April 15, 2019
George Rusnak, CFA, Co-Head of Global Fixed Income Strategy
How Long Can the Good Times Roll for Municipals?
- Municipal bonds recently have performed well, driven partly by demand for tax-exempt assets in the wake of the tax law’s cap on state and local tax deductions (SALT).
- While municipal-to-Treasury yield ratios have approached historically rich (low) levels, supply is limited and we expect demand to remain strong this year.
What it May Mean for Investors
- We are favorable on the municipal bond sector. Yet, we recommend selectivity and a higher-quality bias.
Municipal bonds have performed well year to date (YTD), returning 2.9% last quarter.1 We have a favorable view of municipals, and we anticipate solid near-term support for this sector overall. In fact, we recently upgraded our duration guidance from unfavorable to neutral to reflect this opportunity.2 The new tax law’s limit on SALT3 deductions has fueled strong demand for municipals, which we expect to last through the summer (or longer). In fact, YTD fund flows of more than $20 billion already exceed all fund inflows from 2018 (according to Lipper). There also are some favorable credit developments that suggest some states’ fundamentals are improving. Yet, we favor selectivity and a higher-quality bias, given municipals’ recent outperformance and the historically low municipal-to-Treasury yield ratios.
Tax changes have fueled strong demand
As noted, municipal demand has been strong. The $23.4 billion in YTD municipal fund inflows are the strongest since records began in 1992.4 In the wake of the new tax law and capping of SALT deductions, investors have responded with demand for municipal securities’ tax benefits, particularly in higher-tax states, such as California, Connecticut, New Jersey, and New York. This has caused the yield spread (over the AAA Municipal Market Data curve)5 for these states’ municipal debt to decline to levels near 1-year lows.6
We expect municipal-market demand to remain strong as five of the last nine months of this year are scheduled to have record amounts of maturing bonds.7 A large percentage of maturing municipal bonds historically has been reinvested in municipals. This reinvestment activity also should help to support the market.
Net negative supply
Despite our expectation for higher municipal issuance in 2019 than we saw last year, we anticipate that net municipal supply (after called and matured bonds) will remain negative this year. When maturing and called municipal debt is factored in, net municipal supply for 2019 is expected to cross -$50 billion.8 In fact, some analysts have estimated that net negative supply could top -$60 billion by year-end.9
Many municipal yield ratios are historically rich
The combination of tremendous demand and net negative supply has caused municipal-to-Treasury yield ratios to approach historically low (rich) levels (Chart 2). On April 10, the yield for 10-year municipal securities stood at approximately 77% of 10-year Treasury security yields; this is close to a 1-year low. This ratio is important for “crossover” buyers like banks, insurance companies, and international sovereigns. These buyers are typically attracted to municipals’ value as a high quality investment diversifier, rather than their tax-free benefits. Lower municipal-to-Treasury ratios typically will make these buyers less inclined to buy municipals.
A mixed story for fundamentals
Fundamentally, some state municipalities are doing well, while others are facing challenges, especially for their pension plans. Overall, state tax receipts increased by 7.0% year-over-year (YoY) through September 30, 2018; this is above the 4.5% average since 2012.10 On a national basis, state debt only rose by a modest 1.4% over the five years ended in April 2018.11 This confirms that many states have trimmed their budgets and adopted austerity measures.
One challenge that continues to plague the municipal market is unfunded pension liabilities. Although 22 states contributed enough to reduce their pension liabilities YoY, those states that are underfunding their contributions are doing so at a much larger size and pace.12 In fact, median state unfunded pension liabilities increased by 23% over the past five years.13
With the backdrop of tremendous demand (which we expect to continue through summer), and improving fundamentals, we believe that municipals are likely to continue performing well in the near term. Yet, it is important to note that municipals are coming off a solid performance run, which has left these securities at historically low yield ratios versus their taxable counterparts. We recommend that investors raise average credit quality and slightly favor short-to-intermediate maturities. We also believe that investors should use any market weakness as an opportunity to adopt a more neutral duration stance versus their individually selected benchmark.