fixed income weekly - Janney Montgomery Scott LLC

F i x e d I n c o m e W e e k ly j a n n e y f i x e d i n c o m e s t r at e g y Aug 22, 2016

Summer doldrums? This week is anything but, thanks to a stout muni new issuance calendar and the Fed’s Jackson Hole conference Friday. CONTENTS ECONOMICS

2

INTEREST RATES

3

CREDIT 4 MUNICIPALS

5

DATABANK 6

In this Issue of Fixed Income Weekly: •• It’s always good to question your assumptions. In our extended economic section, we attempt to do just that, by donning an optimistic economist’s suit at looking at those factors that could contribute positively to growth, both today, and well into the future. •• Credit investors seem to have a very short memory: about a year after violent spread widening led by the energy sector impaired valuations across high yield, complacency and the hunt for yield is once again the dominant theme today. •• The Long Island Power Authority suffered operational losses during Hurricane Sandy and is only now getting fully back-on-track, as evidenced by a recent Moody’s rating upgrade on the entity’s municipal debt.

Recent Highlights from Janney Fixed Income Strategy & Research: Eric Kazatsky

Municipal Credit Analyst [email protected]

Guy LeBas

Chief Fixed Income Strategist [email protected]

Jody Lurie

Corporate Credit Analyst [email protected]

Alan Schankel

Municipal Strategist [email protected] See page 8 for important information regarding certifications, our ratings system as well as other disclaimers. JANNEY MONTGOMERY SCOTT www.janney.com © 2016 Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC

JANNEY FI WEEKLY • PAGE 1

•• Guy LeBas appeared on CNBC’s Squawk Box to discuss the influence that US monetary policy has on global economic growth, largely through the currency adjustment handle. •• Alan Schankel talked about the intersection of pension financial metrics and politics in this piece for the Bond Buyer, published last week (registration may be required). •• Jody Lurie offered her comments on the corporate bond markets to the Wall St. Journal in this Moneybeat article.

Fixed Income Strategy & Research Recent Publications

Publication Municipal Bond Market Monthly FI Asset Allocation US Interest Rate Forecasts Employment Commentary Midyear Outlook Municipal Bond Market Monthly FOMC Commentary FOMC Preview Employment Commentary Puerto Rico

Sector Munis Market Economics Economics Market Munis Rates Rates Economics Munis

Date 7/22/2016 7/20/2016 7/12/2016 7/8/2016 6/30/2016 6/29/2016 6/15/2016 6/13/2016 6/3/2016 6/2/2016

Notes Appropriations, CT Still cautious on risk 1.60% year end ten year note Gains to reverse May slowing Quality over yield, prefer munis Demand continues Dots declined, net dovish Low change of hike Worst result in 2yrs Inching towards default

j a n n e y f i x e d i n c o m e s t r at e g y Aug 22, 2016

Economics: An Optimistic Economists’ Clothes

CONTENTS ECONOMICS

2

INTEREST RATES

3

CREDIT 4 MUNICIPALS

5

DATABANK 6

•• Long time readers are well aware that our base case economic outlook is a relatively pessimistic one, constrained mainly by slow population and productivity growth. •• That pessimism has shown itself largely correct in the last several years, though it’s in part a natural bias of a bond market research group. •• In a change of pace, our economic and interest rate comments in today’s FI Weekly turn the tables: what would the world look like if our base case economic outlook were positive? •• “Positive” in this case would require accelerating productivity growth, something of a random variable in the long term, coupled with most likely an upturn in the business investment cycle. We’ve spent the better part of the last five years railing on about the damage population growth— running 0.6% per year compared to 1.8% in the 1980s and 1990s—was causing, and the influence slowing productivity growth—not much above zero—has in effectively capping the US economy’s speed. More narrowly, we’ve worried about how a stronger dollar restricts exports, how China’s slowing growth poses a danger, and how the deterioration and possible breakup of the Eurozone could slam the brakes on lending. Some of these worries have come to define our economic era, while others (mainly the more severe ones) fortunately haven’t come to pass. With that in mind, it’s easy to argue that our economic worldview is a tad too depressive. Perhaps. But it’s also a natural outgrowth of bond-focused, rather than equity-focused investors. Whereas equity-focused investors are charged with chasing down big upside returns, fixed income-focused investors are charged with chasing a little bit of upside and worrying about a small chance of big downside. Pessimism comes naturally. The dismal science rears its ugly head.

It’s good to question your assumptions--and one of our most closely-held ones is the belief in caps to long term economic growth.

Pop. & Productivity Growth Make Us Pessimistic 100 and over 90-94 years

Female

80-84 years 70-74 years

Male

fact and theory, it’s by no means the only

60-64 years 50-54 years 40-44 years 30-34 years 20-24 years

0.6% est. point of view regarding current and fuannual growth in working ageture conditions. The reality is, however, population that we’ve made a mistake once or twice 2010 - 2015

10-14 years 0-5 years 5.0% 4.5% 4.0%

JANNEY MONTGOMERY SCOTT www.janney.com © 2016 Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC

JANNEY FI WEEKLY • PAGE 2

5y Rolling Avg. of Productivity Growth Share of GDP from Business Investment in Equip. & Software

Judging by Fed hesitancy to acknowl-

edge improvements in economic data, it 4.0% est. annual growth seems that Janet Yellen may be among in retirement age populationthis inglorious group of pessimists. 2010 - 2015 While a negative bias has foundation in

10.0% 9.5% 9.0%

3.5%

8.5%

3.0%

8.0%

2.5%

7.5%

in the past, and there’s a chance we may do so again in the future. Eventually. That chance means it’s valuable on occasion to step out of our usual leisure suit attire and into an entirely different set of clothes. The reality is that a genuine economic improvement to, say, 3% growth is a possible, if unlikely scenario.

The majority of arguments for economic strength in the coming quarters and 2.0% 7.0% years rely on traditional wisdom: the 1.5% 6.5% business cycle gyrates above and below 1.0% 6.0% long term trend growth in a cyclical and 0.5% 5.5% rather predictable pattern. In statistical 0.0% 5.0% terms, this is called negative serial auto1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 correlation, in practical terms, it’s called Source: Janney Fixed Income Strategy; Commerce Dept; Census “what happened yesterday means the opposite will happen tomorrow.” In the financial markets, this has oft proven to be a fallacy, but the economic world continues to operate in similar, though not identical cycles. So long as the current situation does not represent a major structural break from the past, and so long as fundamentals support the cyclical assessment, there’s good reason to anticipate a strong bounce back in growth, simply because economic growth has been running below its long term trend for the better part of a decade. Over the last six decades, there have been thirteen peaks of economic growth and thirteen troughs of recession. These peaks and troughs are a consistent enough theme driven by a similar series of events:

j a n n e y f i x e d i n c o m e s t r at e g y Aug 22, 2016

CONTENTS ECONOMICS

2

INTEREST RATES

3

CREDIT 4

1. Optimism about the future leads to corporate investment, job creation, and income growth 2. Investment and income growth leads to greater consumption and output 3. Initial round of consumption growth faces sustainability limits and “peaks” 4. Pessimism leads to corporate cash hoarding, job losses, and weaker consumption Long Term Trend in Annual GDP Growth Has Clearly Been Towards Slowing

5

9.0%

DATABANK 6

7.0%

MUNICIPALS

5.0% 3.0% 1.0% -1.0%1965

1971

1976

1982

1987

1993

1998

2004

2009

2014

-3.0% -5.0% Source: Janney FI Strategy; Commerce Dept.

In the short term, a bounce in inventories could provide the kindling for a more sustainable increase in business investment.

If we plot a trend line though GDP growth over the last sixty, the average growth rate measures approximately 3.3%. In reality, however, both expansion and volatility in expansion have been trending lower and using a polynomial growth model, trend is arguably closer to 1.9%. Regardless, it’s evident that current output is below trend and that there are short term reasons for optimism. The combination of those two factors, historically speaking, creates a decent case for the domestic economy standing at the edge of a moderate upswing. Of the thirteen aforementioned troughs, five resulted in a year-over-year decline in GDP and, on average, these declines were followed by growth 2.2x as strong as the decline, a metric we haven’t reached after the end of the Great Recession. Put another way, the trajectory for years out of recession tends to be stronger than the recession is deep. In the short term, one source of growth that’s a potential launch pad falls in the category of inventories. From 2013 to the present, the pace of real inventory growth has slowed from $330 billion per year to just $65 billion year-to-date. Typically, inventories rise and fall concurrently with economic activity, so there’s little way to use inventory levels as a predictor of output. Based on experience, however, inventory trends tend to be very cyclical in nature and, for that reason, are sometimes supposed to drive the business cycle. A second source of potential growth highlighted in some comments is increased business investment outside of the inventory sphere, while a small contingent of optimistic economists are depending on the housing markets to support theses of stronger activity. Even though we’re trying to fit into more optimistic economists’ suits, it’s too against our style to ignore negative fundamentals: it takes more than just history to argue for a strong bounce. In order to be truly optimistic, one would need to foretell an improvement in the two factors which are constraining long term economic growth, namely population growth and productivity. The first count, population growth, would likely require immigration for upside breakout, and though there are political restrictions on greater immigration, even a +0.1% increase to growth in the working age population would be worth $18 billion in annual economic output—a rounding error in any given year, but hugely significant if it’s sustainable over five or ten years. The second count, productivity, is somewhat random, but probably requires technological innovation (which we’ve got a plenty, but not productive innovation apparently) and a business investment cycle which feeds on that innovation. A reversal of the productivity slowdown since 2002 would be powerful, if hard to detect.

JANNEY MONTGOMERY SCOTT www.janney.com © 2016 Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC

JANNEY FI WEEKLY • PAGE 3

Time to once again don the leisure suit. There’s a certain compelling simplicity to the arguments for a strong and sustained economic growth, but too many of those arguments rely on historical assessments without an acknowledgment of what’s changed this time around. Making matters even more complicated is that the timeframe isn’t exactly favorable: by traditional cycle dynamics, the economy is at more risk of slowing than it is accelerating, now that it’s been seven years since the last recession. But our natural pessimism at this juncture centers on a more subtle point: it’s not what happens in 2016 or even 2017 that matters for the economy and the financial markets, but rather the sources of long term growth in the years thereafter. Guy LeBas

j a n n e y f i x e d i n c o m e s t r at e g y Aug 22, 2016

Credit: Times They Are a’Changin’

CONTENTS ECONOMICS

2

INTEREST RATES

3

•• We have only been in an improving market situation for six months, but in some ways, it feels as if the prior 1.5 years of volatility never happened.

CREDIT 4

•• Whether we are on the precipice of change or will continue down this path remains to be seen.

MUNICIPALS

5

DATABANK 6

It is amazing how short-term is investors’ memory. Some of this forgetfulness speaks to the resiliency of the markets in the face of overweighted concerns that become less dramatic with hindsight. For example, although the year is not over, the anticipated number of defaults has not skyrocketed. At the same time, the notable change in default rates this year versus the past few years speaks to the challenges many companies faced with the difficult market conditions. Nonetheless, most high yield companies have not faltered as their bond prices would have indicated at the start of 2016, but rather rebounded to near or above par. The dialogue around high yield corporates is different this time around than a few years ago. In the 2011-2014 period, the argument in favor of high yield related to falling interest rates and the openness of the markets to new debt issuance. Because many weaker quality credits restructured during the 2008-2009 recession, those companies that remained solvent in the post-recession era had the opportunity to improve credit quality through refinancing debt at lower rates and pushing out maturities. Some firms became more aggressive with expansion towards the end of this period, setting them up for sizable obstacles once a few major institutional buyers of high yield altered their thesis at the same time that energy and commodity prices began to erode and China’s outlook became less promising.

That didn’t last long: it’s almost as if 1.5 years of volatility and spread widening have been forgotten amid the yield chase.

Since February, high yield bond prices have recovered as the major exogenous pressures have subsided. These issues have not fully dissipated—West Texas crude, for instance, has hovered below $50/barrel and below profitable levels for many operators for most of the past six months, despite improving from the lows—yet some of the most exposed companies are trading as if last year’s events did not happen. We see the recent rally as some combination of improving market sentiment and investors being starved for yield such that they have become modestly reckless in their investment decisions. HY Fund Flows Are Net Positive YTD, and Credit Spreads Are Wide of the 2014 Tights $8.0bln

1000 bps

$6.0bln

900 bps

$4.0bln

800 bps

$2.0bln

700 bps

$0.0bln

600 bps

-$2.0bln

500 bps

-$4.0bln High Yield Fund Flows

-$6.0bln -$8.0bln Jan-14

High Yield OAS May-14

Sep-14

Feb-15

Jun-15

Oct-15

Mar-16

400 bps 300 bps

Jul-16

Source: Janney Fixed Income Strategy; Citi; Lipper

JANNEY MONTGOMERY SCOTT www.janney.com © 2016 Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC

JANNEY FI WEEKLY • PAGE 4

While many firms have been able to maneuver around a formal restructuring process, the risk lingers with creative alternatives fewer should another hiccup in the markets occur. What’s more, it is hard to say whether interest rates would rise and what the ultimate effect on high yield corporates could be, but investors would be prudent to position themselves to weather the next volatility storm. We still see some further tightening in high yield credit spreads, but the opportunities for “easy money” investing have reduced since the spring; therefore, investing based on company fundamentals is increasingly more important. Jody Lurie

j a n n e y f i x e d i n c o m e s t r at e g y Aug 22, 2016

Municipals: Long Island Power Authority

CONTENTS ECONOMICS

2

INTEREST RATES

3

CREDIT 4 MUNICIPALS

5

DATABANK 6

•• Hurricane Sandy increased LIPA financial stress, but stress has abated, largely as a result of 2013 legislation at the state level •• Management of day-to-day operations by PSEG as well as debt restructuring have improved LIPA financial metrics although additional regulatory oversight included in the state legislation could be a future hindrance. •• We believe LIPA’s financial stability will gradually improve in coming years. The October 2012 storm known as Hurricane Sandy was, by several measures, the largest Atlantic Hurricane on record causing an estimated $75 billion in damage, a toll surpassed only by Hurricane Katrina in 2005. Although 24 states were impacted by the storm, New Jersey and New York were particularly hard hit. In the storm’s aftermath, Long Island Power Authority (LIPA - A3/A-/A-), which provides electric power and service to 1.1 million customers in Nassau and Suffolk Counties, came under significant stress from both a financial and customer satisfaction standpoint. With narrow liquidity and facing a heavy schedule of storm related repairs (the majority of which were reimbursed by FEMA) LIPA was downgraded by Moody’s to Baa1 in May 2013 and S&P placed its A- rating on negative Credit Watch in July 2013. Revenue Decreases Have Been Offset By Lower Power Costs Amounts in $ million

Long Island Electric Power Authority’s post-Sandy financial stress has largely abated.

Revenue Electric Revenue Other Income (Grants etc.) Expenses Fuel and Purchased Power Other Operating Expenses (Ex Dep) Interest Expense Change in Net Position (Ex Dep)

6 months 2016

6 months 2015

2015

2014

2013

$1,484 $29

$1,683 $35

$3,505 $92

$3,614 $152

$3,756 $61

$561 $768 $175 $10

$791 $699 $183 $45

$1,511 $1,453 $362 $272

$1,659 $1,477 $358 $272

$1,750 $1,405 $335 $327

Source: Janney Fixed Income Strategy; LIPA Financial Statements

In June 2013, the New York legislature passed legislation which reduced LIPA’s operational control and expanded the role of outside service provider PSEG. PSEG gained responsibility for day-today operation and management of LIPA’s transmission and distribution system as well as capital budgeting and planning. The legislation also established a framework for refinancing a portion of LIPA’s $7.6 billion in debt (Dec 2015) through issuance of up to $4.5 billion Utility Debt Securitization Authority bonds secured by a nonbypassable charge to retail customers. Since the new UDSA bonds were rated (Aaa/AAA/NR), LIPA was able to lower interest cost on outstanding debt. The new legislation also added a layer of regulatory oversight from New York’s Department of Public Service, which potentially slows the process for rate increases.

JANNEY MONTGOMERY SCOTT www.janney.com © 2016 Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC

JANNEY FI WEEKLY • PAGE 5

In its recent report supporting a rating upgrade, Moody’s noted that LIPA had achieved “a more stable and predictable cash flow and a more resilient liquidity profile” as a result of implementation of a three year rate plan, including automatic cost recovery mechanisms in conditions including external events such as changes in economic conditions, weather, or energy efficiency programs. Moody’s noted improvements in operating performance as well as customer satisfaction, which had plummeted in the post-Sandy timeframe. Liquidity has improved from 85 days-cash-on-hand in 2013 to 120 days in 2014 and 2015, with external liquidity support available in the form of commercial paper capacity and a revolving credit facility. Fixed cost coverage is projected to improve from 1.15x in 2015 to 1.20x in 2017 and 1.25x in 2018. Although debt load remains high as do rates charged to customers, we believe LIPA’s financial prospects have improved post-Sandy, with the utility benefitting from PSEG management, savings through debt refinancing, and a more predictable (for three years) rate structure providing some insulation from unpredictable external events. Alan Schankel

j a n n e y f i x e d i n c o m e s t r at e g y Aug 22, 2016

CONTENTS

Treasury Yields

ECONOMICS

2

INTEREST RATES

3

CREDIT 4 MUNICIPALS

5

DATABANK 6

3.00%

Today Last Month

2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 0

5

10

15 Maturity (Yrs)

Credit Market Spreads -60 bps

25

30

Credit Secondary Trading Volume

IG (Spread Inverted; Left Axis) HY (Dollar Px; Right Axis)

-65 bps

The last month has been one of the most range-bound interest rate trading periods since prior to 2013.

20

-70 bps

105.80

$30 bln

105.60

$25 bln

105.40

$20 bln

105.20

$15 bln

High Yield Investment Grade 6m Avg

$10 bln

105.00

$5 bln

104.80

$0 bln

-75 bps

Mon

104.60

Tue

Wed

Thu

Fri

104.40 104.20

-80 bps

104.00 -85 bps 19-Jul

24-Jul

29-Jul

03-Aug

08-Aug

103.80 18-Aug

13-Aug

AAA GO Municipal Yield Curve 3.00%

M/T Ratios 102%

106%

Today Last Month

100%

2.50% 104%

98%

2.00% 96%

102%

1.50%

94% 100%

1.00%

92%

90%

0.50%

98%

JANNEY MONTGOMERY SCOTT www.janney.com © 2016 Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC

JANNEY FI WEEKLY • PAGE 6

88%

30yr M/T Ratios (Left Axis)

0.00% 0

5

10

15 Maturity (Yrs)

20

25

30

10yr M/T Ratios (Right Axis) 86%

96% 21-Jul

27-Jul

02-Aug

08-Aug

14-Aug

j a n n e y f i x e d i n c o m e s t r at e g y Aug 22, 2016

CONTENTS

Market Sector Performance

ECONOMICS

2

INTEREST RATES

3

$102.00 $101.50

MUNICIPALS

5

DATABANK 6

$100 Invested One Week Ago is Worth

CREDIT 4

$101.00 $100.50 Munis $100.00 Agencies $99.50 $99.00 $98.50 $98.00

Friday’s selloff locked in modest losses for the Treasury markets, but other sectors held their ground better.

JANNEY MONTGOMERY SCOTT www.janney.com © 2016 Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC

JANNEY FI WEEKLY • PAGE 7

Treasuries

Credit

MBS

j a n n e y f i x e d i n c o m e s t r at e g y Aug 22, 2016

Analyst Certification

CONTENTS ECONOMICS

2

INTEREST RATES

3

CREDIT 4 MUNICIPALS

5

DATABANK 6

We, Alan Schankel, Guy LeBas, and Jody Lurie, the Primarily Responsible Analysts for this report, hereby certify that all of the views expressed in this report accurately reflect our personal views about any and all of the subject sectors, industries, securities, and issuers. No part of our compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Definition of Outlooks Positive: Janney FIS believes there are apparent factors which point towards improving issuer or sector credit quality which may result in potential credit ratings upgrades Stable: Janney FIS believes there are factors which point towards stable issuer or sector credit quality which are unlikely to result in either potential credit ratings upgrades or downgrades. Cautious: Janney FIS believes there are factors which introduce the potential for declines in issuer or sector credit quality that may result in potential credit ratings downgrades. Negative: Janney FIS believes there are factors which point towards weakening in issuer credit quality that will likely result in credit ratings downgrades. Definition of Ratings Overweight: Janney FIS expects the target asset class or sector to outperform the comparable benchmark (below) in its asset class in terms of total return Marketweight: Janney FIS expects the target asset class or sector to perform in line with the comparable benchmark (below) in its asset class in terms of total return Underweight: Janney FIS expects the target asset class or sector to underperform the comparable benchmark (below) in its asset class in terms of total return Benchmarks Asset Classes: Janney FIS ratings for domestic fixed income asset classes including Treasuries, Agencies, Mortgages, Investment Grade Credit, High Yield Credit, and Municipals employ the “Barclay’s U.S. Aggregate Bond Market Index” as a benchmark. Treasuries: Janney FIS ratings employ the “Barclay’s U.S. Treasury Index” as a benchmark. Agencies: Janney FIS ratings employ the “Barclay’s U.S. Agency Index” as a benchmark. Mortgages: Janney FIS ratings employ the “Barclay’s U.S. MBS Index” as a benchmark. Investment Grade Credit: Janney FIS ratings employ the “Barclay’s U.S. Credit Index” as a benchmark. High Yield Credit: Janney FIS ratings for employ “Barclay’s U.S. Corporate High Yield Index” as a benchmark. Municipals: Janney FIS ratings employ the “Barclay’s Municipal Bond Index” as a benchmark. Disclaimer Janney or its affiliates may from time to time have a proprietary position in the various debt obligations of the issuers mentioned in this publication. Unless otherwise noted, market data is from Bloomberg, Barclays, and Janney Fixed Income Strategy & Research (Janney FIS). This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by any person for any purpose without Janney’s express prior written consent. This report has been prepared by Janney and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. The information presented herein is taken from sources believed to be reliable, but is not guaranteed by Janney as to accuracy or completeness. Any issue named or rates mentioned are used for illustrative purposes only, and may not represent the specific features or securities available at a given time. Preliminary Official Statements, Final Official Statements, or Prospectuses for any new issues mentioned herein are available upon request. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, securities prices, market indexes, as well as operational or financial conditions of issuers or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. We have no obligation to tell you when opinions or information contained in Janney FIS publications change.

JANNEY MONTGOMERY SCOTT www.janney.com © 2016 Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC

JANNEY FI WEEKLY • PAGE 8

Janney Fixed Income Strategy does not provide individually tailored investment advice and this document has been prepared without regard to the circumstances and objectives of those who receive it. The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. For investment advice specific to your individual situation, or for additional information on this or other topics, please contact your Janney Financial Consultant and/or your tax or legal advisor.