With nine months in and three to go, the municipal bond market has delivered three quarters of positive total returns and the tax-free income muni investors come to rely on.
That it has done so during challenging times is a testament, we believe, to the fundamental strengths of the muni market: Overall, It has continued to generate positive total returns for investors seeking tax-free income despite the persistence of low interest rates, the prospects of federal tax reform, the potential for changes in the Fed Funds rate, and the significant fiscal and economic problems in Puerto Rico, the latter now exacerbated by the devastating impact of Hurricane Maria.
In the 9 months ended September 30, 2017, the market has produced a total return of 4.66%, a 66 basis-point improvement over the comparable period of 2016, according to the Bloomberg Barclays Municipal Bond Index.1 For the third quarter, the market’s total return equaled 1.06%.
Market technicals in general continue to be strong. Third-quarter volume for bonds maturing in 1 year or more was down 19.5% versus the prior quarter and 24.8% versus the third-quarter of 2016. Year-to-date volume in 2017 was down 16.2% versus the same period of 2016. Demand continues to exceed supply and, to the benefit of investors, the muni market continued to have negative net issuance during the third quarter. In July 2017, the volume of bonds that matured or were called reached an all-time high.
The overall muni fund market continued to be in inflows – with sales exceeding redemptions – driven in part by investors in top tax brackets, for whom the benefits of tax-free income are the greatest. As of September 30, 2017, AAA-rated munis with maturities of 15 years or more offered taxpayers in all federal tax brackets more favorable after-tax yields than Treasury securities with comparable maturities, and AAA-rated munis had higher nominal yields than Treasuries at maturities of 20 years or more; Treasury bonds are backed by the full faith and credit of the U.S. government.
The quarter was also characterized by credit spread tightening, which occurs when the difference between yield on low-rated municipal bonds and higher-rated bonds decreases. When credit spreads tighten, investments in BBB-rated, lower-rated and unrated securities typically outperform municipal securities with higher credit ratings, a condition that tends to enhance the performance of muni bond funds that are invested across the credit spectrum.
At its September meeting, the Federal Reserve Open Market Committee (FOMC) held the Fed Funds target rate to a range of 0.75% to 1.00%. The FOMC, noting that it expects economic conditions to “evolve in a manner that will warrant gradual increases” in the Fed Funds rate, continued to signal its intent to increase the rate once more in 2017 and three times in 2018. As had been previewed in the second quarter, the Fed’s $4.5 trillion balance sheet will begin to be “normalized.”
As the third quarter neared its end, the Commonwealth of Puerto Rico was primarily focused on addressing the extensive damage to aging infrastructure and property caused when Hurricane Maria made landfall. The work of the federal oversight board established by PROMESA (the Puerto Rico Oversight, Management and Economic Stability Act of 2016) and Title III proceedings under PROMESA, which are similar to Chapter 9 proceedings, were temporarily halted. The Puerto Rican government was rightly focused on immediate needs. However, the government rejected a $1 billion loan offered to PREPA (Puerto Rico’s electric utility authority) by a creditors group that included Oppenheimer Rochester, despite the government’s assertion that its cash position was weakening. This loan was designed to provide immediate relief and to help Puerto Rico qualify for matching funds from FEMA.
Earlier in the quarter, the federal oversight board approved a restructuring plan for the Government Development Bank of Puerto Rico, approved a budget for fiscal year 2018, and announced plans to conduct a “comprehensive investigation” of the Commonwealth’s debt. U.S. District Judge Laura Taylor Swain, who was selected by the Chief Justice John Roberts to oversee the Title III proceedings, set timetables to resolve various debt disputes, but those are likely to be revised in light of the hurricane damage. Additionally, the 10-year fiscal plan that was approved earlier in the year will need to be revisited.
Our team firmly believes that the best interests of all stakeholders can be met through negotiated settlements that 1) offer Puerto Rico a path forward, 2) strengthen its economy and 3) improve the quality of life of its residents, all while providing our shareholders with an appropriate return.
Developments after September 30: Following his visit to Puerto Rico, President Donald J. Trump spoke of wiping out Puerto Rico’s debt, a comment that led to steep declines in securities issued by the Commonwealth of Puerto Rico on October 4. Mick Mulvaney, Mr. Trump’s budget director, later explained that “what you heard the president say is that Puerto Rico is going to have to figure out a way to solve its debt problems.”
The situation vis-à-vis Puerto Rico is expected to remain challenging and dynamic, and the U.S. equity and bond markets are also bound to react to headlines about tax reform and other news out of Washington. Markets can and do fluctuate, and market prognosticators may turn up the volume as that happens. Nonetheless, we believe investors should remain focused on their own long-term financial objectives. And, while past performance does not guarantee future results, we think it’s worth noting our funds’ recent results: At quarter’s end, 17 Rochester funds produced dividend yields at net asset value (NAV) of at least 3%, including 9 funds with dividend yields at NAV in excess of 4%. The yields for 2 of the 9 – Oppenheimer Rochester High Yield Municipal Fund and Oppenheimer Rochester Virginia Municipal Fund – were above 5%.
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- ^The Bloomberg Barclays Municipal Bond Index is an unmanaged index of a broad range of investment-grade municipal bonds that measures the performance of the general municipal bond market. Index performance is shown for illustrative purposes only and does not predict or depict performance of our funds. Past performance does not guarantee future results.
Fixed-income investing can entail credit and interest rate risks; as interest rates rise, bond prices generally fall and a fund’s share price can fall, too. A portion of a municipal bond fund’s distributions may be subject to tax and may increase taxes for investors subject to federal alternative minimum tax. Capital gains distributions are taxable as capital gains.
Below-investment grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Under certain market conditions, some unrated securities may trade less actively than rated securities. Our funds can have a relatively high portion of their portfolio holdings in particular segments of the municipal securities market, such as tobacco bonds or real-estate-related securities. They may also invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. Funds may also invest substantially in Puerto Rico and other U.S. territories, commonwealths and possessions, and could be exposed to their local political and economic conditions. Deterioration of the Puerto Rican economy could have an adverse impact on Puerto Rican bonds and the performance of the Rochester municipal funds that hold them. Diversification does not guarantee profit or protect against loss.