INSIGHTS

On December 06, 2017

The “Hack” For Fixed Income Portfolios?

Browse through any social media post and you will no doubt get countless advertisements about productivity hacks, smartphone hacks or any multitude of hacks meant to make life easier or less complicated (two different things in actuality). Due to a confluence of factors from the tax bill and uncertainty arising from it, the municipal market is front and center in the fixed income markets. One area of focus for us in the last two years is controlling our duration, and most recently is beginning to step up credit quality on a methodical basis.

With the market awash in the unnatural negative interest rates and low yields on nearly everything fixed income, controlling duration has been secondary thought to most investors. Most have been stretching for yield of any kind and has caused some concern about shifting fund flows going forward when rising rates begin to take its toll.

The Federal Reserve began raising short-term rates in December 2015. As is the case when they begin raising rates, the curve flattens for a multitude of reasons (which I detailed in my November commentary). However, in evaluating history, some interesting conclusions about tax-exempt municipals and their response to Federal Reserve rate hike cycles is very interesting.

First and foremost, the swirling winds that are tax legislation has thrown a very large kink into the markets as a tremendous amount of new issue is projected in the slowest trading parts of the year. Many are trying to get in some refundings and access capital markets in case the new tax law restricts them from doing so next year. This has caused a large selloff as the market was not prepared for new supply of this magnitude. It has also created a unique buying opportunity for those who benefit from tax-exempt bonds. Though there is always a risk when tax laws abruptly change, comparing the most probable event allows for buyers to benefit from this dislocation. To further amplify the potential of this opportunity, consider that many see a negative net new issuance in municipals next year. JP Morgan is expecting a negative net new issuance of $120 billion next year based on tax changes and various other factors. Anyone remember supply-and-demand economics from their college courses? To put this in perspective, they are also expecting a net $2 trillion in total net new issuance for the year. The only other sector they are expecting negative net new issuance for 2018? Non-Agency mortgage-backed issues which have had negative new issuance annually every year since 2010.

I apologize in advance for getting in the weeds, but the conclusion of the work is worth it. Below is a chart showing the Fed Funds Target Rate and the Barclays Bloomberg Municipal Index yield to worst (YTW).

What stands out is the volatility of the Fed Funds rate relative to the yield to worst. One also notices the Fed Funds rate starts substantially below the yield to worst in each case only to accelerate well beyond the yield to worst in fairly short order. This is extremely important. In comparing the beginning spreads to ending spreads, traditionally the Fed funds rate begins 170 bps (basis points) below the yield to worst. At the conclusion of the Fed rate hike cycles, it finishes 144 bps above the yield to worst.

The following measures the change in basis points

Source: Federal Reserve, Barclays Bloomberg

One little note of explanation above; due to the fragmented rate hikes in the 1990s, I broke it into two scenarios, however, the average constitutes the longer economic cycles to give us a tool to see what the municipal market may be pricing in with regard to the Fed Funds rate. These are denoted by the green arrows in the chart below.

The average spread shows the yield to worst is an average of 114 bps higher than the Fed Funds rate over the long run. However, the range is dynamic with the standard deviation of the Fed Funds rate being 2.77% while the yield to worst of the Barclays Bloomberg Municipal index standard deviation is only 1.53%, or 40+%, lower. 

With a current yield to worst of 2.42%, we can reverse engineer what the municipal market may be pricing in as far as the future of the Fed Funds rate. Based on the average of a finishing spread in which the Fed Funds is 177 bps above the yield to worst, that gives us a Fed Funds rate priced in of 4.19%...or roughly 290 bps from our current position. Based on 25 bps hikes the Fed has raised so far (not a safe assumption to think this continues in our opinion), that would be 11.6 more hikes. If we take the most pragmatic view – much more sensible in our opinion – that puts the Fed funds rate at a 3.20%, or 190 bps from here and 7.6 rate hikes.

The average spread shows the yield to worst is an average of 114 bps higher than the Fed Funds rate. However, the range is dynamic and when the Fed begins raising the Fed Funds rate at the end. The YTW moves from being above the Fed Funds rate to being an average of 158 bps below the Fed Funds rate.

The standard deviation of the Fed Funds rate is 2.77% while 1.53% for the YTW of the Barclays Bloomberg Municipal Index – roughly 45% lower.

Considering most taxable bonds are trading at historic spreads to Treasuries, it is hard to conclude they are pricing in a number of rate hikes moving forward.

A couple of other “hacks” (we prefer “nuances”) with regard to municipal portfolios:

• Attempt to match municipal portfolios coupon to that of their duration number.

• Do this for both tax-free and taxable municipal portfolios.

• In taxable municipals, target market or index returns to the first call, but have such coupons that if not called in first call, you get significant bump to the second call.

• According to Moody’s, historically, municipals have had a much better credit profile than that of its corporate counterparts: since 2007 the five-year municipal default rate is 0.15% while the five-year global corporate credit default rate was 6.92%.

• Since 1970 through 2016, the default rate for all Moody’s rated municipal debt is 0.07%. This number has the potential to be skewed higher when the outcome of the Puerto Rico is taken into account.

• Historically, there are higher rated issues in municipals as compared to the global corporate universe.

There are some important caveats to this which should be taken into account. The current tax legislation is very fluid and could alter some of the issuance conclusions made above and also future changes to tax-exempt interest. Secondly, this is the slowest Federal Reserve Rate hike cycle in history. Historically the average number of rate hikes over the first 18 months is 18 bps per month on average versus the current pace of 5 bps per month since December 2015. These two conditions could adjust the conclusions made above. 

As buyers have stepped into the fold over the last few days, the analysis above should give reason to think that for those seeking credit quality and yield, municipals continue to offer value in light of higher rates in the future. We are being very selective in which issues we prefer to buy and which ones we believe should be stayed away from, and the issue that lay in each of these categories depends primarily on the needs of each client. Last but not least, we believe investors should have permanence and definition in their fixed income portfolios so as to know exactly what credit risk they have, defined and specific cash flows, and maturity and duration demarcated. This not only builds a personalized fixed income portfolio for each client, but is unique to them and their individual needs. 

CRN: 2017-1206-6289R