Muni Market Update
The municipal bond market is off to a good start in 2017. Across the yield curve, rates are down 10 to 40 basis points, with the best performance at the middle of the curve. Demand for high-grade and high-yield securities has been robust, despite a post-Election Day “blip.” One recent new offering was oversubscribed by a factor of 8 and garnered significant attention in the secondary market. Supply has pulled back, but it’s too soon to tell if 2017 will have positive or negative net new issuance; the market experienced positive net new issuance in 2016 but, to the benefit of existing bondholders, had negative net new issuance in each of the five previous years.
The muni market and several of the Oppenheimer Rochester funds are in inflows for 2017, even as low rates and narrowing credit spreads continue to create downward pressure on dividends throughout the industry. Refunding has remained popular with issuers and, as a result, the portfolios of many muni bond funds have had less income to distribute to their shareholders.1
U.S. Treasury rates have risen, but the nominal (or pre-tax) yields on munis have often been equal to or better than the taxable rates on Treasury securities of comparable maturities. The yield spread between BBB-rated muni credits and AAA-rated muni credits has widened, which we believe supports our focus on long-term and lower-rated bonds.
Top-performing muni funds continued to provide big yield advantages as the market has moved beyond the end-of-2016 volatility and rebounded. Total returns in Rochester have been solid and our weighted results have landed our complex in the top quartile for 2017 year to date and the 1-, 3- and 5-year periods. Our funds’ performance continues to be driven by yield advantages, allocations to below-investment-grade securities, and overweight “tobacco bond” positions. Securities issued by the Commonwealth of Puerto Rico have not performed well to date, although Puerto Rico bonds contributed favorably to many of the funds with annual reporting periods ended March 31, 2017. (For more about tobacco bonds and the situation in Puerto Rico, keep reading.)
Our team continues to take a long-term view of fund management, seeking to build yield advantage by investing in a diversity of sectors and bond structures that in time, we believe, will drive attractive total returns. Our performance in recent years, we believe, demonstrates the power of active management to succeed through various market ups and downs.
The White House released its “2017 Tax Reform for Economic Growth and American Jobs” in late April, but Congress has yet to provide details about any meaningful progress on this front. The President’s plan – a single page of 200 words – calls for three federal tax brackets versus the current seven, but it does not specify the income ranges that will be subject to the new tax rates (10%, 25% and 35%). While taxpayers who were in the highest federal tax bracket (currently 39.6%) will certainly have a lower rate, it is plausible that some taxpayers will move into a higher-rate bracket.
While the administration seeks to decrease the top marginal tax rate, we note that there is no long-term correlation between the top marginal tax rate – which has seen a range of 28% to 70% since 1980 – and how muni bonds trade. The typical muni investor, by the way, pays a top marginal tax rate of about 25%.
The administration also seeks to repeal the alternative minimum tax (AMT) and to eliminate the 3.8% tax on unearned income that was established under the Patient Protection and Affordable Care Act (Obamacare). The latter is levied on some of the net investment income earned by higher-income taxpayers, but the net investment income generated by municipal bonds has been exempt from this tax.
The favorable tax treatment for the income produced by muni bonds and muni bond funds is often top of mind whenever Washington takes on tax reform.2 The federal government has a long – and unsuccessful – history of targeting this exemption, and we believe that state officials will once again push hard against any effort to eliminate the exemption. States are always in need of infrastructure financing, and the municipal market has enabled elected officials to access capital and manage their municipalities’ overall debt-service obligations.
The market’s best-performing sector year to date – and in 2014 and 2015 – has been the tobacco bond sector. These high-yield securities are backed by the proceeds of the 1998 tobacco Master Settlement Agreement (MSA), which set the formulas and rules regarding annual payments that participating tobacco companies pay the states and territories that signed the agreement. The MSA includes assumptions about consumption declines as well as adjustments for inflation that lead to higher payments when inflation is above 3%.
While the sector is not without risks – consumption could decline at a faster clip than the MSA forecast, for example – the bonds have offered extreme yield advantages. Some tobacco bonds have been refunded, others are trading at par and even premiums. As a result of these prices, our team has chosen to reduce some funds’ tobacco sector holdings.
Investors in the municipal bond market have seen plenty of media reports regarding the Commonwealth of Puerto Rico and the Puerto Rico Oversight, Management and Economic Stability Act, aka PROMESA, which was enacted in June 2016. PROMESA established a federal oversight board, and it set the framework for restructuring Puerto Rico’s debt. PROMESA gives members of the oversight board broad authority and discretion over the operations and finances of Puerto Rico and its instrumentalities.
The Rochester complex holds significant investments in a variety of bonds issued by the Commonwealth and its instrumentalities and had hoped to reach negotiated settlements that would be in the best interests of all stakeholders: ones that would offer Puerto Rico a path forward, strengthen its economy and improve the quality of life of its residents while providing our shareholders with an appropriate return for lending money to the Commonwealth. However, the oversight board recently commenced proceedings under Title III of PROMESA, similar to a Chapter 9 bankruptcy, for the Commonwealth and COFINA. The proceedings will be overseen by U.S. District Judge Laura Taylor Swain, who was selected by the Chief Justice of the U.S. Supreme Court, John Roberts.
Net asset values (NAVs), of course, already reflect current market prices of our funds’ Puerto Rico holdings. Separately, while it is impossible to predict the ultimate outcome of pending and future Title III proceedings, we currently believe the market has priced in much of the downside risk.
We remind investors that our holdings are heterogeneous and that many are current in their scheduled payments of principal and interest. The trustee for COFINAs has already received the sales tax revenue needed to make the bonds’ August 1 payment. COFINA’s Title III proceedings, however, could affect the August 1 payment. Other issuers who are current and not in Title III are: PREPA, Puerto Rico’s electric utilities authority; PRASA, its aqueduct and sewer authority; the University of Puerto Rico, and an assortment of the territory’s hospitals and smaller universities. Tobacco bonds issued by Puerto Rico, like the rest of our funds’ tobacco bonds, remain current on their payments.
While the situation in Puerto Rico remains challenging, the market for bonds issued by the Commonwealth remains liquid and Puerto Rico’s revenues stand at an all-time high.
1 When a municipality issues a refunding bond, the proceeds are escrowed in U.S. Treasury bonds and earmarked to pay off a previously issued bond; Treasury bonds that are purchased with the proceeds are backed by the full faith and credit of the U.S. government.↩
2 In 1895, the U.S. Supreme Court ruled that any interest earned on a state bond was immune from federal taxation (Pollock v. Farmers’ Loan and Trust Company.) The Court’s ruling remained intact through the ratification of the Sixteenth Amendment, which enacted the first Internal Revenue Code, and the passage of the Revenue Act of 1913. Even though the U.S. Supreme Court decided in 1988 that Congress could authorize the taxation of municipal bond securities, Congress has repeatedly (and in our opinion wisely) chosen to leave the exemption intact.↩
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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.