With contributions from Daniel Sarnowski, Portfolio Specialist, WFAM Global Fixed Income

We are now in a period of rising interest rates, and investors may wonder how municipal bonds have fared in past periods of rising rates and if they have a place within an asset allocation plan today. The answer is that, historically, municipal bonds have performed well when interest rates are increasing.

With contributions from Gabriel G. Diederich, CFA, Portfolio Manager; Brandon Pae, Senior Analyst, Municipal Credit Research; and Gilbert L. Southwell III, Senior Analyst, Municipal Credit Research

The U.S. Supreme Court ruled on June 21, 2018, that states may require online retailers to collect sales taxes.

Time-series comparison of statewide drought conditions

With contributions from Terry J. Goode, senior portfolio manager, Tax-Exempt Fixed Income, and Brandon Pae, senior research analyst, Tax-Exempt Fixed Income.

After four years of drought, municipal water utilities in California are facing scarcer water supplies and, in turn, potentially lower revenue streams due to selling less water and spending more on capital projects for more  sustainable water sources. While investors have traditionally viewed the more-than-$18-billion California water and sewer sector as high quality—the median rating is AA- from Standard & Poor’s and Aa3 from Moody’s—it will be increasingly important to differentiate between issuers to find the best investment opportunities. Successful responses to the drought crisis have allowed many utilities to keep their financial positions strong while other less-nimble issuers have seen their balance sheets weaken. Below we explain why the challenge of scarce water supplies is here to stay, how it is affecting California water and sewer bonds, and what our investment themes are within this sector.

The challenge of water scarcity is here to stay

Virtually the entire state is in drought conditions, with more than 92% of the state in severe drought or worse. The National Oceanic Atmospheric Administration (NOAA) estimates four-year rainfall amounts were between 54% and 75% of normal 2011–2014, resulting in significant precipitation deficits throughout the state. Over the past four years, NOAA reports that every region in the state is missing at least a year’s worth of precipitation and the south coast of California is missing almost two years’ worth. As a result of this deficit, more than 15 million acre-feet of groundwater and reservoirs have been depleted. Given the dire situation, Governor Jerry Brown declared a state of emergency on April 1, 2015, and issued an executive order to cut urban water use by 25%. Anecdotally, several small communities in the California Central Valley have run out of water, and prices for secondary-market sales of surplus water supplies between water customers have reached record highs.

Percentage total return performance by credit quality

Puerto Rico’s governor warned investors in late June that the island wouldn’t be able to pay its sizable debts, and it has turned out to be more than idle talk. On Monday, the commonwealth defaulted by not paying its full $58 million in Public Finance Corporation debt service. This marks the first default of Puerto Rican debt. Valuations on select Puerto Rican securities reached as low as 12% of par value during the month. Various plans are being floated to the commonwealth by bondholder groups, but none have gained real traction. Legislative proposals have found few advocates in Washington. The market will stay tuned for the next month as the commonwealth’s working group prepares its financial recommendations.

Naturally, this leaves municipal investors wondering about the true scope of the problem and whether Puerto Rico’s troubles could expand beyond its borders. The biggest single question we receive when talking about the municipal market with clients and other investors is what the implications will be for a restructuring of Puerto Rican municipals. Our view remains that Puerto Rico’s woes are not systemic to the municipal market. Said another way, even if Puerto Rico has additional defaults, it should not create a longer-term repricing of municipal market risk. Much of Puerto Rico’s own risk is already baked into current valuations, particularly now that we’ve seen the first default occur.

Puerto Rico general obligation bond prices

On June 28, Puerto Rico Governor Alejandro García Padilla told The New York Times that the economically troubled island would be unable to pay its $72 billion in public debts, while the commonwealth would seek concessions from its creditors in order to avoid what he termed “a death spiral.”

The market for Puerto Rican bonds reacted swiftly. Month to date (as of June 29), the average Puerto Rican security included in the Barclays Municipal High Yield Index has fallen over 9%. Longer-dated general obligations from the commonwealth have fallen roughly 12% to begin this week. Owners of Puerto Rican securities vary, as do the opinions on fair valuations. Since 2012, we have believed that unenhanced Puerto Rican municipals have not compensated investors for their risk. Investors who purchased bonds from 2012 or earlier likely have positions that trade at a loss. More recent buyers have included hedge funds and emerging markets debt managers who are attracted by the large amounts of debt available as well as the exceptionally high yields. We caution that buying the debt because it appears cheap is not a sound investment thesis (sometimes things are cheap for a reason).

Illinois credit spreds

While the past few years have been tumultuous for investors of Illinois and Chicago-area municipals, the volume of headlines has increased recently. Pension reforms, which were necessary early steps in healing the perennially poorly funded state and city pensions, were passed by the legislature and then struck down in the courts, including a recent affirmation of that decision by the state’s Supreme Court on May 8. While the state had increased income taxes to provide budgetary relief, the increased rates were recently allowed to sunset. This combination has contributed, in part, to recent spread-widening of the state and Chicago-area holdings. Rating agency downgrades, most recently from Moody’s on the city of Chicago to Ba1 and other Chicago-area issuers, have exacerbated volatility. City ratings are disjointed today at Ba1/A-/A-/A- from the four major agencies of Moody’s/S&P/Fitch/Kroll, respectively. For the patient investor, we believe both Chicago-area and Illinois state municipals offer opportunity.