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Fixed-Income Insights

Here’s a look at what has driven the muni market’s strong showing thus far in 2016—and whether those factors may remain in place.

 

In Brief

  • Counter to many forecasts at the start of the year, the U.S. municipal bond market has posted a strong showing thus far in 2016.
  • What are the factors that have driven this performance? In this article, we have identified six, and examine each in detail:
    –Downward pressure on global interest rates
    –Tighter supply of new and secondary-market bonds
    –Strong investor demand
    –Positive credit-quality trends
    –Low volatility
    –Attractive relative value
  • What about the outlook for munis? We believe the attributes listed above still appear positive.
  • Against this backdrop, investors should be aware of some potential catalysts that might affect demand for munis, including changes in interest rates, investor perception of issuer credit, and U.S. tax policy.
  • The key takeaway—In the current environment, our approach remains the same. Our investment team consistently follows all sectors of the market, along with key technical trends, while carefully managing our risk to prepare for future scenarios.

 

When 2016 started, many market forecasters said that municipal bond investors should expect low returns for the year. Typically, they thought investors would earn the coupon paid on bonds, but not realize much price appreciation. As with many other forecasts for 2016, these prognostications were proven wrong. As of August 12, the Barclays Municipal Bond Index, for example, was up more than 4% year to date, while the Barclays Long Municipal Bond Index was up nearly 7%.

Although the upward price movement has slowed during the summer, the strong returns for the year are still holding up. Investors clearly should be happy with the results—but they also might be wondering just why the municipal bond market has done so well thus far in 2016, and how it may perform in the months to come. 

We think that there are six main reasons why the market performed positively, which we examine in detail below. Each has had an important impact on the muni-bond sector, and each is worth analyzing to gather information regarding where the markets may be headed.

1) Downward pressure on global interest rates
U.S. Treasury bond yields have fallen about 70 basis points (bps) since the beginning of the year in both the 10- and 30-year maturities, according to Bloomberg. Economic concerns have continued to focus upon the pace of growth in China, the stability of the European Union, and uncertainty regarding geopolitical tensions. Also, oil prices have stayed low, putting pressure on some sectors of the economy.  Many central banks around the world have moved key interest rates into negative territory and are providing substantial amounts of stimulus to keep their economies from going into recession. 

The U.S. economy has maintained its steady growth pace, and the events around the world have kept the U.S. Federal Reserve (Fed) from raising interest rates. The downward movement in rates has been the major factor leading to attractive municipal bond total returns, but there have been other factors that have led to strong performance relative to other markets.

2) Tighter supply of new and secondary-market bonds
Apart from interest-rate movements, supply dynamics have had a significant influence on both the primary and secondary markets. In the primary market, new-issue supply has fallen behind last year’s pace. According to The Bond Buyer, the $250 billion of new bonds issued through the end of July 2016 was down about 5% from the prior year. Supply picked up during May and June, but the $26 billion of new issues brought to market during July represented a 27% decline from the same month one year earlier.  So, while there have been a good number of bonds issued, the new-issue volume (i.e., the total par amount issued) is relatively low.

Another part of the supply picture is the secondary market, which is more difficult to measure with municipal bonds. One indicator is Bloomberg’s index of bonds being put out for the bid on its system. Since the beginning of 2015, the average number of bonds put out for bid each day has been about $540 million in par value. Since June 30, 2016, the average has fallen, to $384 million. During the same summer time frame in 2015, the average was $445 million. So, the low primary-market supply, along with a reduced amount of securities offered in the secondary market, has meant that fewer bonds have been available for investors. This has fostered a positive technical environment for munis, supporting their strong performance.

3) Strong investor demand
On the flip side, demand for munis has picked up considerably. As of the second week of August, municipal bond mutual funds have seen 45 straight weeks of inflows, according to Lipper and ICI. Many weeks have seen more than $1 billion coming into muni funds, while the trend in recent weeks has held above $700 million. Through early August 2016, more than $40 billion has flowed into municipal bond mutual funds; the flows have been strong in all categories, including long, intermediate, short, and high yield. This robust demand—coupled with the reduced supply of munis discussed above—has supported a strong market.

4) Positive credit quality trends
Improving issuer credit quality has been an important factor in setting the positive tone for the municipal bond market. Although much attention has been focused upon the difficulties of Puerto Rico and Illinois, those pressures have been mostly contained in those areas. Otherwise, the overall credit quality of the rest of the United States is strong. One example supporting this is the ratio of credit rating agency upgrades to downgrades. For instance, during the first quarter of this year, Standard & Poor’s upgraded 272 muni issuers, while downgrading only 130 (according to the latest available data). Through the second quarter of this year, Fitch had upgraded 112 credits, while downgrading 62. These developments are strongly positive, and help investors to be comfortable adding to their municipal bond holdings, despite the challenges facing Puerto Rico and Illinois.

5) Low volatility
Another positive attribute of the muni sector has been its relative calm in a year marked by turbulence in other global markets. International economic concerns have significantly affected markets with material exposure to countries around the world. For example, when the United Kingdom voted to leave the European Union on June 23, 2016, there was a dramatic reaction in the equity and corporate high-yield markets. In the summer of 2015, there was a lot of volatility in reaction to China, Europe, and the movement of oil prices. During each of those times, the municipal bond market displayed much lower volatility than other areas of fixed income. For example, during July and August 2015, the broad Barclays Municipal Bond Index had a relatively low standard deviation of 0.10%, while the Barclays Corporate Bond Index was at 0.33% and the Barclays U.S. Treasury Index was at 0.28%. It was around that time that investors began to recognize the benefits of the domestically focused municipal bond market—and flows into municipal bond funds started their long, positive trend.

6) Attractive relative value
The relative value of municipal bonds versus taxable fixed-income categories is another important consideration attracting many investors to the asset class. We can analyze this in many ways, but two good examples are 1) the ratios of municipal bond yields to comparable-maturity U.S. Treasuries and 2) tax-equivalent yields. Using Municipal Market Data (MMD) and U.S. Treasury information, the yield ratio (as of early August 2016) was 83% for five-year maturities, 94% for 10-year maturities, and 95% for 30-year maturities. These numbers are based upon MMD benchmark yields, and most municipal bonds trade at levels higher than these yields, so most municipal bonds are trading at yields that are higher than Treasury yields. And this is without including the benefit of munis’ tax exemption. For a municipal bond with a 3% yield, the tax-equivalent yield is 4.62% for someone in the 35% tax bracket. (The tax-equivalent yield is the yield that must be offered on a taxable bond issue to give the same aftertax yield as a tax-exempt issue.) This means that an investor would need to find a taxable bond with the higher yield to match the aftertax yield on the municipal bond. Personal income tax rates are generally higher than 35% for many people, so the difference is actually greater. The tax-equivalent yield advantage is even higher for bonds with state and local tax exemptions.

The Current Outlook
With all these factors leading the municipal bond market to strong performance this year, the environment has been favorable for investors. Currently, we believe that all these attributes still look positive. The Bank of England, for example, recently increased its monetary stimulus amid concerns about growth after the “Brexit” vote. This suggests that the global economy is still under pressure, and that could put a ceiling on potential growth and inflation in the United States. Obviously, there is much uncertainty as to how this will play out, but the overall takeaway is that global interest rates appear unlikely to rise significantly for quite a while. 

Meanwhile, supply for both the primary and secondary municipal bond markets is still on the lighter side. Demand for municipal bond mutual funds continues to look strong. The trend of more upgrades than downgrades from credit rating agencies appears to be continuing. As Treasuries have shown some volatility in recent weeks, municipal bond rates continue to be steadier. Municipal bond yield ratios to Treasuries moved lower since being very high earlier in the year, but remain elevated compared with levels before the financial crisis of 2008–09, according to MMD. Income tax rates used to calculate tax-equivalent yields show no sign of decreasing, and actually have risen in recent years.

While the optimists appear to have the upper hand in terms of the relative value of municipal bonds compared to other fixed-income markets, we also need to understand which catalysts could change these dynamics and lead to underperformance. U.S. Federal Reserve data indicate that the municipal bond market is driven to a greater degree by retail investors than other fixed-income sectors because they hold a large proportion of the outstanding bonds either in brokerage accounts or managed products. So, retail demand is among the most important indicators for municipals, and one that needs to be tracked closely.  These numbers are reported weekly, so demand can be actively followed. 

What could hurt retail demand? A few possible examples include a large, upward movement in interest rates; the perception that major security-specific credit issues are not isolated; or government actions to reduce tax rates or the tax deduction of municipal bond interest. None of these appear imminent, but these potential issues need to be followed closely. An increase in interest rates might cause some outflows, but eventually higher yields would attract new investors, so it is a scenario that likely would reverse over time, which is important for investors with a long-term perspective.  As always, our investment team consistently follows all sectors of the market, along with key technical trends, while carefully managing our risk to prepare for future scenarios.

 

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