Outlook 2016: Municipal issuance to stabilize as refundings dry up; $350 billion of supply eyed

By Sheri Kasprzak

New York, Dec. 31 – The municipals landscape is likely to change somewhat in 2016, market insiders anticipate, as higher interest rates could discourage refundings and improving economic conditions will encourage new-money deals.

Despite a projected decline for refundings, new-money issuance is expected to grow about 10% as postponed infrastructure projects are financed and gradual economic improvement continues, said Alan Schankel, managing director with Janney Montgomery Scott LLC.

Between the decline of refundings and the rise of new-money deals, some market participants expect supply to slip a bit to $350 billion in 2016 with volume predictions ranging from $325 billion to $375 billion.

Issuance year to date for 2015, as of Dec. 11, was $372.9 billion, up 24.9% from the same year-ago figure, according to data from Sifma.

But maybe not ...

Although some market insiders expect refundings to fall in 2016, others feel the number of bonds eligible for refunding in 2016 will bolster them.

“Estimates are $250 billion eligible for possible refunding in 2016 compared to $220 billion in 2015,” said Craig Elder, senior fixed income analyst with Baird & Co., in a note.

“The caveat is that if rates spike higher, it could dampen the activity in refunding,” Elder said.

Tom Kozlik, municipal strategist with PNC Capital Markets LLC, agrees that refunding issuance will be driven by the interest rate environment.

“There are likely still going to be refunding opportunities issuers can take advantage of in 2016,” said Kozlik.

“New money issuance will almost certainly remain below the 2001 [to 2010] average.”

Even though infrastructure upgrades are still needed in the United States, revenues to support new debt service are scarce, he noted.

“Policymakers’ political will in support of infrastructure is waning, despite recent proposals and rhetoric,” he added.

Rate hike matters

The big question on muni investors’ minds as the year wound down was the Federal Reserve’s highly anticipated interest rate hike. The Fed finally pulled the trigger at its December meeting on Dec. 15, raising the range of its benchmark rate by 25 bps to 50 bps. But what exactly does the hike mean for muni investors?

“For municipal bond investors, the question is whether to wait for the Fed to move – and for the possibly higher yields that could come as a result – or capture the current yield,” said John Dillon, municipal bond strategist with Morgan Stanley Wealth Management, in a December note.

“Looking back, municipal bond investors have been rewarded for stepping in at the top of trading ranges. Is this time different?”

Dillon noted that historical context might prove helpful here.

The Barclays Municipal Index, he said, has posted a 2.44% total return for the year-to-date through Nov. 30. Ten-year triple-A muni yields have risen by 1 basis point to 2.02% over the same period.

“During a volatile 2013, the benchmark 10-year muni yields rose by 31 bps and the loss to the index was 2.55%,” Dillon said.

“Coupon income plays a major role, as the average coupon in the Barclays Municipal Index is 4.81%, which is consistent with our advocacy of owning bonds with 5% coupons.”

Bond duration is another significant consideration for this rate hike, Dillon said.

“Shorter client portfolio duration is often driven by the combination of bond refundings and maturing or called bonds, along with a reluctance to move out on the yield curve due to concerns about rising interest rates,” he said.

“Since we suggest a slightly more defensive structure than the index, the losses that may occur from interest rates moving higher are likely to be less than that of the index. In the interim, muni bondholders continue to be paid to wait during what most market participants believe may be a long, slow trek to a less-accommodative monetary policy.”

Moving back to historical perspective, during the last rate hike, the benchmark 10-year triple-A muni significantly outperformed Treasuries with the 10-year relative value ratio beginning at 86% and ending at 80.2%.

“Given today’s elevated relative value ratios – the 10-year is 91% – munis could outperform Treasuries even as rates rise,” Dillon wrote.

“Select entry points have now emerged, as interest rates have risen ... Be aware that 70% to 90% of the yield available in 30-year bonds can be captured within the 11- to 18-year maturities. We expect the yield curve will flatten post-liftoff, with longer maturities outperforming shorter maturities.”

Water pressure ahead?

Looking to specific sectors, water and sewer utilities will face increased pressure from rising costs and lower sales, Fitch Ratings managing director Douglas Scott wrote in a report released in early December.

“Drinking water projects like saltwater desalination and recycled water that would have been inconceivable a decade or so ago are starting to become a reality as traditional sources have come under severe pressure,” Scott wrote.

Ratings agencies like Fitch will watch water supply stability in the coming year, particularly in areas like California, which grapples with a 25% statewide mandatory conservation requirement.

Looking to cash flow, many water and sewer providers are not charging enough, Scott said.

“Financially, the sector continues to post healthy debt service coverage margins and cash balances are exceptional,” he wrote.

“But generally the sector has not charged enough for its services to pay for upkeep of its pipes and treatment facilities. Recovering these costs from customers is a growing concern given numerous studies pointing to significant investment needs to maintain existing service levels in the coming year. Recent legislation signed by the president will provide utilities with a new tool to help finance replacement costs, but Fitch believes borrowings will remain modest in 2016.”

School spirit generally high

Moving to the higher education sector, U.S. colleges and universities should be stable in the coming year, but the sector is not without pockets of concern, said Fitch senior director Joanne Ferrigan, in a note.

“Small, tuition-dependent schools in demographically declining areas or highly competitive regions will experience greater pressure,” Ferrigan wrote.

“Overall, the sector may become more bifurcated with stronger institutions maintaining their positions and the weaker losing ground.”

Declines in high school graduates indicate demographic shifts in student demand, Ferrigan noted.

“Given that these shifts were anticipated, institutions with proactive management ostensibly have had time to assess their competitive position and shape enrollment strategies,” she said.

“Macro issues, like constrained family finances, job attainment post-graduation and student loan access, are playing a more prominent role in affecting demand and will be closely watched.”

Meanwhile, liquidity improved for most Fitch-rated colleges and universities in 2015, driven by positive investment performance, which would mitigate demand and operating challenges, Ferrigan wrote.

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