Muni Market Update
While municipal bond market performance was generally positive during the first three quarters of 2016, the fourth quarter has brought market volatility not seen in the previous 18 months. This volatility was generated by a confluence of factors. For one, bond investors became skittish about rising bond yields following a prolonged period of stubbornly low yields. Simultaneously, a large number of newly-issued municipal bonds came to market during the fourth quarter. October’s $53 billion in new bond issuance set a municipal bond market record and caused supply-driven market volatility. Market concerns over tax policy were also heightened during this period, following the election of Donald J. Trump as President of the United States. Despite market volatility, the Oppenheimer Rochester municipal bond funds stood up very well compared to their competitors; the funds’ weighted average peer group ranking remained in the top decile of their respective categories for the 1-, 3- and 5-year periods, and year-to-date. Most notably, these funds’ weighted average peer group ranking remained top-decile for the 6-month period despite market volatility.
Since the beginning of October, the municipal bond market has undergone a dramatic rise in interest rates. During this period, municipal bond yields rose by 100 basis points in some segments of the municipal yield curve, as bond prices declined. Approximately 70 basis points of this increase occurred during the month following the Presidential election. At the same time, credit-yield spreads have widened, meaning that prices of lower-rated, higher-yielding bonds have declined at a generally faster rate than prices of higher-quality bonds, resulting in an increased difference in yields. Municipal bonds also underperformed U.S. Treasury securities during this period. On December 7th, the yield on 30-year, AAA-rated municipal bonds represented 103.3% of 30-year U.S. Treasury yield, up from 97 .5% as recently as September 30th. High-yield municipal bonds also underperformed high-yield corporate bonds, as corporate bond credit yield spreads actually tightened as the price of lower-quality corporate bonds increased.
Market uncertainty regarding future U.S. tax policy has been a significant contributor to municipal bond underperformance. Many investors find municipal bond yields attractive largely because of their immunity to the effect of Federal income taxes and, for many investors, that of State income taxes. While the future remains unclear, President-elect Trump ran successfully, in part, on the proposal of tax reduction. Investors have also sought clarity on the future of municipal bond tax exemption itself. Reduction in Federal income taxes would reduce the value of municipal bond tax advantages to tax-conscious investors. Historically, investors’ fears of reduction in the value of the municipal bond tax advantage have been, in our opinion, over-reactive. While future tax policy may well include a reduction in Federal income tax rates, we believe that municipal bond tax advantages will continue to offer opportunity for tax-sensitive investors.
All of the factors that have recently affected municipal bond prices are technical and market-driven in nature – not credit-driven. Stated differently, recent declines in municipal bond prices have not resulted from bond issuers failing to make principal or interest payments on their outstanding indebtedness. As a result, we perceive lower municipal bond prices – and higher yields – as an opportunity for investors. In recent years much has been discussed about the widespread “yield famine” that has left many income -seeking investors wondering how to find investments that meet their income needs. Recent volatility has provided opportunities to invest at much more attractive yields than the market has offered in 18 to 24 months. The question is whether investors are positioned to take advantage of those opportunities.
We believe that the Oppenheimer Rochester municipal bond funds have been well-positioned to take advantage of recent yield opportunities. Some of our competitors have succumbed to the lure of higher yields offered by marginal borrowers in recent years, we have adhered to our time-tested strategy of relative value analysis. Despite a prolonged period of low market rates, we have not chased yield by investing in bonds issued by marginal borrowers, while maintaining top yields among our competitors. Recently, as some of our competitors have been selling bonds whose prices have fallen, we have selectively taken advantage of these opportunities on behalf of our shareholders. Because of our historically strict relative value analysis, the Oppenheimer Rochester municipal bond funds were well positioned to benefit from opportunities unearthed by recent market volatility.
One factor that has helped our funds to maintain attractive recent performance compared to our competitors has been their investments in bonds issued by and within the Commonwealth of Puerto Rico. While the municipal bond market has been roiled by rising yields and tax concerns, our Puerto Rico holdings generally have not. In recent years, prices of Puerto Rico bonds have been greatly influenced far more by pure credit considerations than by interest rate fears and our holdings have, as a result, helped to provide a measure of stability for our funds’ share prices. The Puerto Rico credit picture continues to evolve and, in our opinion, improve.
One major positive development in Puerto Rico was the November election of Ricardo Rossello as Governor of the Commonwealth of Puerto Rico. An ardent supporter of statehood for Puerto Rico, Governor-elect Rossello campaigned, in part, on a platform that included his resolve to work with owners of Puerto Rico’s municipal bonds to ultimately pay 100% of interest due on Puerto Rico’s outstanding municipal debt. While the success of any such effort remains to be seen, we believe that Governor-elect Rossello stands to negotiate with bondholders in good faith, as he appears to understand the direct relationship that payment of existing debt bears to future access to municipal bond market borrowing. In total, we believe that Governor-elect Rossello represents a positive factor for the future of Puerto Rico’s municipal bonds.
Puerto Rico’s new Fiscal Control Board (the “Board”) mandated in the passage of 2016’s PROMESA bill continues to take shape, as members have been seated and have begun to unravel the true nature of Puerto Rico’s finances. While we believe that this will be neither a fast nor an easy task, the Board has been working with Puerto Rico’s current governor and governor-elect to gain all relevant information necessary to make informed decisions on the Commonwealth’s financial future. It is also selecting advisors and an executive director, both key elements in how the Board may approach bondholder negotiations and, if necessary, bond restructuring. We believe that the Board will keep a keen eye on fiscal sustainability and access to capital markets, and remain constructive on the possibilities of Board actions going forward. News of its activities is likely to be forthcoming early in 2017.
Conversely, we do not expect payment of Puerto Rico’s General Obligation debt service, or that of its Public Buildings or Highway Authorities, to be forthcoming as scheduled on January 1, 2017. However, we remain mindful of the fact that the Funds remain entitled to these debt service payments, and also to those missed in July of 2016, and will continue to pursue these monies through negotiation. We believe that Fiscal Control Board activities will help to hasten resolution of these issues, as the stay of creditor lawsuits provided in the PROMESA bill is scheduled to expire in February of 2017. We feel confident that sufficient incentives are in place to speed negotiations between bondholders and the Commonwealth, and look forward to negotiating mutually satisfactory solutions.
As always, the Oppenheimer Rochester municipal bond funds are being managed in an effort to provide shareholders with long-term, income-driven total return. There is no doubt that recent short-term market volatility has resulted in diminished short-term total return for our funds. But we remain confident in the time-tested approach to generating long-term return through tax-free yield that has been employed by Rochester fund management since 1986.
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Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates, or an expectation of rising interest rates in the near future, will cause the values of a Fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at, or near, historic lows. When interest rates rise, bond prices fall and a fund’s share price can fall. Municipal bonds are subject to default on income and principal payments. Further, a portion of some funds’ distributions may be taxable and may increase alternative minimum tax (AMT) for investors subject to that tax; distributions from net realized capital gains are taxable as capital gains. The funds invest in below-investment-grade debt securities, which may entail greater credit risks, as described in each fund’s prospectus. These securities (sometimes called “junk bonds”) may be subject to greater price fluctuations and risks of loss of income and principal than investment-grade municipal securities. The funds may invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. The 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.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.