Behind the Surge in Taxable Muni Bond Issuance | Lord Abbett
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Fixed-Income Insights

Increasing investor interest in this asset class appears to be driven by ultra-low yields on U.S. Treasury securities.

Read time: 3 minutes

This article is from the Q2 2020 edition of The Muni Quarterly.

Taxable municipal bonds, an often-overlooked corner of the muni market, appear to be increasingly on investors’ radar.  In 2019, taxable municipal issuance doubled, to just over $63 billion, according to data from Bloomberg.[1]  On the whole, taxable debt represented a significant 16% share of total long-term municipal issuance in 2019, up from only 9% the prior year, and the highest since the Build America Bonds program was introduced in 2009-10. In fact, while overall municipal supply increased substantially in 2019, the majority of the growth concentrated in the taxable market, with tax-exempt issuance only increasing 10%.

Though taxable supply has grown across most sectors and rating categories, the bonds are generally issued by larger, highly-rated entities and are not a feasible option for all municipal issuers, in our view.  We believe the rapid increase in taxable issuance, which began in earnest in the second half of last year, was primarily driven by a marked decrease in U.S. Treasury yields and, subsequently, borrowing costs for certain municipal issuers in the taxable market.  This lower-rate environment increased the appeal of both refunding transactions and taxable new money issuances, which are free from legal constraints, including restrictions on use of proceeds, which hamper financing flexibility in the tax-exempt market. At the same time, many of these federally taxable issuances still benefit from exemption at the state and local level.

 

Figure 1. Falling Treasury Yields Helped Spur Growth in Taxable Muni Issuance in 2019

Data for the 2019 calendar year

Source: Bloomberg. Data as of June 15, 2020.

 

Taxable Advance Refundings Take Center Stage

Prior to the passage of the Tax Cuts and Job Act in late 2017, municipal issuers were able to take advantage of lower tax-exempt municipal bond interest rates by refinancing older, higher interest rate callable bonds, oftentimes several years ahead of their call dates – an “advance refunding”. Historically, advance refundings represented a significant portion of total tax-exempt bond supply. However, with tax reform in 2017, these tax-exempt advance refunding provisions were eliminated, leaving municipal issuers unable to capitalize on refunding opportunities ahead of call dates in the tax-exempt market. Instead, issuers were forced to turn to the taxable market to implement these strategies.

While taxable advance refundings have for years been employed by some, generally larger and highly-rated, municipal entities, for many issuers the borrowing costs and inefficiencies associated with issuing taxable bonds have historically proved too great to render an advance refunding economically feasible.

Inefficiencies associated with taxable debt eased considerably in the second half of 2019; long-term U.S. Treasury yields fell over 100 basis points (based on Bloomberg data) and many issuers found that, with borrowing costs significantly lower, taxable refundings in advance of call dates would begin to produce material debt service savings even though the older bonds had been issued with tax exempt yields. Taxable advance refunding issuance subsequently surged,2 with approximately $40 billion (nearly 80%) of taxable bonds issued with all or a portion of proceeds utilized for refundings in the second half of the year.

Issuance of Taxable Debt Is Up across Sectors and States

The past year saw increases in taxable issuance across sectors and security types. General obligation issuance by states, counties, and towns rose by more than 60% in 2019, to $12.7 billion, driven by large refunding and new money transactions by the States of Massachusetts, California, and Texas, among others.  Growth was pronounced even in revenue sectors traditionally accustomed to issuing predominantly taxable debt, notably higher education and healthcare, both of which additionally benefit from use of proceeds flexibility associated with taxable debt.  Taxable higher education supply rose 350% on the year, to $8.2 billion, and remained well above recent historical trends.

While recent taxable issuance has occurred across the yield curve, we have also seen a larger concentration in longer-dated taxable supply, including over $2.3 billion of 100-year “century bond” issuance, concentrated in the higher education sector.

 

Figure 2. Taxable Municipal Bond Issuance Skews Toward Longer Maturities

Issuance by maturity segment for 2019

Source: Bloomberg. Data as of June 15, 2020.

 

Conclusion: Taxable Municipal Bond Issuance Likely to Remain Strong

As Treasury yields reached fresh lows in early 2020, issuers continued to take advantage of lower borrowing costs to both advance refund existing bonds and issue new money for capital projects in the taxable municipal bond market. In the first two months of the year, taxable municipal issuance totaled nearly $3 billion, accounting for 14% of total municipal supply. The emergence of COVID-19 does not appear to have slowed taxable issuance. In fact, while total municipal supply of $17.6 billion in March 2020 was well below the $27 billion level of the year-earlier month, taxable supply only fell $500 million to $3.0 billion. In April and May 2020, taxable supply exceeded $6 billion in each month, greatly surpassing the $1.2 billion and $1.3 billion in supply in the respective year-earlier months. The increase was driven both by issuers taking advantage of advance refunding opportunities and seeking funds for working capital, and new money without the restrictions of tax-exempt debt.

At the same time, the increase in issuance has attracted non-traditional buyers to the taxable municipal market. Typical buyers of corporate debt, including international accounts and taxable bond funds, in particular, have taken a renewed interest in the space. We expect these trends to persist into the second half of 2020 and provide potentially attractive opportunities for investors.

 

1Fixed-rate, federally taxable municipal issuance with a term of greater than one year. Unless otherwise noted, all municipal bond issuance and supply data in this article are from Bloomberg.

2Scott Crist, “The Changing Landscape of the Municipal Bond Market,” https://blog.umb.com, January 7, 2020.

 

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

A basis point is equal to one one-hundredth of a percentage point.

The call date is the date on which a bond can be redeemed before maturity.

A “century bond” has a maturity of 100 years.

General obligation (GO) bonds are municipal bonds backed by the “full faith and credit” of a government, and are issued by entities such as states, cities, counties, and school districts.

Revenue bonds are municipal bonds backed by revenues from a specific projects or facilities (such as toll roads, water/sewer systems, or airports).

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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