Global Fixed Income

Weekly discussion of fixed income market action and what it may mean for investors.

November 30, 2016

George E. Rusnak, CFA, Co-Head of Global Fixed Income Strategy

A Silver Lining for Municipals

  • Recent municipal underperformance likely stems from expected lower tax rates with the new administration.
  • Yet, municipal-Treasury yield ratios are approaching historically favorable levels.
  • Additionally, the long-term factors driving municipal demand, including an aging U.S. population seeking the income benefits of municipal securities, still favor the sector.

What it may mean for investors

  • Although lower federal tax rates may be on the horizon, we believe that the recent decline represents an opportunity for long-term, investment-grade municipal investors.

The municipal market has experienced a more significant downturn than taxable fixed income with the recent rise in bond yields. While much of this decline can be attributed to concern over expected federal tax-rate reductions under the new administration, some of it can be attributed to an expected decline in demand for municipals after more than a year of positive weekly municipal fund flows leading up to the election. While the downturn highlights underlying concern over future tax rates, we believe that investors should consider municipals in relation to their taxable counterparts today, along with other administration policy changes that may be more favorable to municipals in the longer term.

Chart 1. Bloomberg Barclays Municipal Index Level: November 2015 to November 2016Chart 1. Bloomberg Barclays Municipal Index Level: November 2015 to November 2016Source: Bloomberg 11/27/16. Past performance is not a guarantee of future results.

What Happened?

Investment-grade municipals have suffered a decline of nearly three percent (-2.96 percent) since the end of October as the Republican presidential win led to a rise in Treasury rates and to concern over lower future federal tax rates potentially reducing the benefits of municipals. Additionally, the possible elimination of the Affordable Care Act (and its accompanying tax on an additional 3.8 percent of passive income) could further reduce the benefits to municipal bondholders. These concerns had immediately followed consistent and significant positive flows into municipals (more than $50 billion year to date) in anticipation of a Democratic-led administration that campaigned for higher tax rates.

Chart 2. Municipal Fund Flows Have Declined Dramatically in Recent WeeksChart 2. Municipal Fund Flows Have Declined Dramatically in Recent WeeksSource: Lipper, 11/28/16. Past performance is not a guarantee of future results.

Is It All Bad News for Municipals?

Despite the possibility of lower federal tax rates under the new administration, there also are some positive potential outcomes that deserve consideration by municipal investors. These include:

Elimination of the Municipal Exemption is Less Likely than Lower Tax Rates—We believe that the new Republican-led Congress and the administration are less likely to explore eliminating the municipal exemption status (than they are to lower federal tax rates). Leaving the municipal exemption status unchanged offers more certainty to current and future municipal bondholders of their tax-exempt security benefits.

A Cap on Municipal Bond Benefits Also is Less Likely than Lower Tax Rates—Additionally, we believe that the new administration likely will focus on simplifying and lowering federal tax rates rather than capping the benefits that municipal bondholders would receive from their municipal securities. A cap on municipal benefits would reduce the benefit for higher tax-bracket investors more severely than lowering the federal tax rate would.

Municipal New Issuance is Supportive of Price Discovery—Close to $70 billion in new municipal bond issuance passed in November’s ballot. This is the most in a decade. This new issuance may lead to improved price discovery within the market.

Timing and Details—Although the current administration has campaigned on a lower tax-rate policy, it is still unclear whether the federal tax policy being discussed will be approved and when it might be effective. Although the White House, Senate and House will all be Republican-led early next year, perspectives nevertheless differ among congressional representatives. It remains to be seen what the timing and details will be on final tax-policy legislation.

Year-End Seasonality—As we approach year end, it’s important to understand that municipal new issuance is likely to slow and possibly stop toward mid-December (based on historical seasonal trends). Historically, December has been a challenging month for municipal supply, with new issue inventory picking up in January. This has the potential to be supportive of municipal prices late in the year.

Favorable Ratios—Current municipal/Treasury yield ratios are fairly favorable vs. historical norms. When this is the case, it has historically represented good municipal buying opportunities for longer-term investors.

Chart 3. AAA Municipal/Treasury Yield Ratios: Past 12-Month Range and Current RatioChart 3. AAA Municipal/Treasury Yield Ratios: Past 12-Month Range and Current RatioSource: Thomson Municipal Market Monitor, 11/28/16. Chart shows municipal/Treasury security yield ratios at comparable maturities as indicated at the bottom of the chart. The Municipal/Treasury ratio is calculated by comparing the yield of AAA-rated municipal bonds vs. the yield on the equivalent Treasury Note Past performance is no guarantee of future results.

Recommendations

Although we believe that the municipal market will be more volatile over the next quarter, we recommend that longer-term investors use the recent rise in investment-grade municipal yields as an opportunity to invest in the sector. We believe that year-end supply issues, along with attractive yield ratios to taxable alternatives, outweigh the uncertainty over federal tax-policy developments that could be negative for municipal investors. We recommend that municipal investors move up in quality, favor the short-to-intermediate part of the yield curve, and consider including more defensive, higher-coupon callable structures in their portfolios. We also recommend essential-service revenue issues over municipal general-obligation issues given their historically more dependable revenue streams. In the longer term, the municipal market is likely to benefit from ongoing demand from an aging U.S. population. While the tax landscape may be changing, the changes are not likely to completely eliminate the income, tax and cash-flow benefits of municipal securities.

Risk Factors

Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer.

Definitions

An index is not managed and not available for direct investment.

Bloomberg Barclays U.S. Municipal Index represents municipal bonds with a minimum credit rating of at least Baa, an outstanding par value of at least $3 million and a remaining maturity of at least one year. The index excludes taxable municipal bonds, bonds with floating rates, derivatives and certificates of participation.

AAA Bond credit rating: Highest possible credit rating — principal and interest payments considered very secure.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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