an economic perspective, this is bad news for municipal finance. Several muni bond issuances have already been delayed, given the nasty volatility. Just when some had hoped that employment at the state level may have stabilized, the increased cost of funding will now create additional headwinds.

Source: U.S. Bureau of Labor Statistics 

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From our sponsor:

What's causing the sell-off in muni bonds?

Municipal bonds came under pressure last week, pushing the asset class into the red for the year. And it hasn't just been the recent rise in longer term treasury yields driving the selloff. On a year-to-date basis munis now materially trail treasuries. Some investors attribute it to seasonal factors such as sellers raising money to pay taxes. All of a sudden people realized they have a tax liability? Right. What's really pushing these bonds lower?

Source: Ycharts

There is a sad notion in Washington that requiring the wealthy, many of whom have substantial positions in munis, to pay taxes on their muni holdings will raise federal tax revenue. In reality the wealthy will simply rotate out of the muni market, forcing states and municipalities to pay significantly higher rates. And the revenue side of the equation will not increase substantially - instead forcing more capital into offshore tax exempt life insurance and annuity-based estate structures.

Nevertheless we all know how Washington operates. Fears of tax changes in the upcoming budget negotiations - as the debt ceiling debates approach - has contributed to munis trading lower. In fact according to Morgan Stanley the chances of muni bonds losing tax exempt status are at 30% (see post from Barron's).

Tulsa World: - The battle that took place over the "fiscal cliff" foreshadowed the current fights that Congress and the president are having over taxes and spending as Congress bumped up against the March deadlines on raising the debt limit, funding the government and automatic spending cuts that were delayed as part of the fiscal cliff deal.

Congress will likely consider sweeping changes to the federal income tax system either as part of this round of budget talks or in the context of comprehensive tax reform. These changes could include a revision to the current federal tax treatment of interest paid on municipal bonds.

Other threats to the muni markets are coming from state governments lowering taxes to attract families and businesses.

Barron's: - Now, proposals have surfaced to cut or eliminate state income taxes in Arkansas, Indiana, Iowa, Louisiana, North Carolina, Ohio, Oklahoma, and Wisconsin. Two factors give such proposals a decent chance. First, 39 states now have one-party control of their legislatures and governorships, the most since 1952, and 24 of these are controlled by Republicans, the party pushing hardest for lower income tax rates.

The second factor is competition. Kansas Gov. Sam Brownback succeeded last year in slashing tax rates for high earners and eliminating them for many businesses in what he calls a path to zero income tax. The cuts will cost the state more than $850 million a year in revenue, which Brownback hopes to offset by extending a sales tax that's set to expire and ending some deductions. A tax cut in one state forces neighboring ones to consider following suit in order to avoid seeing high-income residents defect, says Heckman.

These are positive developments that should generate incremental economic activity in these states. However should the economy in any of these states take a turn for the worse for some reason, state budgets could be in trouble.

What really spooked the muni markets however was the risk of underfunded state pensions. Pension funds tend to use archaic discounting methods that make the present value of their liabilities (expected payouts on pensions) look significantly lower than they really are. As pension asset returns remain weak, pension funds may require unplanned injections of capital to cover the liabilities. And when it comes to funding state pensions vs. paying on municipal debt, we all know which road state politicians and the unions who often control them will take. What's particularly troubling is that states are not above hiding pension problems in order to sell their bonds. In the case of Illinois (as well as NJ in 2010), the SEC called this lack of disclosure fraud. Market participants are asking if there are other such situations out there.

CNN: - The Securities and Exchange Commission and the Illinois state government have reached a settlement over charges that the state defrauded investors by not giving them proper information about its pension funds.

The SEC, which disclosed the charges with a filing Monday, said the fraud occurred between 2005 and 2009 when the state sold $2.2 billion in bonds without disclosing the impact of problems with its pension funding schedule. There were no fines or penalties against the state as part of the settlement.

"Municipal investors are no less entitled to truthful risk disclosures than other investors," said George S. Canellos, acting director of the SEC's Division of Enforcement. "Time after time, Illinois failed to inform its bond investors about the risk to its financial condition posed by the structural underfunding of its pension system."

The impact of course is not limited to the lower rated bonds like Illinois. The AAA muni bond yield hit a level not seen in almost a year (chart below). And as investors become jittery about long-term rates in general, the muni market will fall under increased scrutiny.

10y AAA muni yield (Bloomberg)

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From our sponsor:

Fiscal uncertainty undermining the muni markets

The US fiscal negotiations are putting pressure on the muni bond markets.

ETF Trends: - The tax hoopla has depressed municipal bonds, with high-grade 10- and 30-year munis comparably yielding as much as taxable Treasury securities at 1.79% and 2.73%, respectively, writes Randall W. Forsyth for Barron’s.

According to reports from trading desks, bids have become more scarce as a greater number of investors are sitting on the sidelines and waiting it out as the fiscal cliff goes down to the wire.

Congress has reportedly proposed levies on high-income investors in munis as part of of the deficit plan.

More pessimistic muni observers are wondering if taxes could be imposed retroactively on tax exempt securities. George Friedlander of Citi, though, believes this is a “pernicious concept” that could destroy confidence in the federal government’s ability in the capital markets.
...

“The fact that there’s support on both sides of the table is what freaked people out,” said George Friedlander, managing director and chief municipal-bond strategist at Citigroup...

Fund flows into munis have slowed to a trickle.

Fund flows (source: GS)

Once again some zealous politicians who wish to "tax rich people" are simply going to transfer funds from municipalities to the federal government (in an inefficient manner).

ETF Trends: - Friedlander has also pointed out that if there were a limit to the value of tax-exemption on munis to up to a 28% cap, yields would rise 0.4% to 0.6%, which would devalue munis by $200 billion. Looking at the recent correction in muni ETFs, the potential tax hikes may have already been priced in.

Indeed the market has corrected from the peak reached at the end of November, as the chart for NY munis shows.

SPDR Nuveen Barclays Capital NY Muni Bd  (INY)

Ultimately whatever politicians decide to do, they need to get it done soon in order to return some certainty into this market. Otherwise they simply end up hurting municipalities around the nation who rely on this market for funding.

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From our sponsor:

California munis return from the dead as investors bid up bonds, but risks remain

In another sign of strong demand for fixed income product (basically anything with extra yield) the muni market has been quite strong. In particular the tightening in the California's bonds has been extraordinary. California 10y general obligation (GO) paper has been trading at some 50bp spread to the national average (chart below) as the issuance of new bonds has slowed.

Source: JPMorgan (click to enlarge)

The rating agencies seem to have gotten fairly comfortable with what looked like a bankruptcy in the making just three years ago.

Fitch (via Reuters): - Fitch affirms the 'A-' rating on approximately $72.6 billion in outstanding GO bonds of the state. The Rating Outlook is Stable. SECURITY General obligations, for which the state pledges its full faith and credit, subject to the prior application of moneys to the support of public education; funds for education represent approximately half of state spending. KEY RATING DRIVERS WEALTHY, DIVERSE ECONOMY: The economy is wealthy and unmatched among U.S. states in its diversity and breadth. Growth has resumed after severe, widespread recessionary conditions.

The rating agencies are hanging their hat on the size and diversity of California's economy. To put things in perspective, the chart below compares California's output to the largest economies in the world. California's "GDP" is larger than that of India, Canada, Russia, Spain, Australia, etc.

Source: JPMorgan (GSP = Gross State Product)

Nevertheless risks in California GOs remain, and investors should exercise caution - particularly at such tight spreads.

Fitch : - 

HISTORY OF BUDGET AND CASH STRESS: State finances are subject to periodic, severe budget and cash flow crises due to structural imbalances, revenue cyclicality and institutional inflexibility.

VOLATILE REVENUES: Revenues are volatile, notably the component tied to personal income. Modest revenue growth has resumed since the downturn although the course of future collections is uncertain.

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Defaulted California cities share much in common; muni investors don't care

We now have a sample of four California municipalities that have or are about to default.

NYTimes: - As San Bernardino, Calif., moved toward bankruptcy this week, municipal bond analysts were questioning how widespread the fiscal distress may prove to be, but were not predicting a wave of defaults.

San Bernardino’s vote to authorize a bankruptcy filing came after filings this summer by the California cities of Stockton and Mammoth Lakes. Those cities were following Vallejo, which emerged from bankruptcy in 2011, after a three-year struggle to reduce its debts to investors, retirees and others.

Are there common trends shared by these areas that made them more vulnerable? Let's take a look at some demographics compiled by JPMorgan.

It seems that population growth, unemployment, poverty, and the housing crisis (all reducing tax revenues via declines in sales and property taxes) make these cities/areas stand out.  Other issues JPM analysts point to include unusually high personnel and pension costs.

There are clearly multiple other municipalities across the US with these sorts of demographics. Does that mean we are going to see more defaults? The muni debt markets are simply shrugging these off as a set of isolated cases - a tiny portion of the massive municipal bond market.

NYTimes: - Over all, investors in municipal debt showed little sign of concern about the woes of either California or any other states. On Thursday the interest rate on the highest-quality 30-year municipal bonds fell below 3 percent for the first time ever, according to Daniel Berger, a senior market strategist at Municipal Market Data.

In fact investors these days love the riskier, lower rated municipal bonds - exactly the sorts of bonds issued by the San Bernardino-types across the nation. The chart below shows shares outstanding (indication of fund inflows) for Market Vectors High Yield Municipal Index ETF (ticker symbol HYD). Shares outstanding index has gone vertical recently. San Bernardino, Stockton? Investors don't seem to care.

HYD shares outstanding

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Treasuries reduce volatility better than munis, corporate bonds

Some readers have asked if other fixed income asset classes could be just as effective as long term treasuries for an equities portfolio in hedging an equities book (discussed here). Here the comparison is made to municipal bonds, investment grade corporate bonds, and HY corporate bonds. Long term treasuries are still superior in reducing the portfolio volatility - at least based on the last couple of years. That's because muni and corporate spreads tend to be inversely correlated to equities, reducing the hedge effectiveness of these instruments.

Again, the x-axis is the percent of the portfolio invested in the S&P500, with the rest of the portfolio being in one of the fixed income asset classes. The y-axis is the combined portfolio daily volatility over the past two years.

That is the reason investors are willing to take asymmetric risk and dismal current yield to hold long term treasuries. Whether this relationship holds going forward remains unclear. A scenario in which both treasuries and equities sell off some time in the future is not unrealistic.

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New fund flows and limited supply provide support to the muni market

The municipal bond (muni) market in the US has been on fire lately. Seems investors have discounted Meredith Whitney's famous dire forecast.

SFGate: Investors in the $3.7 trillion U.S. municipal-bond market are buying long-term debt at the fastest pace since the eve of Meredith Whitney's 2010 prediction of "hundreds of billions of dollars" of public-borrower defaults.

As the chart below from JPMorgan shows, the flows into muni funds represent at least a partial reversal of what was occurring in this market the same time last year.

Muni fund flows (source:JPMorgan)

The market has responded strongly to these inflows with the S&P Municipal Bond Index outperforming treasuries by nearly 2% during the past month.

S&P Muni Index vs. the iBoxx US treasury index (Bloomberg)

Furthermore it looks like the supply of new bonds is not expected to increase substantially. JPMorgan forecasts $350 billion of issuance in 2012 or 20% above what we saw in 2011. That seems like a bunch of new supply, but much of it represents refinancing of existing bonds. A number of municipalities are projected to be taking advantage of lower rates and calling their existing debt. In fact as the chart below shows, the net new supply of munis for 2012 is expected to stay close to flat (the negative numbers on the chart indicate a net reduction - more bonds being called than issued).

Net new supply of municipal bonds - 2012 forecast vs. 5-year average (source: JPMorgan)

Clearly risks to the downside remain.  A disruption in global credit markets could quickly widen municipal bond spreads.  A less likely scenario is a sharp steepening of the US treasury curve that may hurt the longer term munis.  These risks aside however, the limited supply and low rates should provide sufficient support to the muni market, as flows into fixed income funds continue. 


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Rough road for munis

Even with the advantage of paying tax free interest, municipal bonds in many instances are yielding more than their corporate equivalents.

Bloomberg: State and local governments that sold $43.8 billion of taxable Build America Bonds this year will pay $385 million a year more in interest than similarly rated corporate borrowers, based on data compiled by Bloomberg.

The spread between corporates and munis varies along the yield curve. In the short end the tax advantage keeps the spread (corporate yield minus muni yield) positive, but for the longer maturities the spread reverses.




This means that in spite of the tax advantage of municipal bonds, given the choice between two equally rated long duration bonds with the same coupon, investors prefer the corporate paper. Clearly unlike corporate bonds, munis have lower analyst coverage and are viewed as a specialty market. Buyers of longer-term munis tend to be specialized muni funds, while corporate paper is held by institutional investors, fixed income funds, etc.

But that's only part of the story. If the risks were truly equivalent, over time the spread would tend to zero. The spread however shows incremental credit risk of municipal bonds over the longer time periods. But how is that possible, given that unlike corporations, municipalities "can raise fees or taxes to make up for deficits. Corporations are at least 90 times more likely to default than local governments, according to Moody’s Investors Service"? (Bloomberg)

The reason given by Bloomberg is poor transparency of municipal issuers.

The public paid extra costs for borrowing with tax-exempt bonds because local governments resist providing investors the same level of disclosure as corporate borrowers, which file quarterly reports.

Municipalities typically file financial statements only once a year. Detroit, the largest U.S. city with a less-than- investment-grade credit rating, released its annual report for fiscal 2007 in March, more than 18 months later.

But other reasons include the deterioration of state budgets and the risk that in the long run munis may lose their tax-free status at the Federal level. But there is something else. Private investors continue to be nervous when dealing with governments as political risk enters into the picture. Who is to say that 10-20 years down the road, municipalities will not walk away from their obligations. There is only so much pain that angry taxpayers in various states may be able to take. And for now that risk is costing municipal issuers the extra spread.

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