municipal market guide - ubs.com · to a discussion of the role not-for-profit hospitals play in...

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14 February 2019

Municipal Market GuideChief Investment Office Global Wealth Management

� ETF flows explained

� Munis off to a good start

� Supply remains light

Healthcare transformation continues

This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on pg. 16.

02 At a glance

03 Market view

05 Portfolio themes

06 Closed-end funds

07 Exchange-traded funds

08 Spotlight

10 In the news

12 Chartbook

15 Endnotes

18 Disclaimer

Contents

AuthorsThomas [email protected]

Kathleen McNamara, CFA, [email protected]

Jeannine [email protected]

Sangeeta [email protected]

Sudip [email protected]

David [email protected]

RESEARCH ASSISTANCEArsh Tandon

DESKTOP PUBLISHINGCognizant Group – Srinivas Addugula, Sunil Vedangi

Cover photo: istock.com

At a glanceNew technologies and innovative thera-pies to manage chronic disease have increased the life expectancy of most Americans. While the prospect of a lon-ger and presumably healthier life is an encouraging thought, we will inevitably consume more health care services as we age. According to one study published by the National Institutes of Health, health-care costs are lowest for children, rise slowly throughout adult life, and increase exponentially after age 50. As a nation, we already spend almost 18% of our gross domestic product on health care. As baby boomers age, the ratio may rise.

We devote this month’s feature article to a discussion of the role not-for-profit hospitals play in health-care delivery. We have witnessed a surge in the number of mergers and acquisitions among competing hospitals and health care systems. The dash for greater size is prompted by decelerating revenue growth and narrow operating mar-gins. Reimbursement rates are under pressure and litigation surrounding the Affordable Care Act only adds to the uncertainty for hospital administrators.

We have completed a review of the largest not-for-profit hospitals and

health-care systems in the United States. Our results were published last month and inform the views we share in this month’s Spotlight. The hospital sector has a higher default probability than many other sectors of the munici-pal bond market and is likely to exhibit more credit volatility in the years ahead.

Meanwhile, municipals are off to a strong start in 2019. Fund flows have been positive and new issue supply has been relatively light. While we expect market performance to hinge on the tone set by US Treasury securities, muni bonds are likely to remain a preferred asset class for private investors. As we approach the 15th of April, residents of states with higher tax burdens are starting to feel the pinch from new re-strictions on state and local tax (SALT) deductions. That alone should result in renewed interest among investors.

We also provide a brief review of the closed-end fund and exchange-traded fund markets. Closed-end funds have rebounded strongly and, in many cases, recouped last year’s losses. The increasing popularity of muni ETFs, meanwhile, is evidenced by record in-flows during 2018.

Total return by sector

Source: ICE BofAML, Bloomberg, UBS, as of 11 February 2019

2018 TR

2019 YTD TR

In %

Treasuries

Taxable FI Agg

Munis

Build America Bonds

Emerging Markets

Preferreds

High Yield

Investment Grade

Agencies

TIPs

S&P 500

0 5 10 15–10 –5 20

Municipal Market Guide FEBRUARY 2019 3

Market view

0

5,000

–15,000

–20,000

–5,000

–10,000

0

10,000

4

3

2

1

5

Aug-15 Apr-18Aug-17Dec-16Apr-16 Dec-18Dec-14Apr-14Dec-12 Aug-13Apr-12Aug-11Dec-10

Historically low yields

US presidentialelection

Rate volatility

Rate volatility

Meredith Whitney“60 minutes”

interview

Municipal mutual fund flows and long-term yields

Note: January flows are MTD, as of 30 January 2019Source: Investment Company Institute, MMD, UBS, as of 8 February 2019

Monthly Net New Cash Flow

Figure 1

Fund flows in USD millions (lhs), yields in % (rhs)

AAA GO 30yr Monthly Yields

Off to a good startSince our last monthly update, yields on US Treasury securities have remained range bound, representing an important tailwind for munis. The yield on the 10-year US Treasury government benchmark note fluctuated between 2.63% and 2.78% before drifting lower to now rest at 2.7%. At the same time, AAA munis at the 10-year maturity point rallied as yields declined by about 10 basis points (bps) to sit at 2.14%. Not surprisingly, this firmer market tone for munis had prompted individual investors to place cash into muni funds. Following a period of net cash outflows from muni mutual funds in 4Q18 (USD 11.2bn), fund flows reversed course in the early part of January. On a year-to-date basis through 30 January 2019, ICI reported USD 7.14bn in inflows to muni funds (see Fig. 1).

Thus far in 2019, municipal bonds have gained 1%, matching their performance for all of last year. Tax-exempt paper is now on pace to register four straight months of positive returns (see Fig. 2). Shifting to the muni high-yield market, these low-er-rated securities (+0.8%) are lagging their investment-grade counterparts on a year-to-date basis.

Supply remains light In January, the pace of new municipal bond sales totalled only USD 22.3bn. That’s not much of an uptick compared to the dearth in primary market volume seen one year earlier (USD 21.7bn). Our regular readers may recall that new issue supply plummeted in the early part of 2018, after many state and lo-cal governments accelerated the timing of bond sales into the fourth quarter of 2017 ahead of tax reform. Most notably, the

Tax Cuts and Jobs Act of 2017 eliminated the ability of muni is-suers to advance refund their debt on a tax-exempt basis. That restriction went into effect in 2018 January and had mean-ingful implications for muni supply. On the bright side, state treasurers now are lobbying to restore this important type of financing. That said, it’s too soon to tell whether their efforts will gain traction with Congressional leaders. The US House of Representatives introduced a bill last year to reinstate advance refunding bonds, but it did not move forward.1

This month, supply is poised to move higher by a modest amount (USD 25bn). That said, the forward calendar remains at levels below longer-term averages. As shown in Fig. 3, the 30-day visible supply sits at only USD 7.5bn. By comparison, this metric totalled USD 9.8bn on average over the past five years.

Deal reviewIn mid-January, the City of Chicago was in the market with its sales tax securitization taxable municipal bonds sale. The loan represented the final segment of a USD 3bn bond program that was authorized by city council in October 2017. The deal was sized at USD 605.4mn consisting of long-dated bonds (--/AA-/AAA) with maturity terms in 2040 and 2048. The bonds due in 2040 were issued with a 4.637% coupon rate and were priced at par. As a point of reference, this represents a spread of 155bps over the 30-year US Treasury benchmark. At the same time, the sales tax securitization bonds due in 2048 were issued with a 4.787% coupon rate and priced at par, representing a spread at issuance of 170bps vs. its relevant benchmark. By comparison, this issuer sold bonds with a com-

4 FEBRUARY 2019 Municipal Market Guide

parable maturity date at a much tighter spread of only 95bps in February 2018. We attribute these wider spreads on the recent bond sale in large part to some meaningful headwinds for this issuer. Mayor Rahm Emanuel’s pending departure, S&P’s credit rating downgrade based on a criteria change, and the prospect for a surge in Chicago-related debt issuances are some examples.

More recently, the Dormitory Authority of the State of New York (DASNY) was in the market in the early part this week with a USD 605.9mn tax-exempt muni deal for New York University. The longest-dated bonds were issued with a 5% coupon due in 30 years and were priced at a 3.24% yield, representing a 24bps spread to the AAA benchmark. Also, the issuance included USD 259.4mn of taxable (Series B-1) and taxable green bonds (Series B-2). The taxable green bonds portion of the loan was comprised of long-dated bonds due in 30 years, issued with a 4.014% coupon and priced at par. On a spread basis, this pricing represented 100bps vs. the 30-year Treasury benchmark. From a credit quality standpoint, CIO classifies New York University into Category 2 risk category (see Municipal Brief, Private higher education: risk assessment framework, 14 November 2018).

Outlook Now that investors are in the process of filing their taxes for 2018, we expect munis to garner more attention from some individual investors. Only now will taxpayers experience the full implications from the USD 10,000 limit placed on the state and local income tax (SALT) deductions. As a consequence, we believe that many taxpayers who reside in states that im-pose high state income taxes will turn their attention toward munis to obtain tax-free income. New York, New Jersey, and California are some examples.

By contrast, we expect that demand from institutional inves-tors such as banks will remain soft. Following tax reform, mu-nis are not as attractive to many corporate investors based on the reduced tax rate imposed on these investors (21% from 35%). As a point of reference, banks reduced their muni hold-ings by almost USD 40bn in the first three quarters of 2018.2

In the near term, we expect the performance of the munici-pal bond market to hinge heavily on the market tone seen in US Treasury securities. The government bond market’s reaction to the end of the Fed’s balance sheet unwind may temporarily result in lower Treasury yields and a steeper yield curve. Over the longer term, however, the increased Treasury supply from a rising federal deficit, and the recent wait-and see forward guid-ance given by the Fed, will be the main influences determining the future value of fixed income assets, including munis.

Market view

Monthly muni total returns, Jan 2018 - Jan 2019

Source: ICE BofAML, UBS, as of 31 January 2019

Figure 2

In %

–2

–1–0.4

0.2

1.2

2

1

0

Jan-

18

Jan-

19

Apr

-18

May

-18

Feb-

18

Mar

-18

Aug

-18

Sep-

18

Oct

-18

Nov

-18

Dec

-18

Jun-

18

Jul-1

8

–0.6

0.2

–0.7

1.1

0.3

–0.4

0.1

1.2

–0.8

0.8

Figure 4

Municipal returns by maturity Returns in %, duration in years

Maturity 2018 total return

2019 YTD total return

Effective duration

Municipals 1–3 Yrs 1.8 0.4 1.8




Municipals 22+ Yrs 0.1 0.5 10.5

Source: ICE BofAML, UBS, as of 8 February 2019

Feb-19Feb-14 Feb-15 Feb-16 Feb-18Feb-17

25,000

15,000

20,000

0

10,000

5,000

Visible supply vs. 5-year average

Source: MMD, UBS, as of 8 February 2019

Figure 3

30-day visible supply

5-year average

In USD millions

http://ubs.com/content/dam/WealthManagementAmericas/documents/private-higher-education-risk-assessment-framework.pdf

http://ubs.com/content/dam/WealthManagementAmericas/documents/private-higher-education-risk-assessment-framework.pdf


Portfolio themesMaintain preference for 10-year to 15-year munis Thus far in 2019, tax-exempt yields on shorter-dated bonds have fallen at a faster pace than levels at the long end of the curve (see Fig. 1). This yield movement has had the effect of steepen-ing the muni curve (2s/30s), which now sits at 136 basis points (bps), up from 124bps at the end of December. By contrast, the US Treasury curve remained flat, with the spread between the 2s/30s part of the curve hovering around 50bps (see Fig.2).

We continue to believe that the steeper muni curve vs. the one seen in the US government bond market presents an op-portunity to pick up values a bit further on the curve (10-year to 15-year maturity area). By contrast, yields on short-dated munis appear rich based on strong demand from individual investors pursuing low-duration strategies.

Choose investment-grade munis vs. lower-rated, high-yield munis We do not believe that high-yield munis offer sufficient in-cremental yield at current levels to prompt investors to in-crease exposure, despite some spread widening in high-yield credit towards the end of 2018, reflecting outflows from muni mutual funds. As a point of reference, the yield gap be-tween high-yield munis (4.77%) and investment-grade munis (2.46%) now sits at only 231bps. By comparison, this spread differential was as high as 323bps four years earlier.¹

That said, we still believe that a smaller strategic allocation to municipal high-yield within a diversified portfolio makes sense. We recommend the use of a third-party asset manager to monitor credit developments. Within the investment-grade space, we prefer single A rated credits (+48bps) over lower-rated BBB bonds (+85bps). See Fig. 3.

Exercise caution in the healthcare sector The probability of default on health care bonds is higher than many other sectors of the muni market. Thus, we believe pri-vate clients should approach this sector with a degree of cau-tion. The sector is undergoing substantial transformation and consolidation that is altering the healthcare delivery model, with significant implications for credit quality. In our Municipal Brief, Not for profit hospitals: risk assessment framework, 4 February 2019, we examine the top 86 obligors with the most debt outstanding. Compared to other muni sectors we have published so far, a significantly higher proportion of obligors are placed in CIO Risk Categories 4 and 5. At the same time, only one obligor is classified in Category 1, highlighting the higher risk profile of this sector. Category 1 represents our lowest (safest) risk category while Category 5 signals the high-est level of risk.

0

–5

–10

–25

–20

–15

Change in AAA muni yields YTD


Change in yield

Figure 1

In bps

5-yr 10-yr 15-yr 20-yr 25-yr 30-yr

Feb-19Jan-16 Aug-16 Feb-17 Aug-17 Aug-18Feb-18

250

200

150

100

50

0

AAA muni and US Treasury 2s/30s spread


Figure 2

AAA GO 2 yr - 30 yr

Treasury 2 yr - 30 yr

In bps

Feb-11 Feb-17Feb-15Feb-13 Feb-19

250

200

150

100

50

0

Credit quality spreads


Figure 3

BAA GO 10 yr - AAA GO 10 yr AA GO 10 yr - AAA GO 10 yr

A GO 10 yr - AAA GO 10 yr

In bps

https://www.ubs.com/content/dam/WealthManagementAmericas/documents/muni-hospitals.pdf




Closed-end funds updateStars are alignedLow interest rates, steady borrowing costs, and higher taxes pro-vide optimism in the closed-end fund (CEF) world. It appears that the stars are strongly aligned for municipal closed-end funds as they continue their January bounce well into February. So far, funds have recouped the full year 2018 losses and in some cases a bit more. As shown in Fig. 1, national leveraged CEFs are up 7% on average and have recovered all of the losses for 2018 (down 5%). Net asset values (NAVs) are also up 1%, which is in line with the underlying municipal bond market adjusted for leverage. Also, state funds we cover have rallied and are now breakeven in terms of total return from 1 Jan 2018 through 8 Feb 2019. Once again we remind investors that CEFs are long term investments and that holding them through market volatility eventually pays off.

Steady borrowing costsMost funds’ leverage is based on short-term rates and pegged to the Securities Industry and Financial Markets Association (SIF-MA) Municipal Swap Index. Recent stability in the index gives us some optimism that the pace of distribution cuts will slow. As shown in Fig. 3, the SIFMA index reset at 1.51% last week and is in line with the average rate for 2018, although 40–50 ba-sis points (bps) higher from year-ago levels. Seasonally, SIFMA could move higher leading up to the 15 April tax filing deadline.

Valuations still attractiveThe solid year-to-date performance, well ahead of NAV per-formance, means that valuations on average are no longer cheap. However, several names are still trading at high single-digit discounts as the averages are skewed due to handful of funds trading at significant premiums.

Interest rate outlookPost January’s Fed meeting, 10-year Treasury yields are about flat from 3 January 2019 levels. CIO forecasts one more in-crease in the Fed funds rate for 2019 and 10-year Treasury yields to be in the 2.7–3.2% range for the next 12 months. This outlook should calm the fears of closed-end fund inves-tors and their worries of owning leveraged CEFs.

In conclusion, we see the fundamental backdrop supporting the municipal bond market and closed-end funds as strong. In addition, as mentioned in our last monthly report, tax filing season is apt to prompt investors to bring additional monies into closed-end funds, given their attractiveness on a taxable-equivalent basis. We expect demand to be particularly strong in states with higher taxes, where limitations on the state and local taxes (SALT) deduction will result in higher tax liabilities on 15 April. CEFs offer an alternative way to get exposure to municipal bonds at a discount and with higher yields through the use of leverage. On average, leveraged municipal CEFs we cover pay around 5%, which is higher than open-end munici-pal mutual funds and municipal ETFs.

Figure 2

ValuationsFunds under coverage, in %

Current average discount

52 - week average discount

2 year averagediscount

Municipal National Leveraged –4.0 –6.6 –4.2

Municipal Non Leveraged –5.3 –6.5 –4.7

California Leveraged –3.0 –6.2 –2.7

New Jersey Leveraged –12.8 –13.3 –8.3

New York Leveraged –2.5 –6.5 –4.1

Source: Bloomberg, UBS, as of 8 February 2019

2018 market returns vs. YTD 2019 market returns


Figure 1

Funds under coverage, in %

0

–2

–4

–6

–8

–10

8

6

4

2

–6

10

National Non leveraged New Jersey New YorkCalifornia

6

–2

2018 YTD 2019

877

3

–5–7 –7

Dec

-18

Oct

-18

Au

g-1

8

Jun

-18

Ap

r-18

Feb

-18

Feb

-19

2

1.5

1.75

0.75

1.25

1

SIFMA Index, currently at 1.51%


Figure 3

In %


Exchange-traded funds updateFlows! What are they good for?Municipal bond ETFs posted record inflows of nearly USD 7bn in 2018, and over the past three years municipal ETF assets have doubled (Fig. 1). There are now 46 municipal bond ETFs that combine for USD 36bn in assets. We expect the municipal ETF market to continue to grow, given the benefits of the ETF structure around costs and tax efficiency as well as the many ways ETFs can be used within portfolios (e.g., core holdings, tactical positioning, managing liquidity needs).

While municipal bond ETFs only account for 1% of the overall municipal market, there will be more attention paid to ETF flows as the municipal ETF market grows. Larger flow days are becoming more common. Fig. 2 shows the number of days when flows either into or out of the largest municipal bond ETF, the iShares National Muni Bond ETF (MUB), exceeded USD 50mn. This occurred 38 times last year, which exceeded the total number of instances between 2007 and 2017 combined. In January of this year, it happened seven times.

We caution reading too much into flows. As we discuss in our blog posts, Fund flow fallacies and The myth of “more sellers than buyers,” flows simply represent a change in ownership between investors. They do not tell us that cash has entered or exited an asset class, only that more or less of that asset class is being owned in a given structure (for example ETFs). Also, sim-ply looking at ETF flows or mutual fund flows only tells us part of the overall picture. It ignores direct ownership of individual securities as well as other third-party managed investments (e.g., separately managed accounts, hedge funds).

On a more granular level, ETF flow data is noisy. ETF shares can be created (potential bullish indicator) with the intent of being sold short (bearish application). Additionally, it’s not uncom-mon for flows of ETFs tracking the same or very similar indices to move in opposite directions. For instance, despite track-ing the same index, flows for the two largest municipal bond ETFs, MUB and the Vanguard Tax-Exempt Bond ETF (VTEB), moved in opposite directions on 15% of the daily observations since VTEB’s inception (Fig. 3).

ETF fund flow data can provide insights into broader structural trends, such as preferences for how to access an asset class. We do not recommend using flows data as an indicator to try to time the market.

Source: Morningstar Direct, UBS, estimated daily flows from 7 September 2007 to 31 January 2019

Larger flows will become more common as the market grows

0

10

5

35

30

20

25

15

0

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2019

10

5

50

45

40

35

30

25

20

15

40

# of ETFs (right hand side)

Assets (USD billions, le hand side)

Figure 1

Larger flows will become more common as the market grows

Source: Morningstar Direct, UBS, estimated daily flows from 7 September 2007 to 31 January 2019

Figure 2

# of days when absolute value of MUB's flows were > USD 50mn

35

30

25

20

0

5

10

15

40

2007 20182017201620152014201320122011201020092008 2019

Despite tracking same index, MUB and VTEB flows don‘t always move in tandem

Source: Morningstar Direct, UBS, estimated daily data from 25 August 2015 to 31 January 2019

Figure 3

% of observations when both MUB and VTEB had net flows

Opposite directionSame direction

85.3

14.7


SPOTLIGHT

Spotlight on not-for-profit hospitalsThe US healthcare sector is a major component of the US economy, constituting an estimated 17.2% of US gross do-mestic product.1 The aggregate share of nominal spending on health care has increased markedly since 1965, when it repre-sented just 6% of GDP. The spike in spending is attributable to a variety of factors. As baby boomers age and life expec-tancy increases, household spending on health care increases. Meanwhile, advanced technology and innovative therapies have transformed formerly fatal diseases into chronic condi-tions that must be actively managed.

The health care sector also is an important constituent of the US municipal bond market, comprising approximately 13% of the Bloomberg Barclays revenue bond index. Not-for-profit hospitals, which issue tax exempt municipal bonds, are the most numerous providers of acute medical care in America. According to the latest data from the American Hospital As-sociation, they comprise approximately 67% of all hospitals in the country, well ahead of for-profit institutions and gov-ernment-run facilities. Medicare and Medicaid have assumed greater importance to the operation of these hospitals. Their combined share of total health care spending increased from 7% in 1966 to 36% in 2014.2

Winds of changeAnd yet, despite the importance of the health care sector to the US economy, many private investors approach the health care sector with a degree of trepidation. Their concern is un-derstandable. History suggests that the probability of default is higher than in many other sectors of the municipal bond market (see Fig.1). Investors are compensated for the incre-mental risk and longer duration through a higher average yield (3.07%) but the difference is only about 40bps higher for the health care sector than for the revenue bond index as a whole.3

We attribute the incremental credit risk to the rapid transfor-mation of the industry. Operating margins are under pressure as competition among hospitals increases and reimbursement policies evolve. Reimbursements from third parties are focus-ing more intently on patient outcomes, rather than on tradi-tional ‘fees for service.’ The shift in emphasis toward ambu-latory care has contributed to slower growth in hospital ad-missions and undermined the efficacy of some recent capital investments at acute care facilities.

New competitors also have begun to emerge. The CVS-Aetna affiliation, for example, is designed to win a share of hospitals’ outpatient dollars by providing similar services at a lower cost and at many more physical locations. According to Moody’s,

Number of defaults by sector (1970–2017)

Source: Moody‘s US Municipal Bond Defaults and Recoveries, 31 July 2018, UBS

Figure 1

20

8

5

2 3 2 2 2

23

0

5

10

15

25

City/County

GO

City/Countylease

SchoolGO

ElectricUtility

TollFacility

WaterSewer

HigherEducation

Health-care

Source: Kaufman Hall, UBS, as of 31 December 2018

Healthcare M&A activity

0

40

20

120

100

80

60

$–2017201620152014201320122011201020092008 2018

$100

$50

$450

$400

$350

$300

$250

$200

$150

140

Transaction Seller Size by Revenue per Transaction (rhs)

Lhs: number of transactions; Rhs: seller size by revenue, in USD millions

Announced Transactions (lhs)

Figure 2

6050

7486

9198 102

112102

115

90

2013201120092007200520032001199919971995 2017

12

–2

0

6

8

10

2

4

2015

Operating and cash margin have been pressuredover time

Source: American Hospital Association, UBS Data from January 1995 - January 2018.

Figure 3

Operating margin

Cash Margin

In %


SPOTLIGHT Spotlight on not-for-profit hospitals

Figure 4

Merger descriptions with rationaleMerger Key reason for merger Scale rationale Scope rationale

Catholic Health Initiatives & Dignity Health Increase in scale; moderate increase in scope

Geographically complementary with no overlap; Gives CHI exposure to CA market where Dignity is a big player. Additionally creates bargaining power for both systems

Focused on increasing scope with specialized care that will ultimately allow for price increases.

Bon Secours & Mercy Health Increase in scale The combined entity covers 7 states (overlapped in KY) with a focus on improving economies of scale and cutting costs

Both operate hospitals and post-acute care facilities. Bon Secours brings skilled nursing facilities to the combined system

Advocate & Aurora Increase in scale and scope Advocate (IL) and Aurora (WI) partnership expands geographic footprint and enhances scale to recognize greater efficiencies

Transaction gives Aurora access to some of the nation’s best hospitals and a large home health and hospice company. Advocate now has access to over 150 clinics and more than 70 pharmacies.

Atrium Health & Navicent Health Moderate increase in scale and scope Navicent health gives NC based Atrium a hub for operations in central and south GA

Atrium will maintain and expand Navicent’s core services: Level 1 trauma center, tertiary services and teaching hospital

ProMedica Health & HCR ManorCare Increase in scale and scope Partnership has enabled ProMedica to significantly scale its system to become the 15th largest in the nation. ProMedica previously operated in 2 states, acquisition gives access to 28 more

Gives ProMedica access to post-acute care market creating an organization providing an unmatched breadth of services and capabilities: hospital system, a physician group, telehealth, several health plans, an academic affiliation, skilled nursing, assisted living, rehab, home health and hospice.

Source: UBS, as of 4 February 2019

the competitive supply of outpatient services has led to an ac-tual decrease in hospital outpatient visits in 2018, down for the first time in five years.

Over the next decade, hospitals will be competing with a pow-erful combination of insurers and retailers. Moreover, patients are now equipped with more information regarding the cost of their medical services. The introduction of high deductible health plans has encouraged them to shop around for bet-ter prices. Younger consumers have higher expectations and are more likely to treat their health care as they would any other consumer item, raising the specter of more competition around pricing and service levels.

Medicaid expansion, as a result of the Affordable Care Act (ACA), has benefited many hospitals by providing reimburse-ment for care that otherwise would have been uncompensat-ed. However, the recent US District Court decision invalidating the ACA and the persistent ambiguity over the constitutional-ity of the Affordable Care Act makes long-term planning far more challenging for hospital administrators.

For many, the only option is a merger or acquisition, essentially a mad dash for greater size and scale to improve their nego-

tiating position. Larger hospital systems have inherent advan-tages over their smaller rivals. Their greater size provides more geographical diversity, better leverage in contract negotiations with suppliers, and flexibility to invest in more sophisticated IT applications to manage patient populations and treatment outcomes. In recent years, mergers and acquisition activity has significantly intensified – with an increase in both the number and the average size of transactions in the last 10 years (see Fig. 2). Of course, acquisitions also come with intrinsic integra-tion and execution risks that are hard to objectively evaluate and, over time, there are bound to be winners and losers em-ploying this strategy.

A new analytical frameworkThe UBS Chief Investment Office (CIO) has developed a series of credit frameworks to assess the credit risk posed by indi-vidual hospital and health care systems. We apply fixed and objective criteria to the analysis of hospital financial opera-tions. The net result is a relative ranking of credit risk among those hospitals with the most municipal debt outstanding. For a detailed discussion of the criteria and the credit scores as-signed to each hospital system, please refer to our Municipal Brief, Not for profit hospitals: risk assessment framework, 4 February 2019.





California

Fiscal year to date 2018–19 state revenues of USD 74.4bn were lower than expected in the proposed and enacted bud-gets by USD 2.87bn and USD 1.32bn or just 0.2 percent lower than a year earlier.

The Los Angeles Unified School District (the “District”) agreed to a new contract with members of the United Teach-ers of Los Angeles (“UTLA” or “the union”) after a six day strike. The agreement included a three-year contract through the 2021–22 school year inclusive of: 1) a six-percent raise for teachers (three-percent retroactive, three-percent ongoing), 2) the District’s commitment to hire additional support staff, and 3) a reduction in class size (by one student per year). The District, City of Los Angeles, Los Angeles County and the state have agreed that additional funding sources may need to be instituted to offset anticipated increases in expenses.

San Diego City Employees’ Retirement System (SDCERS), San Diego’s largest pension plan, approved two new rules to help reduce unfunded liabilities more quickly. The first rule insti-tutes a contribution floor equal to approximately USD 275mn (the 2018 contribution amount), which is currently higher than the actuarially determined contributions. The second rule seeks to require the system to amortize its unfunded liabilities over 20 years (versus 30 years) despite any future legislative amendments or changes to these rules.

Sacramento City Unified School District’s (the “District”) general obligation (GO) bonds were super downgraded by Standard & Poor’s (S&P) four notches from A+ to BBB (ap-proximately USD 488mn outstanding) and five notches on its lease revenue bonds from A to BB+ (approximately USD 66mn outstanding). The district’s S&P rating remains on CreditWatch with negative implications. Moody’s also downgraded the Dis-trict GO bonds two notches from Aa3 to A2 while also reas-signing the outlook from stable to negative. The downgrades came after the state’s Fiscal Crisis & Management Assistance Team (FCMAT) released a report in December expressing con-cerns related to the District’s weak liquidity, structural imbal-ance and lack of a plan to resolve its current situation.

Connecticut

The state revised its revenue projections which result in an an-ticipated operating surplus of USD 462mn by fiscal year end. The Office of Policy and Management Secretary, Melissa Mc-

Caw, is estimating that the revised operating surplus will result in USD 2.3bn of reserves in its Rainy Day Fund. The upward revision is driven by increases in sales tax, personal income tax, estate tax and gambling revenue collections.

IllinoisGovernor Jay “JB” Pritzker’s administration has revised the 2020 budget gap estimate to USD 3.2bn, from prior Gover-nor Bruce Rauner’s administration’s previously reported USD 2.765bn. As part of the Governor’s transition, Pritzker’s bud-get committee released several reports containing initiatives to reduce the budget shortfall, sizeable unfunded pension li-ability of USD 133.7bn, and USD 7bn backlog of unpaid in-voices. Improvement measures include revenue increases from both new and existing sources as well as stronger expense management controls. New tax revenue streams include legal-izing marijuana and sports betting as well as shifting from a flat to graduated income tax. Moody’s recent review of the state mentioned that revenue growth from existing sources will be too tepid to offset escalating fixed costs, while new taxes could threaten to increase the outflow of residents. The Governor is expected to unveil his combined budget proposal on 20 February.

Kentucky

After Kentucky’s Supreme Court unanimously struck down the General Assembly’s pension reform legislation in December, the state created a formalized taskforce to conduct a review of the retirement system’s structure, costs, benefits and funding levels. The Public Pensions Working Group was appointed to recommend changes by 15 February. Critics and many legisla-tive leaders have criticized the expedited timeline as they want a more comprehensive and thoughtful review. State Auditor Mike Harmon, recently presented a report breaking down the state’s total debt burden of USD 54.6bn, which is largely driv-en by the unfunded pension liability of USD 43.3bn.

Missouri

St. Louis mayor Lyda Krewson and St. Louis County Execu-tive Steve Stenger expressed support for a proposal to merge the two entities into the 9th largest metropolitan city in the US. A city-county governance task force, “Better Together”, was launched in 2013 to research local government operations. The combined entity would encompass 90 municipalities, 23 fire districts, at least 60 police departments, 20 municipal fire departments and 81 municipal courts. The taskforce’s propos-

In the news 9 January 2019 – 11 February 2019


al was released on 28 January outlining how a merger could result in an estimated USD 250mn to USD 750mn of annual savings for taxpayers due to the elimination of inefficiencies and service duplication. The proposal requires 160,000 sig-natures to be placed on the 2020 ballot for statewide ap-proval. The plan preserves current municipalities but reclas-sifies them as municipal districts of the Metro City, with all current debt and outstanding liabilities to remain within the district in which they were incurred. Critics fear a loss of lo-cal control as well as potential unanticipated policy and fiscal impacts.

New Jersey

Jersey City (the “City”) and the Port Authority of New York and New Jersey (PANYNJ) resolved litigation founded on the City’s claims that the PANYNJ was not paying suffi-cient taxes on certain properties to the City. The settlement includes PANYNJ paying the city almost USD 53mn over 25 years of payments in lieu of taxes (PILOTs), inclusive of 10 years of back payments. Additionally, the PATH rail system (owned by PANYNJ) will pay the City an additional USD 18mn so that a new station could be built with the city, PA-NYNJ and PATH agreeing to share in any additional revenue created from such redevelopment of the station.

Governor Phil Murphy vetoed a toll rate increase for the Dela-ware Memorial Bridge, which is operated by the Delaware River & Bay Authority (“DRBA” or the “Authority”). The toll hike was unanimously approved by the Authority in De-cember to help fund its USD 440mn capital improvement plan through 2021. Governor Murphy’s attributed his re-jection of the toll hike to the absence of any critical safety improvements. The toll increase from USD 4 to USD 5 was intended to generate USD 34mn annually. Given such rev-enues are no longer anticipated, the DRBA says that many infrastructure investment projects will be delayed or post-poned indefinitely until revenues are available. This is the first time in the Authority’s history where a proposed toll increase was not enacted.

New YorkThe State Comptroller, Tom DiNapoli, said that state income tax revenue collections are down USD 2.3bn or 3 percent of general revenues, for December and January. Governor An-drew Cuomo has announced that the shortfall will force him to revise the USD 175.2bn proposed budget which was re-leased 15 January. According to the Governor, the decrease

is largely driven by federal tax changes instituted in late 2017, which encouraged many wealthy residents to relocate. He anticipates seeking an extension to the millionaire’s tax be-yond its 1 January 2020 expiration, along with a series of possible new revenue generators including the legalization of recreational marijuana, casino sports betting and online sales tax. The state’s final state budget is due 31 March prior to the new fiscal year which begins 1 April.

An arbitration panel ruled on 8 January that the Seneca Na-tion must continue to share casino revenue payments with the state under the original terms of its 2002 agreement. The Seneca Nation discontinued making such payments in 2017 after claiming that the extension agreement did not explicitly state that they needed to continue to share such revenues. Under the original terms, the Seneca Nation must remit 25 percent of slot machine revenues to the State, a quarter of which the state then remits to the casino’s host cities: Niagara Falls, Buffalo and Salamanca. The panel ordered the Seneca Nation to make all past due amounts in addition to resuming future shared revenues. Both the State and Seneca Nation must report back to the arbitration panel by 19 February with repayment details.

Texas

The DeSoto Independent School District (the “District”) posted a voluntary disclosure on EMMA in early January stating that the District’s financial condition has weakened since revising its tax rates in 2015. During that year, the Dis-trict reduced its debt service tax rate and reallocated such amounts towards its operational levy. Since the realloca-tion, the District has grown dependent on annual transfers from the general fund for payment of debt service, forcing the District to issue loans to pay for operations and debt service. Outstanding debt is supported by the states Per-manent School Fund which is rated AAA. S&P downgraded the District’s underlying rating on 5 February from A+ to A citing the District’s financial weakness and left its rating on CreditWatch with negative implications as it awaits the District’s plan to revert the financial distress and payment of its ongoing debt obligations.

In the news


Chartbook muni metrics

4.0

3.5

2.5

1.0

1.5

3.0

2.0

Feb-15 Aug-15 Feb-16 Aug-16 Aug-18Feb-18Aug-17Feb-17 Feb-19

8,5006,5004,5002,500

10,500

20,50018,50016,50014,50012,500

24,50022,500

Visible supply and yields

Source: Bloomberg, MMA, UBS, as of 11 February 2019

30-Day Visible Supply (rhs)

Figure A1

Yield in % (lhs); supply in USD millions (rhs)

Treasury 10 yr (lhs)

AAA GO 10 yr (lhs)

Feb-17 Aug-18Feb-18 Feb-19Feb-15 Aug-15 Feb-16 Aug-16 Aug-17

4

3

2

0

1

AAA Muni yields


Figure A3

AAA GO 5 yr

AAA GO 10 yr

In %

AAA GO 30 yr

Feb-19Feb-13 Feb-14 Feb-15 Feb-18Feb-17Feb-16

200

150

0

100

50

Credit quality spreads


Figure A5

BAA GO 10 yr – AAA GO 10 yr

A GO 10 yr – AAA GO 10 yr

In bps

AA GO 10 yr – AAA GO 10 yr

Historically low yields

Fed li-off

15,000

10,000

5,000

–5,000

–20,000

0

–15,000

–10,000

Municipal mutual fund flows

Note: January flows are MTD, as of 30 January 2019Source: Investment Company Institute, UBS, as of 30 January 2019

Monthly Net New Cash Flow

Figure A2

In USD millions

Jul-13Jan-13 Jul-14Jan-14 Jul-16Jan-16Jul-15Jan-15 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19

25 300 5 10 2015

4

3

0

2

1

AAA yield curve change


Figure A4

11/02/2019

11/01/2019

In %

09/02/2018

May Sep Oct Nov DecJan Feb Mar Apr AugJun Jul

70

60

40

0

20

50

10

30

Monthly Issuance 2017 Monthly Issuance 2019

Total monthly municipal issuance

Source: Bond Buyer, UBS, as of 8 February 2019

Monthly Issuance 2018

Figure A6

In USD billions


Chartbook muni metrics

4.0

3.0

0.0

1.0

2.0

292827262524232221201918171615141312111097653210 304 8

One-year horizon total return assuming unchanged AAA yield curve


Favored maturity range

Figure A7

Total return (TR), in %

1 year horizon TR w/ roll down

AAA GO

200

180

160

120

60

80

140

100

‘96‘95‘94‘93‘92‘91 ‘97 ‘99‘98 ‘11‘10‘09‘08‘07‘06‘05‘04‘03‘02‘01‘00 ‘13‘12 ‘14 ‘15 ‘16 ‘17 ‘18 ‘19‘90‘89‘88‘87‘86

Tax Reform Act

stock market crashOctober 1987

stocks sell-off 1989

Orange County CAbankruptcy

1995–1996 flat tax proposal

Asian crisis

Global recessionSeptember 2001

WorldCom bankruptcy Monoline insurer

Euro debtcrisis

Jefferson County, AL files for bankruptcy

Threat to tax exemption

Rate Volatility

Current:99.33

Techbubble burst

Globalfinancialcrisis of

2008/2009

Historical events’ impact on muni-to-Treasury (m/T) yield ratio (1986 through present)


Figure A8

AAA GO 30 yr – Treasury 30 yr

m/T ratio, in %


Feb-19Feb-18 Apr-18 Jun-18 Oct-18 Dec-18Aug-18

110

100

70

90

80

AAA muni-to-Treasury yield ratios


Figure A9

10 yr

30 yr

In %

Feb-19Feb-18 May-18 Nov-18Aug-18

220

190

70

160

130

100

Industrial Corporate and BABs spreads


Figure A11

U.S Industrial Corp 10+yr OAS

BABS Build America Bond Index OAS

Option adjusted spreads, in bps

Feb-19Feb-18 Apr-18 Jun-18 Oct-18 Dec-18Aug-18

100

90

95

70

85

80

75

A muni GO versus A Industrial Corp. yield ratio

Source: MMD, Bloomberg, UBS, as of 11 February 2019

Figure A10

10 year

30 year

In %

Feb-19Feb-17 Jun-17 Oct-17 Jun-18 Oct-18Feb-18

84

78

80

82

70

76

74

72

Tax-exempt to BABs yield ratio


Figure A12

Tax-exempt Munis YTM to BABS YTM

In %

350

300

250

150

0

50

200

100

Feb-18Feb-17Feb-16Feb-15Feb-14 Feb-19

IL

NJ

PA

CT

CA

NY

TX

FL

10-year GO spreads for select states


Figure A13

State spreads, in bps

Chartbook relative value


Market view1 H.R.5003-To amend the Internal Revenue Code of 1986 to reinstate

advance refunding bonds, 13 February 20182 Based on Federal Reserve Board, Flow of Funds Accounts, 3Q 2018

Portfolio themes1 Spreads are based on S&P municipal bond indices as of 8 February

2019

Spotlight1 Tsung-Mei Cheng, “Health Care Spending in the US and Taiwan: a

Response to It’s the Prices, and a Tribute to Uwe Reinhardt”, Health Affairs, 6 February 2019. Note: Brookings has estimated health care’s share of GDP at closer to 18%.

2 David Boddy, Jane Dokko et al, Six Economic Facts about Health Care and Health Insurance Market after the Affordable Care Act, The Hamilton Project, Brookings, 6 October 2015.

3 Yield and duration is based on Bloomberg Barclays municipal bond indices as of 8 February 2019. The sector’s longer duration (8 years) contrasts with the broader revenue sector duration of 6.7 years. The health care sector also has a lower average credit rating (A1/A2) than the broader revenue bond index (Aa3/A1).

Endnotes


Required disclosures

UBS Closed-End Funds Ratings and Definitions

UBS Financial Services Rating Definition and criteria

Buy Higher stability of principal and higher stability of distribution

Hold Potential loss of principal, lower degree of distribution stability

Sell High potential for loss of principal and distribution risk

Municipal bonds: Although historical default rates are very low, all munici-pal bonds carry credit risk, with the degree of risk largely following the par-ticular bond‘s sector. Additionally, all municipal bonds feature valuation, return, and liquidity risk. Valuation tends to follow internal and external factors, including the level of interest rates, bond ratings, supply factors, and media reporting. These can be difficult or impossible to project accu-rately. Also, most municipal bonds are callable and/or subject to earlier than expected redemption, which can reduce an investor’s total return. Because of the large number of municipal issuers and credit structures, not all bonds can be easily or quickly sold on the open market.

Closed-end fundsInvestment Risk: Performance results reflect past performance and is no assurance that a fund will meet its investment objective. Market Risk: The market value, net asset value (NAV) and distribution rate of a fund’s shares will fluctuate with market conditions. Leverage Risk: Each fund’s use of leverage (borrowing to increase invest-ments) creates the possibility of higher volatility and greater risk for the fund’s per share NAV, market price, distributions and returns. Credit Risk: Refers to the possibility that the issuer of the bond will not be able to make principal and interest payments (default).

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Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issu-

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UBS does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a con-flict of interest that could affect the objectivity of UBS research reports.

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Required disclosures

Agency credit ratings

S&P Moody’s Fitch/IBCA Definitions

Investment grade

AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality.

AA+ Aa1 AA+AA Aa2 AA Issuers have very strong credit quality.AA- Aa3 AA-

A+ A1 A+A A2 A Issuers have high credit quality.A- A3 A-

BBB+ Baa1 BBB+BBB Baa2 BBB Issuers have adequate credit quality, This is the lowest Investment Grade category.BBB- Baa3 BBB-

Non-investment grade

BB+ Ba1 BB+BB Ba2 BB Issuers have weak credit quality. This is the highest Speculative Grade category.BB- Ba3 BB-

B+ B1 B+B B2 B Issuers have very weak credit quality.B- B3 B-

CCC+ Caa1 CCC+CCC Caa2 CCC Issuers have extremely weak credit quality.CCC- Caa3 CCC-

CC Ca CC+CC Issuers have very high risk of default.CC-

D C DDD Obligor failed to make payment on one or more of its financial commitments. This is the lowest quality of the Speculative Grade category.

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ETFs are subject to the same risks as the underlying securities and commis-sions may be charged on every trade, if applicable. This definition does not imply that ETFs are endorsed by the Securities and Exchange Commission. ETFs are sold by prospectus, which contains details about ETFs, including investment objectives, risks, charges and expenses. Clients should read the prospectus and consider this information carefully before investing. Clients may obtain more information about ETFs, including copies of prospectuses or summary, from their UBS FS financial advisor.


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