Inauguration, New Policy and The "I-Word"?
January 25, 2021 | Cameron Parkhurst
Good Day Friends,
It has certainly been a newsworthy few weeks entering into 2021. We have seen political chaos, have ended up with Georgia Senate elections swinging to the Democratic side of the ledger, thus giving The Democrats control of overall policy. We are currently seeing a transition of The Presidency and have also seen a historical storming of the Capitol Building by rioters. Regardless of which side of the aisle you focus your political views, these are all extremely newsworthy events and, in some cases, can help drive markets as we proceed through 2021 and beyond.
On the COV-19 front, we are in what most would consider a middle ground area. The vaccine is now out and being distributed to government workers, medical personnel, and those over the age of 65. More widespread distribution is warranted, however, as we have also seen a resurgence of the virus in many states, and death tolls on the rise. This is a constantly evolving situation and is likely the major driver of decision making for most players currently.
We have seen another round of stimulus that has been brought to the table and distributed by the outgoing Trump administration. All the while, incoming Joe Biden is talking in goodly detail about a new round of an additional $1.9 trillion to be planned for distributions quickly after inauguration. This, along with both Fedspeak/Fed action and many major Biden policy initiatives, will help determine what kind of inflationary scenario we may see unfold over the next few years. One item that is consistently discussed ad nauseum in our team meetings is the possibility that we might see inflation looking out into 2022-2023 and beyond, especially if certain initiatives take affect and the economy keeps chugging along at a good pace. A lot of this ultimately depends on where all the “free” money flows.
With these themes as the major overlying factors, lets look at the interest rate landscape before focusing on the muni/taxable muni world:
First regarding rates in general - In Fed dialogue last month, there was a renewed vow to essentially continue the lower bound, zero interest rate mentality for Fed Funds through at least 2023. See the dot plot chart below:
In an interview with CNBC, Thomas Barkin, the Richmond Fed Bank President said, “I do think you’re looking at a second half (of 2021) that is going to be very strong and the question I think is how do we get through where we are today to that second half.”
The Fed plans to continue the purchasing of bonds at a $120+ billion monthly clip (mainly Treasuries and Agencies/MBS) until it has seen significant further improvement in the unemployment rate. It is also open to keeping inflation hotter vs. colder as a bias, bring it to and possibly above 2% if necessary. Some Fed Presidents with voting power believe that the second half could provide strong GDP numbers upward of 5% and this could ultimately lead to the tapering of bond purchases to some extent. However, if this tapering happens, the Fed has indicated that they want to be very careful in communication to not induce “taper tantrum” like what we saw in 2013.The goal is to not cause rampant market volatility and move rates significantly upward. A lot of this is dependent on the results of a feedback loop regarding these proposed policy initiatives and upon the efficiency of vaccine distribution channels. If all goes according to plan, the Fed could be walking a tightrope between inducing some of these tapering tactics/possible Fed Funds changes and keeping the economy moving forward without causing rampant inflation nor a slowdown effect (if action is too aggressive on increasing Fed Funds eventually).
Now to muniland. This is our primary focus after thinking about general interest rate scenarios.2020 was a very interesting ride to say the least. Rates were plunging early in the year, followed by one of the quickest sell-offs we traders have perhaps ever seen in March. At that point there was quite a lot of uncertainty regarding the Novel Coronavirus, and investors were essentially running for the hills. Once it became clear that the Government was going to step in in a variety of ways to support the national and local economies, we saw a grind lower in rates throughout 2020.We have recently seen a retracement to a small extent, with some analysts beginning to discuss inflation, the Georgia state vote moving the probability that we will see increased stimulus/ infrastructure development, and various credit stories unfold.
The muni market has become fairly bifurcated, with some sub asset classes, in our opinion, providing better risk reward tradeoffs. We will walk through a handful of them below. A lot of the bifurcation involves continual analysis of how the COV-19 pandemic has significant impacts on various municipal revenues, especially usage and tax revenue.
Large metropolitan areas are at the forefront, with there seemingly being a large bias towards both teleworking and residents making the choice to potentially move out of populous areas. Some statistics indicate that 50% of the labor force continues to work from home, even almost a year into this pandemic. Another key point is that those working from home are typically higher wage earners than those who are in offices. Most of these portions of the labor force also indicate through polling that they would prefer to remain in a teleworking environment, even after the pandemic. If this were to come to fruition, it would lead to fewer people shopping, eating and using
various facilities in large urban centers.It would have direct effects on sales tax revenues, public transportation systems, commercial real estate (property taxes), etc.
Transportation bonds currently seem to be rather volatile. Obviously, ridership on planes, subway systems, etc. has been minimized with COV-19. One chart that we have often referred to is the current TSA checkpoint travel numbers relative to 2019 levels. See below:
In late spring of 2020, we saw ridership drop to around 9% of what is considered “normal”. It slowly gained ground as some travelers became more comfortable with traveling under precautions. One report showed ridership creeping back above 53% leading up to Thanksgiving 2020. However, we have seen a reemergence in COV-19 in many areas, and it has caused ridership to again plummet, even net of the increased vaccine distribution.
Decreased ridership has many direct and indirect effects. First, direct passenger revenue is depressed, causing airlines to entertain laying off staff, cutting back flight schedules, taking on more debt/leverage, etc. Secondly, there is a decrease in revenue generation of airports in general, as well as restaurants, concessions, parking lots, etc. at these facilities. This leads us to a choice of certainly avoiding bonds of the small regional airports for the time being. Larger hub airports may be less problematic, due to various agreements that will allow them to maintain enough cashflow to service debt, continue major operations, etc. More importantly, there are questions as to whether business travel will ever get back to pre-2020 levels due to the efficiency of video calls and other ways of communication. This could have long term impacts on small regional airport bonds.
While commercial road traffic seems to be strong, driven by online retailers, we have seen civilian traffic slowly rebuild on roads as well. Most major tollways seem to be in decent shape. However, switching to major urban transportation systems, they are really struggling. MTA for example has maxed out credit facilities and is asking for more subsidy money. They have indicated that they may have to cut capacity by 40% to stay alive. It seems like the typical “too big to fail” situation…but is this reality? If the population in a major area like New York City does not come back, what happens to mass transit systems? We are avoiding these bonds.
Hospitals are full but are struggling. Most have transitioned to lower margin, essential practices around COV-19. The gravy train for hospitals has historically been elective procedures, requiring fewer staff, supplies and involving much higher margins. Hospitals did benefit from CARES Act subsidies and emergency funds, but if this pandemic is long term, they will be under stress. Our focus here continues to be on major teaching institutions and not on buying regional hospital bonds.
Lastly, returning to higher education bonds. There has been a drought of returning students and many campuses are closer to empty than full. It seems that a good percentage of students chose to take the year off, rather than potentially get exposed. Online learning has a similar effect that the airports have – students are not using many campus and local facilities when learning over the internet. This can have impacts on revenues for both the colleges and the local municipalities surrounding them.
The focus on higher ed is the major, reputable colleges and state level universities. These have much more stable cash flows than many small, private and community colleges that are more significantly tuition based.
Utilities – this is our favorite sub-asset class when we can access essential service bonds. They typically have the most stable cash flow scenarios, as residents of a municipality pay these services to live prior to other lesser debt. The one problem is that utilities are currently a very rich sub-asset class and have been difficult to bid and win paper at reasonable levels.
We are staying the course on our strategy of buying high quality munis and taxable munis in the secondary market, focusing on odd lots and using the bid side to add incremental yield to portfolios. We favor high quality and less than benchmark duration here. We have continued to see better spreads for the risk taken in taxable munis vs. corporates, and tax free munis continue to stick out as attractive in most instances for higher tax bracket clients.
Finally, as we have said before, the playbook of our focused sub-asset class securities will likely open up a bit as we see the efficacy of the vaccine and its impacts on markets, but we will remain cautious and continue to perform systematic due diligence on held cusips for our clients. This will allow us to continue to be an excellent resource to our Advisors who rely on us to create business efficiencies and add value to their practice.
As always, if you have any questions or would like us to conduct a portfolio review for you, please do not hesitate to reach out.
Your PeachCap Team
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