In the first half of 2017, the municipal bond market and the Oppenheimer Rochester municipal bond funds delivered solid performance.
Following an uptick at the end of 2016, the yield on 30-year Treasury bonds declined to 2.84%, from 3.07%, in the 6 months ended June 30, 2017. Yields on 30-year municipal bonds were similarly affected, falling from 3.08% to 2.81% for the period.At the same time, 10-year municipal bonds outperformed 10-year Treasury bonds: 10-year muni yields declined by 26 basis points, while Treasury bond yields were down by 13 basis points.
Muni yields for 10-year, AAA-rated paper ended the half at 84% of 10-year Treasury yields, which is in line with the historic yield relationship. At 30-year maturities, however, the nominal yields on AAA-rated munis and Treasuries were practically identical. As a result, the muni investment would provide any investor – not just higher-income investors – with more after-tax income than the Treasury investment, albeit with fewer protections.
Supply of new municipal bonds contributed to overall performance year to date. For 2017, we anticipate total municipal bond issuance of around $365 billion, compared to nearly $445 billion in 2016. From 2008 to 2016, municipal bond issuance had been somewhat muted, possibly because the political appetite for creating new debt is lacking. By 2016, however, low overall interest rates combined with the recognized need for infrastructure projects to engender more municipal borrowing. During the last election cycle, $55 billion in borrowing for infrastructure initiatives was approved by voters.
For 2017, we anticipate approximately $30 billion in net new municipal bond issuance, slightly less than net new issuance for 2016. It appears that July of 2017 will result in negative new bond issuance, with $30 billion in new bonds versus a record $45 billion in bonds scheduled to mature. Additionally, municipal bond issuance normally slows during the summer, which helps support overall performance.
The municipal bond market has performed well in 2017 even though the U.S. Federal Reserve has been slowly raising the target Fed Funds rate. While some investors fear rising rates, improvement in the U.S. economy – which might prompt higher rates – can actually benefit fixed-income portfolios that own the bonds of smaller or lower-rated issuers; these portfolios tend to perform better when credit fears subside. Generally, market expectations regarding the inflation rate have a greater impact on fixed-income investments than incremental rate changes, and these expectations are currently benign. While price volatility in the future cannot be ruled out, we are prepared to take advantage of lower bond prices should they become available.
Credit spreads have widened during 2017. Last summer, the spread between yields on 30-year, AAA-rated municipal bonds and those of 30-year, BBB-rated bonds tightened well below the long-term average of 100 basis points; this year, the spread is approximately 145 basis points. For investors, this condition normally represents relative value in lower-rated bonds. We currently observe some value opportunities in the muni market, but to a much lesser extent than in previous cycles; as always, we rely on our credit research staff to help identify opportunities to acquire bonds with higher-than-average yields relative to their credit risk.
Speaking of credit risk, we note a positive trend in the credit standing of Chicago and Illinois, a result of the resolution of Illinois’ lengthy and contentious budget process. Nonetheless, we remain hesitant to invest in uninsured bonds backed by either entity. Recently, the Chicago Board of Education issued $500 million in bonds that were very well-received by a yield-starved market. We, however, believe that much more needs to be accomplished regarding the financial structure of Chicago – and that of Illinois – before we would feel comfortable exposing the funds to this type of issuance. We believe that progress is being made in Chicago and Illinois, but are cautious about making meaningful bond purchases before observing continued progress in resolving issues related to government spending and pension funding.
Developments regarding Puerto Rico continue to create headlines and affect those Rochester funds with holdings in municipal bonds issued within the Commonwealth. Recently, the Commonwealth’s federal oversight board let the restructuring support agreement between the Puerto Rico Electric Power Authority (PREPA) and its creditors expire, choosing instead to commit PREPA’s $9 billion debt to a bankruptcy-like procedure, under Title III under the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA). This development arose despite the hope of many market participants, including ourselves, to complete the existing restructuring transactions that had been negotiated over many years. The Puerto Rico Sales Tax Financing Corporation (COFINA) and the Commonwealth have also been relegated to the PROMESA Title III process.
PROMESA’s Title III provides for debt restructuring of the Commonwealth itself or one of its instrumentalities selected by the oversight board through a plan of adjustment in federal court, like a Chapter 9 bankruptcy proceeding of a municipality under the U.S. Bankruptcy Code.
In Title III, the issues will proceed along separate tracks: mediation and litigation. We believe that other creditors share our hope that court-facilitated mediation will be effective in resolving the issues efficiently. However, a very real possibility of protracted litigation must be recognized. It is not possible to accurately estimate how long any litigation might continue.
Because of these developments, our funds’ dividend distribution calculations cannot factor in debt service payments from PREPA bonds or COFINA bonds—at least for now. For some funds that hold PREPA and COFINA bonds, this has meant a reduction in the amount that we expect to distribute to shareholders, beginning with the July payments. While we continue to believe that some payments from these bonds will be forthcoming, we believe that the most prudent course of action is to keep fund distributions in line with fund income receipts. We will continue to actively enforce the funds’ rights as Puerto Rico bondholders, including the relative priority of payment and liens, while working in good faith and with all stakeholders towards a fair and sustainable solution for Puerto Rico.
The tobacco bond sector, which has caused volatility for the funds in the past, has shown highly positive results of late. The Rochester municipal investment team started adding tobacco bonds to our portfolios when they were first issued in 1999, and we have been constructive on their creditworthiness over the years despite periods of broader-market doubt.
In 2014, 2015 and 2017 year to date, tobacco bonds have been the best-performing municipal bond market sector. By our observation, this outperformance has mainly been the result of two factors: declining oil prices and the refinancing of existing tobacco bonds. We believe that lower oil prices – and gasoline prices – contributed heavily to a small increase in tobacco consumption in 2015, as consumers spent less at the pump and had more disposable income to spend on cigarettes. More recently, as tobacco bond prices increased in an overall environment of low interest rates, tobacco bond issuers have found it expedient to pay off existing tobacco bonds, replacing them with money borrowed at lower interest rates.
While many of our competitors over the years declined to invest in tobacco bonds, we have stayed the course despite periodic price volatility—collecting full debt-service payments along the way. Currently, market demand for tobacco bonds is quite high and, accordingly, we have sold some of our positions into that demand. While our funds still hold many tobacco bonds, we strongly believe that it makes good sense to capture some of the current price appreciation. We anticipate that the funds will continue to have material exposure to tobacco bonds as they offer highly attractive yields. Nonetheless, we are pleased to realize long-term benefits for our shareholders.
Yields on bonds currently available in the municipal market are relatively low, creating pressure on dividends throughout the muni fund industry. As always, the Rochester team seeks the best risk-adjusted yields. We believe our investment approach is well positioned to produce long-term, income-driven total returns through market cycles and to maximize the tax benefits of municipal bond investing for our shareholders.
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