At a time of brisk demand in the market for municipal bonds, we believe the moment is right for a strategy rethink. Muni bonds in our view offer considerable opportunity to diversify and to take advantage of shifting investor dynamics and supply-demand trends.
The current picture is one of rising demand and limited supply. In the first half of 2019, investors piled $21.1 billion into national intermediate municipal bond funds, well above the 5-year average of $8.9 billion (Exhibit 1). Muni issuance, however, has been in line with the prior-year trend; we do not anticipate any meaningful surge in bond issuance.
Source: Simfund and GSAM.
Chart Notes: As of June 30, 2019, latest available. Chart shows the municipal fund inflows averaged over the past five years (2014–2018) and for 2019 year-to-date. ‘Municipal fund inflows' are based on 'net new flows' as defined by Morningstar's 'Muni National Intermediate' category group. Please see end disclosures for additional definitions.
The global hunt for yield in our view is one driver of these strong technical conditions. So is the Tax Cuts and Jobs Act (TCJA) of 2017, which served to reduce muni issuance by eliminating tax-exempt advance refunding as an option for issuers. Aging demographics represent another potential long-term tailwind for muni demand.
Yield-hungry investors in search of higher coupons have also noticed the relative attractiveness of the muni yield curve. In the US, where the 1-30 year Treasury spread is now only at about 20 basis points, the yield advantage is almost 80 basis points greater in the muni markets.1 Unlike other bond markets, inversions in the muni yield curve have been exceedingly rare.
Investors in our view could look to take advantage of long-term structural changes in the muni market. Ever since the demise of muni-bond insurance, the market has grown more idiosyncratic. Credit quality has become a factor to watch, as meticulous credit research now stands a greater chance of being rewarded. Diversifying across the credit spectrum strikes us as one response to consider.
Investors may not need to give up yield potential; in fact, they may enhance yield and other important portfolio attributes. There are, for instance, numerous ways to match the duration of the Bloomberg Barclays Municipal Bond Index while boosting income (Exhibit 2). Similarly, it has been possible to match the yield of the index while reducing rate risk. The resulting portfolios may still maintain a credit rating that is A-or-higher.
Source: Bloomberg Barclays and GSAM.
Chart Notes: As of July 31, 2019. 'Muni Short' refers to the Bloomberg Barclays 3-Year Municipal Bond Index. 'Muni HY' refers to the Bloomberg Barclays High Yield Municipal Bond Index. 'Muni Agg' refers to the Bloomberg Barclays Municipal Bond Index. Chart shows several illustrative municipal bond portfolios that match the historical tax-equivalent yield and duration of the Bloomberg Barclays Muni Index respectively. 'Tax-equivalent yield' is used to compare the yield of a taxable bond to that of a tax-exempt bond. 'Duration' is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. 'Average credit rating' refers to ratings provided through Bloomberg Barclays. Tax-equivalent yield, duration, and average credit rating are portfolio-weighted averages of index data. These illustrative results do not reflect any GSAM product and are being shown for informational purposes only. No representation made that an investor will achieve results similar to those shown. The performance results are based on historical performance of the indices used. The results will vary based on market conditions and your allocation. Diversification does not protect an investor from market risk and does not ensure a profit. Please see end disclosures for additional definitions. Past performance does not guarantee future results, which may vary.
A “lower for longer” interest rate environment in our opinion is likely to persist. Under those conditions, we believe that investors can look beyond traditional high-grade munis to generate yield potential while managing interest-rate sensitivity and tax considerations.
 The spread between the 1-Year US Treasury yield and 30-Year US Treasury yield is 20 bps as of July 3, 2019, from the US Department of the Treasury. The spread between the 1-Year muni yield and 30-Year muni yield is 100 bps as of July 31 2019, from Thomson Reuters Municipal Market Data (MMD).Past performance does not guarantee future results, which may vary.