Municipal Market Performance and Benchmark Rates: Normalized supply, a supportive rate environment, and favorable technicals propelled the municipal market to the best October performance in 10 (HY) and 20 (IG) years, respectively. Both municipal indices were positive for the third consecutive month as the asset class is buoyed by a sturdy fundamental backdrop and steady investor demand. Investment grade municipals outperformed high-yield as LMBITR returned +1.24% vs +1.00% for HY (LMHYTR). The outperformance of IG is more pronounced year-to-date as LMBITR is +3.93% compared to HY +2.31% this year.
Despite a late month sell-off after Fed Chair Powell threw cold water on the certainty regarding the pace of future easing, the US Treasury market closed the month ~7bps lower across the curve. The AAA Municipal Benchmark curve flattened as 5-year rates rose by 9 bps while 10 and 30-year rates were 18 and 19 bps lower, respectively. Despite this month’s curve flattening, the high-grade municipal slope remains historically steep, with a spread of 135 bps between 10 and 30 years versus a 5-year average of 88 bps. Municipal investors continue to be paid for curve extension and taking on duration.
Mutual Fund Flows: Investment grade and high-yield funds experienced net inflows every week in October. The majority of the flow activity was concentrated in investment grade funds, which attracted 87% of October net-flows. Municipal funds have now experienced weekly inflows in 10 out of the last 11 weeks and total year-to-date inflows now exceed $37B, with ETFs accounting for the lion’s share (70%) of those flows. Again, we note our view that municipal high yield ETFs should be used tactically (short-term) rather than strategically (long-term) given the lack of credit analysis on portfolio assets.
Primary Market Supply: Municipal new issuance continued to “normalize” in October, totaling over $55B which was down 17% YoY. Last year’s October total was inflated due to the impending Presidential election, however. With that said, October new issue supply remained realtively healthy compared to historical averages, +10% versus the trailing 5-year average ($50.5bn). While some supply was likely pulled forward ahead of the passage of OBBBA (One Big Beautiful Bill Act) in July, November should provide continued new issue opportunity as municipal borrowers seek to finance critical capital projects before year-end.
Recent headlines surrounding private credit markets and high-profile defaults have raised concerns among investors regarding the current state of credit markets. Tricolor Holdings collapsed in early September and was followed by First Brands, which filed for bankruptcy in late September. Many major banks and private credit lenders had exposure to these bankruptcies leading Jamie Dimon to observe “I probably shouldn’t say this, but when you see one cockroach, there are probably more. Everyone should be forewarned on this.”
This raises the obvious question, should investors be concerned about credit issues in the non-rated municipal market? Broadly, we continue to view the credit environment for our non-rated municipal sectors (senior living, charter schools, private colleges and universities, student and multi-family housing, and economic development) as the strongest since the onset of COVID, over 5 years ago. We note that each of these sectors has a level of essentiality in the economy and is largely, but not completely, immune from economic cycles. Additionally, there are fundamental credit characteristics that apply to the broader municipal bond market, as well as, the non-rated sub-market that provide investors considerable security.
These include financing for hard assets, bricks and mortar projects that are usually secured by a first mortgage on the asset. In the event of distress, the lenders have a claim on project and while it may not provide 100% of bond proceeds in the event of default, it does provide substantial recovery. Additionally, most municipal bond issues, including non-rated issues, have security provisions that include a debt service reserve fund. The debt service reserve fund is a cash collateral account held for the benefit of bondholders in the event of payment disruption. This provides an operating cushion for the borrower and lender to work through periods of stress to “right the ship” and get the enterprise back on solid financial footing. Additional covenants are designed to protect investors and alert them to challenges ahead. These include rate covenants and additional bond tests, both serving to protect investor and alert them to significant credit deterioration. They provide mechanisms for lenders to bring in outside consultants to evaluate operations and implement any necessary changes.
Finally, and most importantly, the sectors that compromise our non-rated municipal bond portfolios are operational businesses that can be analyzed and monitored on an ongoing basis. Because the municipal market largely finances defined brick and mortar projects, rather than shelf offerings with use of proceeds to be determined later, analysts can come a determination regarding the necessity and viability of the project. While fraud is always possible (see: Arizona Legacy Cares project), it can be mitigated by thorough underwriting of the project, sponsor and project participants.
We have always liked the non-rated municipal market for the general lack of complexity in financing instruments, typically long-term, fixed rate fully amortizing debt, traditional security packages and financial transparency with the borrower. Investment risks include successful construction of the project and implementation of a business plan. Deviation from expectations can be monitored and addressed, either with the borrower or selling bond positions.
The explosive growth of private credit ($300 billion in 2010 to $1.6 trillion in 2023)1 has been exciting to watch and will continue to be in the headlines in the future. Thankfully for non-rated municipal bond investors, the two markets share significant yield (tax-exempt vs. taxable) opportunities and not much else. Our co-founders were attracted to the market for the inefficiency and inaccessibility for investors. Our co-founder Dave, who had spent his career in the CMBS market was additionally attracted to the “belt and suspenders” nature of the credit provisions of our loans. That remains true today, the underwriting standards of our portfolio assets have not changed over our 15+ year history and are unlikely to change going forward.
1 The Credit Markets Go Dark by Jared A. Elias and Elisabeth de Fontenay Yale Law Review Volume 134
The chart above shows the increase in value of $1,000,000 invested in the LCP composite at inception (net of management fees and expenses) vs. the benchmark, the Bloomberg High Yield Muni (LMHYTR) as well as the Bloomberg Muni (LMBITR) indices (it is not possible to invest in either Bloomberg Index). Please contact us with questions regarding credit profile, returns, taxable equivalent yields or further portfolio information. Past performance is not indicative of future results.