Supply-Side 'Muni-Nomics' Revisited

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Includes: AFB, BAF, BBF, BBK, BFK, BKN, BLE, BSD, BYM, CXH, DMB, DMF, DSM, DTF, EIM, EIV, EOT, EVN, EXD, FLMB, FMB, FMN, IIM, IQI, KSM, KTF, LEO, MEN, MFL, MFM, MFT, MHD, MMU, MNP, MQT, MQY, MUA, MUB, MUE, MUH, MUS, MVF, MVT, MYD, MYF, MYI, MZF, NAD, NEA, NEV, NIM, NMI, NUV, NUW, NVG, NXP, NXQ, NXR, NZF, OIA, PMF, PML, PMM, PMO, PMX, PRB, PVI, PZA, RVNU, TFI, VFL, VGM, VKI, VKQ, VMO, VTEB, XMPT
by: Neuberger Berman

By Randy L. Gross, Senior Portfolio Manager – Municipal Fixed Income

"I changed my password everywhere to 'incorrect.' That way when I forget it, it always reminds me, 'Your password is incorrect.'"

-Anonymous

The municipal market continued its positive performance in the third quarter, on the heels of geopolitical and natural disaster uncertainty (i.e., North Korea and devastating hurricanes), continued positive fund flows, and the ongoing lack of new issue supply.

A major theme for 2017 has been the scarcity of bonds as investors compete to invest a large amount of cash. New issue supply year-to-date, or lack thereof, has had a profound effect on market strength and investor behavior. One example is the continued rich valuations of five-year AAA municipals when compared with U.S. Treasuries. In addition to some investors' concerns about rising rates, reduced supply in five-year paper adds to the explanation.

As we move into the fourth quarter, supply is down around 17% year-to-date, totaling about $280 billion, as refunding deals have meaningfully decreased. Muni market pundits have been estimating a year-end total of around $350 billion, much lower than last year's historic $445 billion.

Over the last several years, we have learned that undersupplied markets can lead to positive performance, spread compression and, in turn, positive inflows into the muni market. In contrast, we have also seen sharp sell-offs and higher yields during oversupplied markets, as new issue deals are priced to sell. The major takeaway is that credit fundamentals can become underappreciated during periods of undersupplied markets.

And Lastly...

The FOMC recently announced that it would gradually reduce its holdings in U.S. Treasuries and mortgage-backed securities. This, in concert with a possible December 2017 rate increase and prospects for tax reform, could lead to another small step in the normalization of interest rates and potential increased volatility. Bonds are likely to once again be priced based on fundamentals, making security selection even more essential. As an active manager, we welcome such a scenario.

Market Highlights

State Budget Laggards

Connecticut and Pennsylvania became the last two states to pass their fiscal 2018 budgets in late October, after an almost four-month delay. But budgetary challenges remain for both.

In Connecticut, Governor Dannel Malloy, a Democrat, had been forced to operate the state under executive order during budget negotiations, and fiscal uncertainty for many municipalities worsened with the wait. If recent credit pressures persist, state budget negotiations in future years could prove problematic for many municipalities that rely on state aid to fund their operating budgets.

Meanwhile, Pennsylvania has had its own unique issues. It passed a $32 billion spending plan on June 30, but failed to pass a revenue plan to fund its budget shortfall of $2 billion. While Governor Tom Wolf, a Democrat, just approved a revenue package from the state legislature to cover the funding gap, Pennsylvania's budgetary struggles of recent years have become more problematic. During the budget delay, the state had to rely on internal fund transfers to cover some of its expenditures; and Wolf directed the state treasury to delay a $1.7 billion payment, mostly for Medicaid providers and school districts. Future budget delays could have significant negative impacts on multiple constituencies throughout the state.

Struggles in Puerto Rico

The prices of Puerto Rico bonds have fallen sharply in the wake of Hurricane Maria and President Trump's comments questioning the island's ability to repay its outstanding debt. This is despite subsequent statements from the White House attempting to soften the market impact. Regardless of the cause, many investors are now factoring in a larger haircut to potential post-restructuring valuations.

The devastation from Maria has been massive, destroying many homes and businesses, and extending to a shutdown of the island's electrical grid. Puerto Rico was already struggling with $70 billion in outstanding debt and an economy plagued by an unemployment rate of 2.5 times the U.S. average, a nearly insolvent pension system, and a more than 45% poverty rate. The economic and financial outlook for Puerto Rico is bleak, and there is growing concern about shifting demographics as many residents leave the island for the U.S. mainland.

-Stephen Cowie, Senior Research Analyst, Municipal Fixed Income

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