Building on its positive first-quarter performance, the municipal bond market once again delivered attractive total returns for investors seeking tax-free income. Muni bond funds had net positive flows during the 3 months ended June 30, 2017 as fixed-income investors looked for yield amid persistently low interest rates and buoyant U.S. equity markets.
The Bloomberg Barclays Municipal Bond Index produced a total return of 1.96% for the 3 months ended June 30, 2017 and a year-to-date total return of 3.57%.1 The index posted a total return of 1.58% in the first quarter of 2017.
Overall, U.S. equities, Treasury bonds with maturities of 3 years and longer, and AAA-rated municipal bonds of all maturities rallied during the second quarter. At quarter’s end, the median yields on AAA-grade munis were 0.87%, 2.15% and 2.97% for maturities of 1, 10 and 30 years, respectively, versus 0.90%, 2.37% and 3.20% on March 31, 2017.2
Volume for bonds was down 13.6% in the first 6 months of 2017 versus the same period of 2016, and demand continues to exceed supply. The market has had negative net issuance year to date (a positive for existing bondholders); the volume of bonds called and coupons paid in July, which was the highest in 10 years, was a factor in this development. The market remained in inflows, reversing the trend that existed after Election Day, and annual borrowing by local governments reached a 7-year high.
At its May meeting, the Federal Reserve Open Market Committee (FOMC) held the Fed Funds target rate to a range of 0.75% to 1.00%, citing its need for further evidence of economic strength. On June 14, 2017, the FOMC raised the rate by one-quarter of 1 percentage point – to a range of 1.00% to 1.25% – and signaled additional plans to increase the target rate.
Dividends across the industry remained pressured in the second quarter. The pre-refunding trend, which contributed to lower levels of net investment income for some funds, continued to dissipate. For the most part, issuers who were able to sell paper with lower rates have already done so. Liquidity in the marketplace remained strong, which gave the Rochester portfolio team ample opportunities to add incremental value to the funds.
The Commonwealth of Puerto Rico and the federal oversight board established by PROMESA (the Puerto Rico Oversight, Management and Economic Stability Act of 2016) continued to generate headlines during the second quarter. Despite the Portfolio management team’s efforts to reach negotiated settlements with various issuers in Puerto Rico, the oversight board commenced proceedings under Title III of PROMESA, similar to a Chapter 9 bankruptcy, for the Commonwealth, the Puerto Rico Sales Tax Financing Corporation (issuer of COFINA bonds), the Highway Transportation Authority, the Employee Retirement System and PREPA, Puerto Rico’s electric utilities authority.* PREPA and its forbearing creditors had worked together since the summer of 2014 to reach a restructuring support agreement (RSA) in December 2015 (RSA), which was renegotiated and amended from time to time since then. PREPA ultimately allowed the RSA to terminate on June 29, 2017, although the forbearing creditors offered to extend the agreement. Following RSA’s termination, the oversight board commenced PREPA’s Title III proceeding.
Our team continues to believe that the best interests of all stakeholders can be met through negotiated settlements that offer Puerto Rico a path forward, strengthen its economy and improve the quality of life of its residents while preserving the rights of our shareholders.
During the reporting period, Puerto Rico’s governor, Ricardo Rosselló, proposed a $9.56 billion general fund budget that called for a 6.3% increase in spending in fiscal 2018 but no debt payments. In late June, the federal oversight board approved its own consolidated budget and earmarked more than $900 million for debt-service obligations. The Commonwealth also held a vote regarding statehood. Those who voted in the nonbinding referendum were overwhelmingly in favor of changing the Commonwealth’s status to U.S. statehood, but less than one-quarter of the electorate voted.
While the situation in Puerto Rico remained challenging, the market for bonds issued by the Commonwealth was liquid and Puerto Rico’s revenues reached an all-time high. The NAVs of the Oppenheimer Rochester funds that hold Puerto Rican paper reflect current market prices of those securities. 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.
For the year through June 30, 2017, nine Rochester funds outperformed the Bloomberg Barclays index, including
Oppenheimer Rochester Intermediate Term Municipal Fund, which seeks an average effective maturity of 3 to 7 years and, as of June 30, 2017, held less than 5% of total assets in below-investment-grade securities. The strong performance of high-yield tobacco bonds (which are backed by proceeds of the 1997 Master Settlement Agreement) continued to be a boon to performance in many of our long funds.
To the benefit of our shareholders, 18 Rochester funds produced dividend yields at net asset value (NAV) of at least 3% at quarter’s end, including 12 funds with dividend yields at NAV in excess of 4%.
One housekeeping note: On June 1, 2017, a Rochester fund got a new name, an updated strategy and, we hope, a new appeal for investors seeking high yields and tax advantages. Oppenheimer Rochester Limited Term Municipal Fund (OPITX) became Oppenheimer Rochester Short Duration High Yield Municipal Fund, and its threshold for below-investment-grade securities rose to 35% of total assets at time of purchase, from 5%. This new threshold may cause the fund to experience more volatility than in years past but less volatility than can occur in longer-term high yield funds. The fund will still seek to maintain an average effective maturity (AEM) of 5 years or less, and it is designed to have a lower duration than the average fund in its Morningstar category.3 In combination, we believe these two characteristics should deliver a “smoother ride” for investors. We see this revision to our fund lineup as just the latest example of putting client needs first.
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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.
- ^The yields are provided by Municipal Market Advisors (MMA) and are based on its benchmark of general obligation bonds structured with a 5% coupon and a 10-year par call. The MMA benchmark is constructed using yields from a group of active primary and secondary market makers and other municipal market participants.
- ^Duration measures a fixed-income product’s sensitivity to changes in interest rates. Duration is measured in years; the higher the figure, the more sensitive the product.
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.