Muni Market Update
Municipal bond market performance has been generally positive during 2016. Municipal bond funds have experienced “inflows”, for 35 weeks straight, as investments have outpaced fund redemptions. Investor demand for newly-issued municipal bonds (the “primary market”) has been robust, with issuers of new bonds finding ready buyers. Demand has been similarly strong for previously issued bonds (the “secondary market”) as investors continue to seek tax-advantaged income.
Among municipal bond funds, investors have demonstrated the highest demand for high-yield and long-term municipal bond funds. Investors’ concerns about short-term interest rate increases by the Federal Reserve Board (the “Fed”) have waned, while demand for income-producing investments has generally increased. Performance among the Oppenheimer Rochester municipal bond funds has reflected overall strength in the municipal bond market. Performance for all of the Oppenheimer Rochester municipal bond funds has compared very favorably to that of their competitors, particularly for 1-year and 5-year periods.
The ratio of municipal bond yields in relation to yields on United States Treasury securities has decreased. As of the end of August, the yield on 30-year, AAA-rated municipal bonds stood at approximately 95% of the yield on comparable-length Treasure securities. While the price of municipal bonds has increased relative to the price of U.S. Treasury bonds, the yield ratio remains above historical averages. This condition illustrates the fact that municipal bonds currently offer investors price and yield advantages over Treasury bonds.
Relatively reduced supply of newly-issued municipal bonds has been a positive factor for municipal bond market performance. While it appears likely that the aggregate number of bonds issued in 2016 will exceed the 2015 total, it also appears likely that more bonds will be called or mature than are issued. This condition would result in “negative new issuance”, continuing a four-year trend. While a shrinking municipal bond market is generally positive for municipal bond prices, it can also complicate investors’ search for new investment opportunities.
Investors are well-justified in scrutinizing any contemplated municipal bond investment. With broad-based market demand, prices of lower-quality, higher-yielding bonds have increased, resulting in “credit spread tightening” – a lessening in the difference in market yields between higher-rated and lower-rated bonds, as prices of lower-rated bonds have increased. Borrowers of all credit qualities currently have relatively easy access to capital – which should raise red flags for investors. We believe that thorough credit research is absolutely necessary.
Continued strength in municipal bond prices might lead an investor to ask whether the municipal bond market offers any opportunities for investors seeking value. We believe that it does; but also believe that investors should be very selective. Bond price increases have led to pressure on municipal bond yields and, accordingly, on yields offered by municipal bond funds. While we continue to believe that higher-yielding bonds offer a measure of protection for fund yield and long-term total return than higher-quality, lower-coupon bonds, it is important to differentiate between bond credit profiles; chasing yield without thorough credit research is a risky proposition for investors.
One municipal bond market sector that remains attractive is the tobacco bond sector. Tobacco bonds have outperformed other sectors during 2016, representing the continuation of a trend; tobacco bonds have been the top-performing municipal bond sector for the past three years. Outperformance of tobacco bonds has been driven mainly by fundamental characteristics of the bonds themselves. One factor has been domestic cigarette shipments that underlie calculation of the annual Master Settlement Payments that back tobacco bonds. During 2015, domestic shipments increased for the first time in over a decade. Currently, it appears that shipments may slightly increase again in 2016. This may be attributable to the decrease in oil prices or other factors; regardless, the net effect on tobacco bonds prices, and their overall credit profile, has been positive. Shareholders of Oppenheimer Rochester municipal bond funds that invest in tobacco bonds have benefitted from price appreciation and the yield that these bonds offer.
While headlines caused many of our competitors liquidated tobacco bond positions in recent years (only to buy back in at higher prices) we maintained our positions through market volatility. Now, our shareholders have been rewarded with yield and bond-price appreciation. While we believe that the fundamental credit characteristics of tobacco bonds remain solid, we have strategically taken advantage of price increases in response to market demand.
Earlier this year, the United States Supreme Court overturned the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (“DERA”). We believe that this represented a very positive development for owners of Puerto Rico municipal bonds in general, and for our funds’ shareholders in particular. The ruling helped bondholders to maintain legal protections that might otherwise have been imperiled, and helped to provide clarity regarding available relief.
This summer the United States Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act, commonly referred to as PROMESA. In part, this legislation called for creation of a 7-member Fiscal Control Board (the “Board”), whose members were announced at the end of August.
We see the composition of this body as generally positive. Its purpose is to approve budgets and debt-restructuring provisions in an effort to help stabilize finances in Puerto Rico. While we had been comfortable with legal protections in place before appointment of the Board, we are constructive on the benefits of working with all stakeholders to craft good outcomes for holders of Puerto Rico municipal bonds. Historically, control boards have achieved positive results. Control boards that were established for New York City and Washington D.C. are two examples of the potentially positive outcome for this structure. While Puerto Rico failed to make most scheduled interest payments called for on July 1, we believe that institution of the financial control board bodes well for the likelihood of bondholders receiving some payments in the future.
Our negotiations with PREPA, Puerto Rico’s Electric Power Authority, may benefit from intervention of the Board. A Restructuring Support Agreement (RSA) reached last September, under which bondholders would be offered investment-grade bonds replacing existing bonds at 85% of face value, hinges in part on an investment-grade rating of the replacement bonds. We consider it very possible that activities of the Board may help to facilitate investment-grade rating of these new bonds, and that resolution of PREPA bond restructuring could follow promptly.
We believe that ancillary benefits of Board activities bode well for Puerto Rico municipal bonds generally. With a clearer view of potential positive outcomes, the municipal bond market has slowly begun to recognize the potential of these investments, pushing prices up gradually. While Puerto Rico has been the topic of many financial discussions in recent years, causing some investors to disgorge investments in Puerto Rico municipal bonds, we have stayed the course. We continue to believe that there is upside price potential in these bonds, and that the market is now starting to recognize this potential. Working closely with Puerto Rico and various stakeholders, maintaining an in-depth understanding of the Commonwealth’s finances and consistently protecting the rights of bondholders has enabled us to provide our Funds’ shareholders with highly attractive yields in an increasingly challenging yield environment. We will continue to actively participate in developments as we push toward positive resolutions.
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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.