Did you miss the boat to refinance or fund a new capital project at close to record low, tax-exempt interest rates?
The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.
For lower-rated issuers, the answer may be no. Many issuers of municipal (muni) bonds came to market in 2012 and the first half 2013 to take advantage of all-time low interest rates driven by the Federal Reserve Board's quantitative easing program. Now that the economy continues to gain steam and the Fed is gradually tapering the monthly open-market purchasing of mortgage-backed and treasury securities, general expectations were that long-term rates would begin to increase. However, an interesting dynamic in the muni bond market is currently keeping rates low, especially for lower-rated issuers.
A story of supply and demand
Bonds, like other financial assets, are sensitive to the simple economic concept of supply and demand. When the Fed started buying long-term bonds, those increased purchases (demand) helped push prices higher and yields (interest payments to bond investors) lower. The 2012 and first quarter of 2013 time frame is a good example of how decreasing yields correlated with the continued bond purchases by the Fed as yields on the AAA GO (government obligation) muni hovered at or below 3 percent. As yields decreased during this time period, issuers brought lots of volume to take advantage of the lower cost of capital. (2012 saw the highest amount of refunding issues in over 10 years.) However, in June 2013, Ben Bernanke's mere mention of tapering led to an expectation that purchases (demand) would slow, resulting in the Municipal Market Data scale increasing 40 points compared to the prior month. In last half of 2013, issuers began to shelve refunding deals as tapering was initiated and the economy gained steam.
Muni volumes trend significantly lower
Total muni volume in 2013 dropped 12.5% to $334.6 billion in 11,435 issues compared to $382.4 billion in 13,129 issues in 2012, according to Thomson Reuters. This decline can be directly attributed to refunding issues drying up, presumably driven by rate increases that occurred in the last half of 2013. In fact, analysis of the volume reveals that 2013 new money issues increased by approximately $15 billion or 10 percent from the prior year; however, this increase was more than offset by the significant decline in refunding issues, which declined $61 billion or 26 percent from the prior year. Healthcare issues trended with the total muni-market, declining $8.5 billion or 23 percent from 2012, according to The Bond Buyer's 2013 In Statistics Annual Review.
During the first two months of 2014, the decline in volume has been even steeper, starting the year with the first and second lowest issuance months since 2000. January issuance totaled 587 deals for $18 billion — down 33.4 percent from the same period in 2013. February's issuance dropped even further to $14.7 billion in 633 deals compared to $24.7 billion and 1,035 deals in the prior period — a 40.4 percent decline.
Lack of supply keeping yields low
How has this lack of supply affected long term yields?
Near the end of August 2013, the AAA 30-year GO average muni yield reached 4.45 percent — the highest in two years — as prices and volumes fell mainly due to expectations of tapering. However, in September 2013 the Fed did not begin reducing its qualitative easing program as anticipated and the entire bond market rallied. (Yields fell back in the low 4 percent range on the AAA 30-year GO muni.) Then on Dec. 18, the Fed finally announced tapering would start in January, but slowly ($10 billion decreases in purchases a month) and the AAA 30-year GO muni yield increased to approximately 4.19 percent by the end of the year. However, since the end of 2013, muni yields have continued to decrease. The AAA 30-year muni was nearly 3.85 percent at the end of January and 3.63 percent at the end of March. This recovery is directly correlated to the significant drop in volumes (supply) over the same period and bodes well for issuers who may have delayed their deals in the middle of 2013.
Credit spreads compress
Coupled with the declining volume in the muni market, which has helped keep yields low, is that spreads between higher- and lower-rated credits have continued to compress. Specifically, going back to the end of March 2012, the yields on the AAA 30-year GO, Health Care 30-year A and Health Care 30-year BBB were 3.39 percent, 4.57 percent and 5.42 percent, respectively. At the end of March 2014, the yields on those same bonds were 3.63 percent, 4.72 percent and 5.25 percent. Comparing this period provides insight into the compressions of spreads, as the AAA yield has increased 24 basis points and the A yield increased 15 basis points, but the BBB yield decreased by 17 basis points from the same period in 2012. Issuers of lower investment-grade bonds are seeing yields lower than the yields locked in the first quarter of 2012 and the lowest in over nine months, even though yields on the AAA bond are 24 basis points higher over the same period.
Another way to view the compression is to compare the spread between the AAA GO and BBB Health Care yield as a percentage. At the end of the first quarter of 2012, the 30-year BBB Health Care yield was 60 percent higher than the AAA GO yield. Comparatively, at the end of the first quarter of 2014 the 30-year BBB Health Care yield was only 45 percent higher than the AAA GO yield, a 25 percent spread improvement.
Yield hungry investors and diminished supply are driving this compression. Municipal funds saw record net outflows of $64.2 billion in 2013. Record outflows and less supply have led muni-bond funds to seek higher yielding paper in this low yield environment, leading to the credit spread compression (higher demand for higher yield bonds). A lower-rated health care issuer may still have a small window of time to take advantage of record low rates.
Outlier — Housing
Although the muni market overall has seen its lowest volumes in 10 years, housing bonds have bucked the trend. In 2013, housing bond volume grew 29.8 percent to $14.1 billion from $10.9 billion in 2012 — the highest volume since 2008, when $18 billion was issued, but less than half of the 2006 high of $30.8 billion. An article from The Bond Buyer in February 2014 notes high demand for housing bonds can be correlated to strong investor demand for higher yields, as housing bonds tend to be rated lower. Another benefit to housing bonds was the improvement in the housing market, which has led to rising valuations in land districts, helping housing bonds gain momentum. The industry has seen some upgrades to some large issuers in the sector because of the improving market. Housing is expected to continue its strong trend in 2014.
Privately placed bonds
Banks, in general, have also seen their volumes taper off since the highs of 2012 and the first half of 2013 and are hungry to keep feeding their pipelines. Although underwriting standards remain stringent, health care issuers with low-investment-grade metrics are able to obtain favorable terms via privately placed bonds. Recently, it appears banks are even hungrier for investment-grade healthcare credits and are aggressively bidding for the business. Historically, banks have not wanted to go beyond five- to seven-year maturities, but recent borrowers have been able to obtain 10-, 15- and even 20-year maturities with 20- to 25-year amortization schedules. These longer-term maturities allow borrowers to significantly reduce refinance risk in their capital structure and take advantage of the low interest rate environment for the long term. Banks have made other concessions, such as lowering their initial upfront fees or adjusting their pricing to meet or beat competing bids. Privately placed bonds tend to be variable-rate structures and have the ability to be synthetically fixed via an interest rate swap.
Key Takeaways
The three things borrowers need to keep in mind to take advantage of the current low interest rates:
1. Lower-rated healthccare issuers have a small window of time to take advantage of the low supply of issuance in the muni market and tightening credit spreads. The general consensus is that these low yields will not last long as the Fed continues to scale back its bond buying program. Healthcare leaders should seek counsel from their investment banker to find out if a refunding issue makes sense or if the ideal time to fund a capital project is now.
2. Housing bonds should remain in high demand as credit attributes continue to improve, and yield-hungry investors are active, creating opportunities to get new developments off the ground.
3. Borrowers seeking direct funding from privately placed bonds are obtaining better terms and longer maturities by taking advantage of banks' eagerness to win business as their volumes remain low.