Why muni analysts have their caution flags out
Municipal analysts from Oppenheimer & Co. and Ramirez & Co. waved a caution flag this week, advising investors to be defensive and upgrade credit quality as political and financial uncertainty roil the market.
In separate reports, Jeffrey Lipton of Oppenheimer and Peter Block of Ramirez offered their views on everything from portfolio structure and price direction to credit quality and the potential for rising relative value.
“Investing in municipal bonds remains tentative as tax reform can still influence future institutional buyer preferences,” Lipton, managing director and head of municipal research and strategy and fixed income research at Oppenheimer & Co., wrote in a Feb. 20 report. “New issue market activity seems choppy with marques names having the right structure being oversubscribed, while other deals are struggling with price discovery.”
This was true this week and last, as there was a tentative market for several of the biggest deals and buy-side sources said retail muni investors were playing a guessing game over the direction of interest rates.
The three biggest deals this week -- the L.A. Unified School District, Utah Transit, and New York City -- hit an uncertain market on Wednesday and Thursday looking to sell bonds as investors pondered the future of interest rates, traders said.
“Given that in our view, credit quality has plateaued with certain late cycle trends moderating, we are likely to see an emergence of material credit spread distinctions as we move through the next 12 to 18 months,” Lipton said. “This may be particularly evident on a sector-specific basis.”
Oppenheimer views municipal bonds as a “viable investment choice for a broader asset allocation strategy,” he said. “Patience and active security selection can yield ample rewards for the savvy investor.”
Lipton suggested municipal investors reevaluate their portfolio holdings with an eye on trading up in credit quality and further diversification moves as “market dislocations come about in what is likely to be a more volatile trading environment throughout 2018.”
Rising short-term rates have led to strong inflows among tax-exempt money market funds since the start of 2018 and increasing appeal of short-term structures. Lipton said investors should be wary of that trend.
“Until the muni market receives better price direction and there is more comfort from the institutional buyer base, we caution against overly relying on fund flow data as a gauge of relative market demand,” Lipton said. “Given previously stated concerns over the President’s infrastructure proposal, we do not see material added volume over the near-term that would lend itself to price discovery.”
The loss of tax-exempt advance refundings, he said, may give rise to more restructured call optionality on the shorter side, as issuers may consider the use of various derivative techniques as alternatives to advance refundings. However, Lipton said, “caution should be exercised as these mechanisms usually come with their own risk profile.”
At the same time, there could be an advantage to changing market conditions for some investors, he said.
“Any appreciable shift in market technicals which brings considerably heavier volume could impact muni returns and give rise to higher relative value ratios -- a scenario which could present more appealing entry points, particularly for cross-over investors,” Lipton added.
Under current market conditions, Ramirez & Co. recommends investors use a laddered strategy, defensive posture that includes five-year effective duration and seven-year weighted average maturity; and 5% plus coupons that offer lower convexity versus a 4%, Block, managing director of credit strategy, wrote in a Feb. 20 weekly municipal report.
The firm recommends investors stick with double-A GO or single-A or higher rated revenue bonds, while it also favors intermediate to long bonds with shorter calls of five to eight years versus a 10-year call. In the report, Block said “cheaper versus longer calls capture better spread and roll down, and faster reinvestment,” with the best roll down range being eight to 15 years.
He said hope for higher interest rates is dictating many investors’ investment decisions while the market awaits overall price direction towards cheaper levels.
“The muni market remains awash in secondary supply, particularly of intermediate and long bonds, as accounts attempt to reposition portfolios for a higher rate environment by selling bonds 10 years and out,” Block said, adding that dealer inventories remain elevated at over $22 billion or 20% above average.
There is an investor preference for short duration paper, which is being well bid, as are general market California and New York issues maturing in less than 10 years, according to Block.
“We expect the market to remain somewhat tenuous overall until the secondary supply glut clears and bonds are repriced cheaper,” he wrote. “This is particularly the case in the lower-demand 10-year to 30-year spots, where bonds are between seven and nine ratios rich versus three-year averages,” he said. Stronger demand inside 10 years could surface if and when the 10-year Treasury breaches the “psychologically-important 3% level.”