Muni experts take stock of the decade past and assess the 2020s
Turning the page to a new calendar year and a new decade will bring the potential for continued heavy volume, improving credit quality, and overall favorable fundamentals, according to municipal experts.
“We are at a much different point as we begin this decade compared to the last,” Tom Kozlik, head of municipal strategy and credit at Hilltop Securities Inc., told The Bond Buyer in the last week of 2019. “Ten years ago, one of the worst recessions and financial downturns occurred and the worst was still yet to come for municipals and municipal credit."
In a Dec. 18 report, Kozlik called the last 10 years “the most eventful decade in the modern history of the municipal bond market,” citing the 2009 Recovery Act, the debt ceiling crisis of 2011, the "taper tantrum" of 2013, Chicago’s downgrade to junk, Puerto Rico’s $72 billion fiscal crisis, Detroit’s bankruptcy and the federal tax bill of 2017, which eliminated advance refundings.
The Affordable Care Act, as well as a new era of federal regulation, the threat to tax exemption, Superstorm Sandy and federal disaster aid, and increasing electronic and algorithmic municipal trading are among the decade’s other key events, according to Kozlik.
“If there is a key influence that can be considered as a takeaway from the last decade, it is that U.S. monetary policy has been a notable driver of municipal market activity and performance,” Kozlik wrote.
“In the last half of 2019 and going into 2020, that is still the case,” he wrote, noting that U.S. monetary policy remains at center stage as 2020 arrived.
New year, continued strength
Other experts said the market will remain strong in the New Year, albeit slightly weaker.
“2019 was an exceptionally good year,” said Karel Citroen, head of municipal research at global investment manager Conning.
“Quarter over quarter if rates stay where they are, it seems like there are a tremendous amount of deals in the pipeline,” he said.
The municipal market will reflect strong levels, though down from the “very solid and exceptional levels of 2019.”
Citroen expects a slight weakening in credit fundamentals, and market technicals to be less favorable in the early part of 2020 than the second half.
“Combined with favorable fundamentals, it’s going to mean we are looking at a good first quarter of the year,” Citroen added.
Overall weakness in the municipal market might spook investors, but demand will still chase municipals nonetheless, according to Dan Heckman, managing director at U.S. Bank Wealth Management.
“There will still be decent demand for munis, but supply could perhaps overwhelm and create a little softer environment,” he said.
“In terms of pricing, we could start the year off on the weak side,” Heckman continued. He said he expects the “incredible run” of cash flows into the municipal market in 2019 to slow in 2020’s first quarter as some investors search for other ways to produce income or greater rates of return.
Issuance in January could set a stronger volume tone for the first quarter and serve as an incentive for issuers to come to market sooner in 2020, in contrast to 2019's sluggish start, Heckman noted.
“We may not see issuance as plentiful as we saw in the last five months of 2019, but it should be higher than the first seven,” Hilltop's Kozlik said in an interview.
He predicts a record $450 million of muni primary volume in 2020. The market topped $421 billion in 2019.
Heckman said issuance will be impacted by the actions of the Federal Reserve Board. Any increase in municipal issuance in 2020, according to Heckman, could result from issuers trying to get ahead of higher interest rates.
Citroen said the municipal market could experience headwinds in the first and second half of 2020, but for different reasons.
From a technical side, the first half of the year will be slightly less favorable than last year, especially with respect to a decrease in net supply from 2019 levels, which will impact yield and spread levels.
In addition, while there has been moderate revenue growth and expenditure discipline among municipalities, he expects credit metrics to weaken slightly from the strongest levels seen in 2019.
“This is a time to go up in credit quality and make sure you’re positioned in sectors that are not as volatile,” such as transportation and airports, Citroen said.
While he believes the parade of issuance will continue in 2020, supply may be curtailed in the second half, according to Citroen, who has been at Conning for five years and in municipal research for a decade.
“At some point, the election will take over the headlines and create friction and impact muni valuations — in sectors like health care or higher ed — as well as have credit implications,” he said.
“A lot of attention will shift to debt discussion and a lot of what comes out of the candidate choice impacts municipal credit,” he said. “Any investors concerned about that will reduce demand."
The choice of Democratic nominee will dictate the tone of the second half of the year, both Citroen and Heckman said.
Some candidates may have more aggressive tax proposals than others — but, in general, the proposals have a bullish impact on municipals, Heckman noted.
“The market right now is viewing the chances of any tax increases next year as being remote, but that could change as the field narrows and the leading candidate emerges out of the Democratic primaries,” he said.
Any reduction in demand from traditional municipal investors should be offset by the expectation for continued demand from crossover buyers in 2020, experts said.
“They have been buyers of taxable munis and I do expect that to continue as more investors are seeing the value of muni bonds relative to corporates and agency debt,” largely due to the lower default rates, Citroen said.
“International and crossover buyers are likely to pay more attention to municipals because of the higher amount of available product,” Kozlik said.
While Kozlik said he is not certain if 2020 will bring about significant political change, he says the potential for unknown political shifts at some point in this decade seems likely.
“This could be demographically and financially charged,” Kozlik continued. “This could have a moderate to significant impact on municipals in different ways, including items related to tax policy but also credit.”
“Looking further into the decade, we think that state and local government credit is not as prepared for the next recession — whenever it comes — as it was for the last,” Kozlik wrote in his review. “We are concerned about a lack of federal cushion when times get rough.
“While topics like cybersecurity and climate change are issues to watch, we believe that the stress pensions are likely to bring in this next decade are quantifiable and concerning,” Kozlik continued. “The potential stress from pension needs are much more concerning now in 2019 than they were in 2009.”
Advice for the future
Given the prospect for strong market fundamentals, experts say investors should structure their portfolios with quality and intermediate term paper to maintain the best investment opportunities.
Citroen recommends investors move up in credit quality in 2020, particularly in single-A and double-A paper with low default rates compared with corporates that have an average rating of triple-B plus.
Revenue sectors like water, sewer, electric, and utilities are sectors Citroen recommends because of their essential service nature, high usage, dedicated revenue stream, and because they are unaffected by a municipalities’ potential credit issues.
Health care and higher education sectors are more vulnerable because of their potential credit issues, he noted.
While Heckman doesn’t see any immediate threats to credit quality, he said investors should do their homework.
“We are at a point in the cycle where you want to avoid weaker credits and areas where there’s been creative and more aggressive financing,” with less credit quality, Heckman said.
He said a barbell structure should promote the defensive posture that investors need in the first half to find the best value compared with long-term investments. He suggests a structure with allocations to variable-rate demand notes in one- and two-year maturities coupled with 12- to 15-year municipals.
“Predictions are all over the place for next year, but until we get a better read on economic activity it bodes well to have a defensive stance going into 2020,” Heckman said.
He also suggested investors taper duration, and maintain an extra allocation to cash equivalents or short-term bonds that can be quickly converted to longer-term positions.
Kozlik said the political events this year are likely to be impactful on the municipal market, though what those impacts are is uncertain.
“The policy areas that are most concerning to investors have to do with fiscal policy, tax policy and trade policy — especially with China,” he wrote in his report. “These are subjects that are, like usual, difficult to predict no matter who stays or enters the White House.”
Heckman said every decade brings with it lots of challenges, but he expects the municipal market to rise to the occasion.
“There is a tremendous need for infrastructure in the country and hopefully the muni market can play a role in addressing that need nationally,” Heckman said. “The big story will be if the municipal market is used as a financing vehicle in a greater way for the nation’s infrastructure needs in the next decade.”