Municipal Bonds: What to Watch in 2020

Lord Abbett: The Investment Conversation

Municipal Bonds: What to Watch in 2020

VO: Welcome to The Investment Conversation, Lord Abbett’s ongoing podcast series.

Will Andrews: With the end of the year approaching, we thought we’d switch things up for our final Investment Conversation podcasts of 2019. In this special three part series, Lord Abbett investment leaders will have one-on-one discussions about key themes for the coming year—sharing investment insights and ideas directly with our audience.

In this segment, the third and final part of our series, Lord Abbett Investment Strategist Tim Paulson talks with our director of municipal bonds, Dan Solender, about developments to watch in the tax-free market in 2019— covering topics like market supply and demand, the yield curve, credit ratings, and taxes. Tim starts things off with a question for Dan.

Paulson: Dan, it's been a fantastic year for the muni market in general. A lot of assets coming in [to U.S.-registered municipal bond mutual funds] and strong performance for credits. Do you expect something similar for 2020? What's your outlook?

Solender: Well, it has been a great year this year. And I think at this point last year no one would've expected the way it's turned out. You know, this year everything you can do to take more risk has worked, whether it's longer maturities, more credit risk. Everything has worked.

So looking where we are now and where we could go from here, the key things in our municipal bond market are supply and demand. So on the supply side, the 2017 [U.S.] tax bill really reduced the supply of tax-exempt bonds. And there's no sign of that changing, because the tax bill still is out there. So our supply should stay lower than it was a couple years ago, which is beneficial for the market.

On the demand side, the tax bill had a big impact [as well] with the cap on the state and local taxes causing people to look for whatever tax exemption they can find. And that's driven our strong demand this year [2019]. And as we're getting towards the end of the year, the demand is not slowing down. If anything, it's increasing.

And people are getting very comfortable. So they've made money in equities. They're comfortable taking some of their money and putting in the municipal bond market. So looking forward, supply should stay average to maybe on the lower side, but maybe slightly higher than this year.

Demand should be consistent. And those are the main things we're looking at going forward that should put some comfort in the market. And then, if you move to the interest rate side, rates are on the lower side. They've rallied this year. But there really is no sign of inflation [in the United States], and growth is under control. Globally, rates are on the lower side. So it seems like everything suggests we're not going to see any big increase in rates, which should be a pretty comfortable environment [for municipal bonds] this year.

Paulson: So, technicals are pretty positive. Looking at the fundamentals side of things, as you say, supply is limited. There's been a lot of concern about deteriorating fundamentals perhaps in corporate credit, or how long can the U.S. consumer sustain this [level of spending]. Certainly [there has been] an explosion in the U.S. federal deficit. Are we seeing the same thing with a lot of municipal credits?

Solender: Municipals have been performing very well from a credit perspective too. It's been kind of an incredible year--I mean, everything really is working. But, you know, it started [with the way] people are paying their taxes, and you go back to the tax bill. People used to prepay [taxes] in the calendar year before they're due. This year, they didn't do that. They paid them in 2019. So tax revenue came in late, but it came in very strong, above budget [for many states]. Most states had surpluses, putting money into rainy day funds, putting money away, having extra money to make their pension payments. [Things were in] really good shape in our market this year.

If you turn to the rating agency side, [there were] more upgrades than downgrades in every quarter from the rating agencies. So credit quality is really doing well and you have state balance sheets looking good. You have credit fundamentals looking good from the rating agencies’ perspective. And then overall, the [U.S.] economy is moving along at a good pace. It's not booming, but it's not shrinking either. And that means things like oil prices are on the lower side, so transportation credits are doing well, health care is holding in and doing pretty well, education is also doing well. So across the board, credit fundamentals are good.

Paulson: So no real surge in risky borrowing or unsustainable borrowing at the state level. Is there anything that could really kind of start to trigger some deterioration? Certainly some states may be more vulnerable to, you know, loss in income tax revenues than others?

Solender: Well, the market is dependent obviously on revenues from taxes [on income] and real estate. On the income tax side, things are looking pretty good. Although you're hearing in some of the financial areas, you might see some reductions in some bonuses and things like that in the financial industry.

So you have to watch that because that's a big deal in terms of the revenues. But real estate is really an area to look at. This cap on state and local taxes [in the 2017 U.S. tax bill] reduced the value of the [mortgage interest] deduction. So some of the areas around New York, New Jersey, Connecticut, a little bit in California, are not seeing the growth [of other regions]. If anything, [real estate in these areas] might be a shrinking a little bit in value. So that's something we're watching for going forward.

Paulson: Fundamentals look solid. Now one of the things that a lot of folks have talked about this year, at least in the [U.S.] Treasury space, is the inversion for a little while [earlier in 2019] of the yield curve--certainly some folks felt that this may be a signal of recession.

But it's been a really very different story in the muni market. Talk about that a little bit. You know, I've contended in the past that Treasuries are more driven by [buying from] central banks and pensions--maybe investors who aren't thinking about economic tradeoffs.

Solender: It started in the summer of 2018 when the Treasury curve was inverting and we had to spend a tremendous amount of time educating people that, you know, [the municipal curve was] not inverting. We actually were steepening in 2018 when Treasuries were inverting.

So fast-forward to 2019. We came into the year with a steep yield curve. It's definitely flattened some this year. But it is still steeper than other markets. And that's happened because people have gotten more comfortable in the rate environment, and while [the curve has] flattened a little bit, the long end has performed well. But we're still upwards sloping.

And the key thing of where we stand today is that when people ask me “where do you find the best value in the market,” if you're really looking for the best returns, given that we're in an upward sloping market, going out longer--20, 25 years--is beneficial if you can take the volatility that comes with [those maturities] over a three- to five-year time frame, it'll be better. If you're a little more risk- averse, not comfortable with that volatility, then that 10-year range is probably a better place to be just to have the good risk/return trade-off.

Paulson: Anything that's really got you worried as we think about this next coming [year]-- maybe not worried, but [concerned about what] could rock the boat as we go forward?

Solender: I guess the thing to watch, really the main thing with us, gets back to the whole retail demand [question] and how dominant we are [among retail investors], a lot of it has to do with the demand and how comfortable people are taking credit risk, interest rate risk, or being in municipal bonds, [and whether they are] worrying about rates.

So the key thing is really watching that demand, seeing that sentiment. Every week [Lipper] publishes the mutual fund flows of the industry. So that's a good tracker of how the sentiment is in the industry. Seeing how things go. So that's one thing to watch. And then the other is just the [U.S.] economy. I mean, you watch the growth, you watch what's going on, and then you're just kind of factor all that in because every budget has growth in it across the country. And there needs to be some economic growth for everything to work out the way it's projected to.

Andrews: That’s it for this special edition of the Investment Conversation. For those of who listen on iTunes, please be sure to leave a rating for the Investment Conversation. Thanks.

VO: Please drop us a line on social media or visit our website at LordAbbett.com. Our audio podcasts are available on iTunes, Spotify, TuneIn, and other major streaming media services. Thanks for listening.

Glossary:

Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price. The average yield is the market-value-weighted average yield to maturity of a portfolio of bonds.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. One such comparison involves the two-year and 10-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

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