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Fixed-Income Insights

While media reports have emphasized the recent negative performance of municipal bonds, many indicators signal a healthy, resilient market.

 

In Brief

  • While the municipal bond market has had a less than ideal start to 2018, we believe it is worth focusing on the factors that should continue to support the market. Chief among them:
    • The muni market, as represented by the Bloomberg Barclays Municipal Bond Index, has delivered consistent long-term performance.
    • Based on an analysis of return components of the muni-bond index, munis’ tax-advantaged status continues to enhance returns versus other fixed-income benchmarks.
    • Muni-market credit quality remains strong.
    • Supply and demand factors appear to be in the market’s favor.
    • Market predictions of rising interest rates frequently do not pan out.
  • The key takeaway: Long-term investors should remember the municipal bond market’s historical resilience as they survey the current environment.

 

Through the first four months of 2018 (ended April 30), most sectors of the U.S. municipal bond market have had negative total returns, meaning that bond prices have decreased as yields have risen.  These yield movements have raised concerns for some investors, and have led to some negative media commentary about the market’s performance.  Municipal-bond mutual funds suddenly have faced small outflows over the past couple of weeks, according to data from Lipper/ICI, somewhat reversing months of positive flows—which still total $6 billion year to date through May 2, 2018—while separately managed accounts were rapidly gaining assets.

Given this backdrop, we thought it would be worthwhile to reflect on some important points about what has been happening in the municipal bond market, and how things look, to us, going forward.

1. Munis’ long-term track record remains solid.
The total return of the benchmark Bloomberg Barclays Municipal Bond Index (the muni-bond index) was -1.46% through April 30, 2018, according to Bloomberg data.  Interestingly, the trailing one-year return of the muni-bond index has been positive, at 1.56%, so despite the negative first four months of the year, those who have been invested in the market for a full year have seen their portfolios increase in value. What’s more, the muni-bond index has outperformed the Bloomberg Barclays U.S. Aggregate Bond Index (Aggregate index) over the trailing one-, three-, five-, seven-, and 10- year periods. Munis’ consistent long-term track record—through a variety of economic and market environments—serves as a reminder that an overly narrow focus on short-term performance may lead to inappropriate investment decisions.

2. Munis’ tax-advantaged status continues to enhance returns.
In addition, the -1.46% return on the muni-bond index has been superior to that of the Aggregate Index (-2.19%) and the Bloomberg Barclays U.S. Corporate Bond Index (Corporate index; -3.22%) through April 30, and these figures do not even consider the tax benefit associated with municipal bond returns. For example, if you were to gross up the coupon component of the index’s total return for taxes, the index’s taxable-equivalent total return (based on a tax rate of 37%1) would have been -0.51%, demonstrating an excess return of 1.68% and 2.71%, respectively, relative to the Aggregate and Corporate indexes. 

3. Demand factors remain favorable.
There are many reasons why demand for municipal bonds remains strong. Chief among them is the tax legislation that was passed by Congress in December 2017. This bill put a cap of $10,000 on state and local taxes that could be deducted from federally taxable income; it also reduced the deductibility of mortgage interest, to a principal amount of $750,000, from $1.0 million, for homes purchased after December 15, 2017.  These changes reduced the value of these popular tax exemptions—but, to our thesis, the tax exemption on municipal bond interest did not change.  These reduced exemptions have increased the demand from investors in high-tax states looking for income exempt from taxes, because less is now available from other alternatives.

Matters are different, however, for municipal-bond mutual funds. Since the most recent low in interest rates in July 2016, the yield on the 10-year U.S. Treasury note has risen by more than 100 basis points, or more than a full 1%.  During the months around and including July 2016, there was very high demand for municipal-bond investment products.  Therefore, because rates now are much higher, it seems odd that the demand for municipal bond mutual funds is lower.  In this environment, such a mismatch may present a better opportunity for investors to capture value, as buyers eventually should become attracted to the higher yields.

4. Overall, municipal bond market credit quality is strong.
Tax revenues are coming in higher in most states, including California, New York, and Connecticut. Some of this increase is because people have been adjusting to the changes from the tax bill, but most of it stems from an economy that is steadily growing and producing more revenue.  Even fiscally stressed Illinois is seeing increased revenues from a growing economy and the state tax increases imposed last year.  Many people caught up in the headlines about the fiscal situations of Puerto Rico and Illinois might not realize that, overall, credit conditions are fairly good across the United States.

5. Muni new-issue supply is low, and isn’t showing many signs of increasing (but this could change).
The actual and possible changes from the tax bill pulled much of this year’s supply of new muni-bond issuance earlier into last December, so the new-issue market for 2018 has been very thin thus far.  Also, the tax bill eliminated the option for municipal bond issuers to do advanced-refunding bond deals—which is a way for them to lower their borrowing rates by refinancing outstanding bonds prior to their call dates—so issuers no longer have as many reasons to sell new bonds.  Last year, for example, refunding supply was more than one quarter of the total new issuance; this change from the tax bill should slow things down for a while, at least.  Further, municipalities have become more fiscally austere since the Great Recession (2008–09), and have modestly reduced leverage. With low supply and steady demand, the fundamentals remain strong for the municipal bond market.

6. Rising rates are not a done deal.
While many people predict that interest rates will continue to increase in coming months, it is important to remember that similar consensus existed last year at this time, but rates did not move as expected.  The longest maturities outperformed shorter ones significantly throughout 2017 as the yield curve flattened.  According to data from Bloomberg Barclays Indices, while munis with a maturity of one year returned 0.92% in 2017, the 10-year maturity segment posted a return of 5.83%, and the longest-dated category, 22-plus years, returned 8.19%.  We are not, however, making a similar prediction for the rest of 2018—we’re just noting that, for many years, people have been forecasting significant rate increases, and they haven’t always happened.  Also, it is important to remember that rates have risen a lot since the summer of 2016. Yet during that rough patch for the fixed-income market, investors did not see poor results from municipal-bond market investments.

While prognosticators are trying to figure out where rates will go from here, economic statistics are not supporting a major interest-rate rise at this time.  Inflation is still low, at around 2%, and economic growth is not much higher than 2%. While there is steady growth in the U.S. economy, it is not exactly a boom. The U.S. Federal Reserve is indicating that it will continue to raise the fed funds rate, potentially limiting increases in inflation and economic growth going forward.  Also, competitive interest rates in countries such as Japan and Germany are low, so it might be tough for U.S. rates to deviate too much from them.

Summing Up
Despite some of the negative media headlines, the municipal bond market did relatively well during the first four months of 2018.  It has not been as volatile as other markets, and its underlying credit quality has remained strong.  Supply and demand dynamics are favorable, and the economic environment remains supportive.  Municipal bonds still have the attractive tax exemption (as measured by tax-equivalent yields), and the low historical default-rate pattern has continued.  We will have to see how things evolve going forward, but the municipal bond market has successfully navigated challenging times in the past. Long-term investors should keep that fact in mind as they survey today’s market.

 

1Note that under current (2018) U.S. tax law, taxpayers fall into one of seven brackets by rate, depending on their taxable income, ranging from 10% to 37%. Tax-equivalent yield calculation for the municipal indexes above assumes the top marginal tax bracket of 40.8% on investment income, which includes the 37.0% income tax rate and the 3.8% in Medicare tax. This tax rate does not factor in the effect of AMT (alternative minimum tax) or taxes in your individual state. Tax-equivalent yield will vary based on an investor’s tax bracket.

 

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