In this Q&A with Ben Barber and Scott Diamond, we discuss the muni landscape in the context of US tax reform, and offer our views on where to find value across the credit spectrum and along the yield curve.
Tax reform had a major impact on supply and demand dynamics in the muni market in 2018. In our view, this theme will persist throughout 2019. From a supply perspective, issuance was lighter in 2018 than it would have been in the absence of tax reform, which was supportive of muni bond spreads. Issuers were prompted to pull supply forward from 2018 into late-2017 due to two provisions in the original draft of the bill: eliminating the ability to pre-refund municipal debt and the ability of not-for-profit entities to issue tax-exempt private-activity bonds (PABs). Gross issuance declined by 25% in 2018 to $339bn1 and we expect supply to remain relatively muted in 2019, estimating a modest 8% increase, or $365bn by year-end. We believe this moderate increase in supply should be manageable for the market to digest, as it is well below the historical average of $400bn2.
For the first three quarters of 2018, investor demand for munis was resilient even as the Fed hiked rates, with open-end municipal bond mutual funds garnering about $10bn of inflows over that period. There was a sharp reversal though in the fourth quarter amid general risk-off sentiment and concerns about potential rising rates, with Q4 fund outflows of $12bn bringing 2018 muni fund flows to -$2bn3. Investors have already returned to the asset class this year with approximately $3bn4 of muni fund inflows in January, likely driven by the Fed’s dovish5 comments that shifted investor sentiment.
In 2019, the effect of tax reform on individual investors’ demand will pick up as the new tax code capping individuals’ State and Local Tax (SALT) deduction comes into play this year. We expect this to drive even more demand for munis as these investors may seek out other opportunities to shield themselves from taxes. Expectations for demand from corporations in 2019 are less clear given that banks and property and casualty insurance companies, which represent about 25% of muni bond holders, received a much larger tax cut than individuals, likely reducing the appeal of tax-exempt munis.
Overall, lean supply is a tailwind6 for the muni market, and when coupled with the potential for increased demand from individuals, constructs a positive picture of the technical environment for munis.
The muni yield curve usually follows the Treasury yield curve, so when rates rise, muni rates will increase as well. The slope of the yield curve for Treasury bonds and municipals bonds differ, however, due to the distinct demand profile for each asset class. In the muni market, we believe retail investors favor munis with shorter maturities to limit duration risk, whereas corporate investors and mutual fund investors tend to prefer munis further out the curve. Lower corporate tax rates have reduced demand from corporate investors in the long-end of the curve, while new issue supply has increased in order to match the lifetime of infrastructure projects. This mismatch between supply and demand has put pressure on the prices of longer-term munis, pushing up yields. The 10- to 12- year portion of the muni yield curve is the steepest, which may provide a compelling entry point for investors looking to capture the greatest roll-down return. This can potentially offer investors the greatest incremental return per unit of additional duration risk.
Another way to measure the relative cheapness of munis is to compare the ratio of AAA-rated7 municipal bond yields to the yield of a duration-matched Treasury bond. At the longer end of the curve, the muni/Treasury ratio is around 100%8, suggesting that munis are cheap relative to Treasuries as they are essentially giving investors the tax benefit of munis for free.
We believe credit fundamentals are strong and that the muni market has continued to benefit from economic growth and growing tax revenue. In 2018, general fund revenue collections came in ahead of budget projections for 40 states, the highest number of states since 2006. Most municipalities have exhibited healthy credit metrics and have built up their rainy day funds substantially. Overall, we think credit will remain stable in 2019 but recognize that there are many different sectors and states with varying credit quality. This diversity of creditworthiness in the muni market could provide investors with greater potential opportunities to find value by investing across the credit spectrum.
The new governor shifted to a more conservative approach with his budget proposal by modestly increasing spending while also paying down state debts, which was a relief to muni investors. California has experienced one of the longest expansion phases in history, but recently has shown signs of moderating growth. The budget proposal would increase California’s rainy day fund, which could provide some relief in the event of a recession.
Puerto Rico’s (PR) debt crisis has been a pain point for the municipal market as most municipal bond funds have some exposure to Puerto Rico’s triple tax-exempt bonds. The restructuring of PR’s debt is now underway, however, and may mark an inflection point by alleviating some of PR’s burden on the muni market. The issuance of sales tax bonds, called COFINA bonds, in mid-February will allow institutional investors to take advantage of new potential opportunities in the high yield market.
As the Democrats take control of the Illinois governor seat and regain their supermajority in the House, we expect the politically-aligned government will engender greater stability for Illinois’ credit. Governor Pritzker’s proposal to replace the state’s flat income tax with an incremental one would be beneficial in addressing the state’s host of financial issues, such as their unfunded pension liabilities and significant operating deficit. From a credit perspective, we have conviction in the State of Illinois and think there is an attractive risk-reward trade off. For example, the State of Illinois has a BBB credit rating and you can receive an extra 60bps of spread by owning its bonds relative to other BBB-rated sectors like healthcare that have a much higher default rate.