The Midterm elections have put the municipal bond market front and center, at the nexus of state and local politics. The low likelihood of changes to the tax policy in a divided Congress will not have a material impact on munis, but GSAM’s Municipal Bond Portfolio Managers weigh in on the near-term and long-term trends that are shaping one of the world’s largest fixed income markets.
Nearing $4 trillion in size1, the municipal bond market is one of the oldest and largest fixed income markets in the world. But it’s undergone meaningful changes as the post-crisis period ushered in a notable transformation in market structure and ownership, political environment and fiscal drivers, and even muni bonds’ relationship to rates.
We look at both short-term supply and demand dynamics as well as longer-term fundamentals, including tax policies, state and local revenue trends, and public pension liabilities, to evaluate the relative attractiveness of municipal bonds.
The technical environment remains relatively strong, despite the robust outflows in October amidst risk-off sentiment and interest rate concerns. The overall demand picture has remained anchored, while the make-up of demand has shifted materially towards retail buyers, including open-end mutual funds as well as ETFs which have increasingly democratized access to the muni market. Institutional demand, however, has moderated somewhat as the US tax cut dampened domestic buying and US Dollar strength weakened the foreign bid as cross-currency hedging costs rise. At the same time, supply remains light and supportive of bond spreads, after a couple years of net negative issuance and a longer downward trend in supply after a rapid growth during 2009-2010 to help finance the post-crisis fiscal stimulus.
We believe credit fundamentals are in solid shape, supporting the case for munis alongside fair valuations after cheapening since the summer months. The downgrade and default outlook for the municipal market continues to look benign, with a lower default rate than similarly-rated corporate bonds. And state and local revenue trends remain constructive, though trends vary across states. California—the world’s 5th largest economy, even surpassing the UK—is showing signs of moderation, but from an incredibly strong 5% growth rate. The reduction in State and Local Tax (SALT) deductions is having an incremental impact on fiscal policies in high tax jurisdictions, such as California, but the upshot is that demand for in-state bonds could increase. With some exceptions, most municipalities are exhibiting healthy credit metrics and remaining fiscally austere.
The risk from pension liabilities across municipalities needs to be considered in the context of broader credit fundamentals. Reports have sounded the alarm bells, citing $1 trillion in pension obligations across states. However, we think broad determination of muni pension risk across the entire market misses the point. We look at this risk at the issuer level to determine the level of risk and, as a practical matter, there are plenty of opportunities to invest in munis while avoiding the pension pitfalls.
Pension funding levels are still adequate, with the GSAM top 100 local municipalities2 having an average funded ratio of 74% although pockets of risk remain. Pension reform has helped stem a broader crisis, bringing in better mark-to-market of assets, more reasonable discount rates and modernization of benefits. However, we remain alert to the recent equity market volatility, which could further pressure weaker funded systems in cities like Chicago and Philadelphia.
The pickup in rates volatility has had an outsized negative impact on retail demand, especially in longer-dated products where duration3 is longer and liquidity is lower. We believe that higher rates as a function of better growth prospects should actually be interpreted as a positive sign for muni investors in the current environment, as yields look more attractive and the relative cheapness of municipal bonds to US Treasuries may provide a cushion to investors in the event of continued rate volatility.
The correlation between rates and municipal bonds has changed dramatically, however, since the crisis after municipal bonds largely lost their AAA-rated4 status after February 2008. Today, a much smaller share of the market is AAA-rated as well as insured, driving a massive recalibration of the muni market relative to other fixed income sectors. A less stable correlation between rates and munis may provide greater potential opportunities to find value by investing across the quality spectrum and varying duration exposure.