Revenue bonds tend to offer higher yields and entail risks that are typically more straightforward than general obligation bonds (GOs) for research-driven investors to analyze.
- Local government issuers face practical constraints on raising revenue, while large pension liabilities put a heavy strain on their balance sheets. These represent significant and sometimes difficult-to-assess risks for investors in local GOs.
- This has led yields offered by local GOs to now often match or exceed those of the broader municipal bond market — a sea change in muni bond pricing.
The muni market seemed to take Donald Trump’s victory in stride in the days following the November 8 presidential election. We’ll see what happens down the road, but the president-elect’s agenda for tax reform and infrastructure — by itself — appear unlikely to have a dramatic nearterm impact on munis. Understandably, the focus on how the environment for munis may develop under the next president is quite intense. However, today’s spotlight on possible longer term changes makes it all the more surprising that a recent structural change has received little fanfare. Not so long ago, general obligation bonds were viewed as the “safer” part of the U.S. muni market. Because of a state or local government issuer’s ability to increase revenues by raising taxes or fees, the argument went, many bond investors assumed that there would be little problem for these issuers to make coupon payments and return bond principal. For many years, investors were willing to receive about 10% less income, because they viewed local GOs as less risky than most other comparably rated muni bonds. From the end of 2008 to the start of 2014, for example, the average yield for investment-grade (rated BBB/Baa and above) local GOs was about 2.8% — roughly 30 basis points below the broader investment-grade muni market.
What a Difference Two Years Make Gradually, this benign perception has given way to a harsher reality. Starting in 2014, the market began to question whether local GOs actually entailed more risk than previously thought. Recent concerns over Chicago’s stability and bankruptcies associated with Detroit and Puerto Rico have helped crystallize a more unforgiving view. As a result, the yield discount of local GOs to the broader market has largely disappeared. What explains the dramatic repricing of local GOs, which account for 17% of the total issues and about 58% of the GOs in the investment-grade Bloomberg Barclays Municipal Index? Investors may be demanding greater return potential from local GOs, because they have recognized that local governments have:
- Potentially limited flexibility to increase revenues
- Large fixed costs
- Insufficient political will to address substantial and growing pension liabilities
For Local Governments, Reality Bites Although these risk factors have become more widely appreciated and better reflected in bond prices, they are not actually new. The extent to which specific issuers suffer these vulnerabilities also varies widely. For example, cost cutting may prove difficult to implement due to contractual arrangements and fixed costs in some municipalities, while others may face far fewer impediments. Similarly, the ability of local governments to increase revenues in a challenging fiscal environment may be severely limited in some cases but not others. Flexibility is dependent on the overall health of the local economy and the nature of the revenue sources in place. Additionally, the political will to seek greater revenues through taxation or fees may be lacking — particularly in challenging times when increasing the financial burden on individuals and businesses could prove highly contentious. Many local governments also have to clear another major political and legal hurdle, in that they must first gain state approval before enacting any changes.
Pensions Are the Elephant in the Room For muni bond investors, local government pension liabilities are a major risk that shouldn’t be ignored. Pensions for municipal workers are often the largest liabilities on local government balance sheets, and the health of many plans has deteriorated over the past decade. At the end of 2015, local and state governments had an overall funding gap of 28%. Depending on the discount rates used, recent estimates suggest US$1 trillion to US$3 trillion in unfunded commitments need to be addressed (through additional contributions and investment returns) in order for these plans to meet their financial obligations to current and future retirees.
Forward investment return expectations play a critical role in determining whether or not a plan has a funding gap. Therefore, it’s important to note that many local and state pension plans still assume investment returns in excess of 7%, but are likely to moderate those expectations over time. As a consequence, lower return expectations could cause widespread increases in pension funding gaps among local and state governments.
Another Good Reason to Focus on Revenue Bonds Clearly, local and state GOs entail some significant risks, and bond prices have begun to better reflect this reality. However, in many cases, assessing whether or not a bond investor is being adequately compensated for these risks can be quite tricky. For GOs, an issuer’s willingness to repay its debt is a key variable in the investment decision. On the other hand, the situation with revenue bonds is quite different. Revenue bonds (which account for 60% of issuers in the investment-grade muni market) are backed by specific revenue streams from various entities such as water and sewage plants, toll roads, airports and toll bridges. Credit research can provide a well informed assessment of what a revenue stream for a toll bridge could be, whether the project will be successful and whether the associated bond represents an attractive investment.
Revenue bonds typically offer a yield advantage over local and state GOs, without the aforementioned funding, political and pension-related vulnerabilities. Assessing the ability of an issuer to pay on a revenue bond is a straightforward analytical problem for an experienced, research-driven muni investor like Capital Group. These factors have often influenced our portfolio managers to steer their muni-focused investments toward revenue bonds.
Global Bonds Can Help Investors Meet Varying Goals
- One way to protect purchasing power is through exposure to foreign currencies.
- Although the U.S. dollar’s value has risen in recent years, it could be poised to fall if the U.S. is in the late stage of its economic cycle.
- A global bond fund can help investors diversify away from U.S. credit risk, as well as protect purchasing power through foreign currency exposure.
Of the many objectives investors establish for their portfolios, capital preservation and protection of purchasing power typically sit alongside requirements for income and growth of assets. Purchasing power protection basically means generating returns at least equal to the rate of inflation. Bonds such as Treasury Inflation-Protected Securities (TIPS) offer a direct hedge against inflation. Yet a portfolio of TIPS may not address the income and growth objectives of many investors. Meeting these various goals may be possible through a more diversified portfolio that includes an exposure to assets denominated in currencies other than the U.S. dollar. Such assets, like global bonds, not only help to diversify income and returns, but also provide some protection for purchasing power against currency-related volatility.
Why Exchange Rates Matter When a country’s currency exchange rate rises or falls, there can be a direct impact on the price of imported goods in that country. That so-called pass-through rate will vary from country to country, but some studies indicate that the long-term pass-through rate for the U.S. dollar is around 40%. That means if the dollar’s value fell by 10%, then prices of imported goods would broadly rise by about 4%.
In today’s global economy, much of what we consume is produced in whole or in part in other countries. Our foreign consumption basket might include things as expensive as a car or as cheap as a T-shirt. If we want to maintain purchasing power relative to our future consumption basket — the things we expect to buy in the future — then an allocation to assets denominated in foreign currencies makes sense.
Is Now the Right Time to Initiate or Add to Non-dollar Holdings? Over the past few years, the U.S. dollar has strengthened broadly against other currencies and now looks relatively overvalued. The chart on page 3 looks at the trade-weighted dollar index, which is the weighted average of the dollar’s exchange rates with its trading partners, against our internal estimate of its fair value. Since 2012, we have seen the dollar move from being very cheap to fair value to expensive. Currencies tend to be volatile and can diverge significantly from their fair values. However, ultimately they tend to revert to the mean: as relative valuations become extreme, they tend to move back toward fair value.
Today, there are indications that the dollar could be poised to turn. Historically, we have seen turns in the trade-weighted dollar precede turns in the financial cycle. Momentum loss is driven by a halt in the acceleration of house price inflation and private credit growth.
Financial cycle models, which are very slow moving, effectively reflect leveraging and deleveraging stages in the economic cycle. Our model indicates that we are now seeing late-cycle behavior as house price inflation and private credit growth are both decelerating. Typically the deleveraging part of the cycle is characterized by slowing growth, improving external balances and a weaker currency. If the U.S. cycle loses momentum, the U.S. dollar should fall.
Look to a Global Bond Fund Whether or not the dollar turns in the near term, relative valuations suggest that this could be a good time to initiate or add to non-dollar-denominated assets. Actively managed global bond funds can help. They enable investors to gain discrete exposure while relying on the fund’s managers to assess the risk and return opportunities across global bond and currency markets.