Municipal markets at midyear: A focus on the Fed, rating agencies

Our market outlook as we entered 2015 called for low- to mid-single-digit returns. We based our expectations on the market’s generating enough income to offset any potential price degradation resulting from higher interest rates. The consensus view at the time called for the Federal Reserve to begin tightening monetary policy by raising the fed funds rate in June. We did not share the consensus timeline. Instead we called for a potential later starting date predicated on the Fed’s having confidence, based on the data, that the economy could withstand a rate rise and that inflation was heading back toward the Fed’s longer-term goal. That said, we did also believe that the Fed would raise rates by year end.

As we exit the first half of 2015, it is still not certain when, or if, a potential liftoff will occur. Instead, similar to 2014, investors have had to contend with various cross currents that have made predicting interest rates anything but certain.

  • Apart from relatively solid employment data, the U.S. economy once again had a poor showing in the first quarter of 2015, posting mixed economic data.
  • As we navigated through the second quarter, exogenous factors combined to create volatility for investors as markets vacillated between “risk-on” and “risk-off” sentiment. Investors dealt with growth concerns in the euro zone, a slowing economy in China along with a severe stock market selloff, monetary policy actions across foreign central banks, turbulent times in the geopolitical arena, and the debt crisis in Greece.

The Fed obviously did not raise the fed funds rate in June and while consensus now calls for a liftoff as early as September, arguments can be made that the Fed has reason to delay doing so in the current environment. Despite no action on monetary policy in the first half of 2015, the rates markets did sell off ahead of anticipated action. This has often been the case historically.

Aggressive refunding, increased supply

Interest rates greatly influenced technical factors in the municipal market in the first half of the year. The most significant occurrence was the aggressive refunding activity municipal issuers embarked on that led to higher municipal supply than anticipated. The first half of the year saw approximately $215 billion in aggregate supply, according to Bank of America Merrill Lynch, up approximately 43% year over year. New supply was driven by refunding activity, which made up approximately 65% of total issuance. The increase in refunding activity has caused analysts to raise estimates for 2015 total aggregate supply, from the $375-390 billion range to $400-425 billion.

On the demand side, flows were positive into tax-exempt bond funds, with approximately $8.64 billion placed into municipal funds in the first six months of 2015, according to Lipper data. The market finished the period on a negative trend, however, experiencing eight consecutive weeks of outflows from tax-exempt bond funds as news around Greece, falling stock markets in China, and statements from Puerto Rico’s Governor Alejandro Padilla concerning the commonwealth’s inability to repay its $72 billion in municipal debt added to heightened volatility in the market. At this time, however, there has been little if any contagion to other parts of the municipal market resulting from the Puerto Rico credit crisis. (Source: Bank of America, Merrill Lynch.)

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Municipal supply ($ billions)

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Municipal supply ($ billions)

Aggressive refunding activity has led to higher-than-anticipated supply in the municipal market.

Source: Bond Buyer

Past performance does not guarantee future results.

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Municipal fund flows ($ billions)

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Municipal fund flows ($ billions)

Mutual fund flows into the muni market have been positive through the first half of 2015. News from Greece, China, and Puerto Rico, however, caused outflows later in the period.

Source: Simfund.

Past performance does not guarantee future results.

Rating agencies’ new focus changes the muni market

Rating agencies’ change in posture was one other noteworthy development for the municipal market during the first half of 2015. Specifically, the rating agencies are now laser-focused on issuers that have either neglected making necessary pension payments or actuarially required contributions (ARCs), or continue to use one-time measures to close budget gaps. We have made note since the summer of 2013 and the adoption of Governmental Accounting Standards Board (GASB) statements 68 and 69 that issuers’ net pension positions would be clearly stated in disclosure documents and that entities that have been neglectful would suffer disproportionally under new guidance for the discounting of future cash flows.

As a result, we have believed since that time that the market would begin to bifurcate between issuers that have been compliant and those that have not. These developments began to take shape in 2014 and have since continued. The rating agencies downgraded several large names during the first half of the year, namely, the states of New Jersey and Illinois, the City of Chicago and the Chicago Board of Education, and the Commonwealth of Puerto Rico, all of which share bloated pension obligation deficits. Markets have made significant adjustments to trading levels of issuers that continue to underfund pension obligations and/or continue to use one-time measures to balance budgets. States such as Connecticut, New Jersey, Illinois, and Pennsylvania have seen their credit spreads widen over the first half of the year on such concerns.

First half performance analysis

The municipal market had a slightly positive return in the first half of the year, as measured by the Barclays Municipal Bond Index, returning 0.11%. The index’s 2.1% return from income was offset by a -1.99% return from price performance. The municipal market experienced a steepening of the curve as demonstrated by the Municipal Market Data (MMD), with AAA general obligation (GO) 2-year spot up 12 basis points in the first half while the 30-year spot was up 42 basis points. Examining individual segments of the curve, the 5-, 3-, and 7-year spots were the top performers, returning 0.59%, 0.39%, and 0.31%, respectively. The worst performing segments of the curve were the 22+ year segment, or the long end, which finished down 0.04%, and the 15-year segment, which fell 0.28%. (Data: Barclays.)

From a credit perspective, the best performing investment grade credit segment was the BBB category, which returned 0.70%, followed by AA-, AAA-, and A-rated bonds, which returned 0.15%, 0.05%, and generated a flat return (0.00%), respectively. In the below investment grade segment, the Barclays High Yield Index returned -1.92% in the first half of the year. If you consider that Puerto Rico issues make up 26.1% of the Barclays High-Yield Municipal Bond Index and returned -10.99% for the period, the return was actually positive. When you strip out the Puerto Rico exposure in the Barclays High-Yield Municipal Bond Index, for example, the index return was +1.86%. (Data: Barclays.)

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Returns by quality: Investment grade versus high yield

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Returns by maturity: Barclays Municipal Bond Index

From our perspective, the overweights we carried through the first half of the year among BBB-rated securities, along with those rated below investment grade, generally helped offset the 15-30 year curve exposure we like to deploy. Since we have no below-investment-grade Puerto Rico exposures, our credit selection process was generally a positive contributor to performance in this segment of the portfolios. These categories, BBB and below investment grade, provided the income in the portfolios that helped offset the negative price action from rising rates.

From a relative value standpoint, municipal ratios, or the relationship between AAA MMD GO levels and their respective U.S. Treasury counterparts, also showed volatility in the first half of the year, but ultimately closed cheaper than the start of the year. The 10-year ratio closed June 30 at 97.75% after reaching a high of approximately 106.5% during the first quarter. The 30-year ratio finished the period at 105.69% after reaching a high of approximately 113.5%, also during the first quarter. These ratios widened 3.83 and 1.63, respectively, from the start of the year. We have purchased municipals opportunistically on ratio widening for some of our core taxable strategies as an attractive investment alternative to U.S. Treasurys.

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Returns by quality: Investment grade versus high yield

Generally speaking, performance was inversely correlated to credit quality in the first half of 2015

Past performance does not guarantee future results. Chart is for illustrative purposes only.

Data: Barclays.

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Returns by maturity: Barclays Municipal Bond Index

There were no clear performance patterns by maturity segment within the municipal bond market for the first half of 2015.

Past performance does not guarantee future results. Chart is for illustrative purposes only.

Data: Barclays.

A look to the second half of 2015

We continue to focus on adding quality investments to the portfolios in an attempt to maximize total return opportunities for our investors, using our time-tested credit selection process. The first half of 2015 experienced a rates selloff amid market volatility. The markets await the Fed’s tightening monetary policy, but must digest the impact from the aforementioned events, each of which independently affects the markets.

For municipal investors, we believe the heavy supply experienced in the first half of the year will only resume into the second half if rates stay in their current trading range. Municipal bonds’ correlation to U.S. Treasurys should continue to impact trading levels and the market will remain focused on the various credit-related issues into the second half of the year. Thus far, Puerto Rico’s debt crisis has been compartmentalized and not had any major impact on the broader market and particularly the high yield municipal market. We are monitoring secondary trading activity and fund flows, in particular, to gauge investor sentiment and will continue to focus on navigating through market volatility with the goal of opportunistically adding solid, income-producing securities as they emerge.


The views expressed represent the Manager's assessment of the market environment as of July 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Credit quality ratings: AAA refers to the highest rating; extremely strong capacity to pay principal and interest. AA is considered high quality with very strong capacity to pay principal and interest. A generally means an issuer has a strong capacity to pay principal and interest but may be somewhat more susceptible to the adverse effects of changing circumstances and economic conditions. BBB is defined as an issuer having an adequate capacity to pay principal and interest; these issues normally exhibit adequate protection parameters, but adverse economic conditions or changing circumstances are more likely to lead to weakened capacity to pay principal and interest than for higher-rated bonds. BB, B, CCC, CC are each considered to be predominantly speculative with respect to the issuer’s capacity to meet required interest and principal payments. BB refers to the lowest degree of speculation; CC is considered the highest degree of speculation. Quality and protective characteristics outweighed by large uncertainties or major risk exposure to adverse conditions. D - In default.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

Bond funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.

Funds that invest primarily in one state may be more susceptible to the economic, regulatory, and other factors of that state than funds that invest more broadly.

Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to state or local taxes and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.

The Bloomberg Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.

The Bloomberg Barclays High-Yield Municipal Bond Index is composed of US dollar-denominated, noninvestment-grade, tax-exempt bonds for which the middle rating among Moody's Investors Service, Inc., Fitch, Inc., and Standard & Poor's is Ba1/BB+/BB+ or below.

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