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Market View

With more attractive yields on offer, an upturn in demand may come amid a tighter supply of newly issued municipal bonds.

 

In Brief

  • While municipal bonds have maintained their status as a tax-advantaged investment, and yields have become more attractive, demand for muni-bond mutual funds (year to date through May 9) actually has moderated.
  • This stands in stark contrast to the situation in July 2016, when demand strengthened even as muni yields were at multiyear lows.
  • Meanwhile, the supply of newly issued muni bonds has tightened thus far in 2018 (through April 30).
  • As today’s higher yields boost the appeal of municipals for tax-sensitive investors, this supply/demand dynamic could present favorable opportunities for professional managers.

 

In a recent commentary on lordabbett.com, our experts weighed in on some of the implications of the recently enacted U.S. tax legislation for municipal bonds. In our view, one of the key considerations was the impact on investor demand for municipal bonds, particularly from those individuals in high-tax states. We noted that there are now fewer avenues of opportunity for individuals to reduce their tax burden. For example, the new tax legislation placed 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.  In our view, municipal bonds remain an ideal way to realize attractive income not subject to federal taxation. [However, income from municipal bonds may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply.]

Given those positive points, one would expect investor demand for munis to strengthen considerably. But thus far in 2018 (through May 9), demand (as measured by investment flows in municipal-bond mutual funds) has been decent, but weaker than expected. For the year-to-date period ended May 9, 2018, aggregate inflows into municipal-bond mutual funds totaled $4.2 billion. One would think the higher yields available on municipal bonds in the current market would draw greater additional buyers.

Interestingly, demand was stronger around July 2016, a period that caught our attention because that was a multiyear low in municipal yields. The differences between the two periods are striking. For example, the yield on a 10-year ‘AAA’ rated general obligation bond was 1.38% on July 13, 2016, compared with 2.51% as of May 15, 2018, according to Bloomberg. Over the week ended July 13, 2016, municipal bond funds indicated inflows of $2.8 billion. While recent flow data have been influenced by normal tax-time redemptions, Lipper reported outflows of $1.8 billion for the week ended May 9, 2018, despite yields being more than 110 basis points higher than they were last July.

 

Chart 1. Rising Yields Have Not Translated into Strong Demand for Municipal-Bond Mutual Funds
Yield on 10-year ‘AAA’ rated municipal bonds (daily) and muni-bond fund flows (weekly), July 5, 2016–May 4, 2018

Source: JPMorgan and Lipper MMD.  Yields represented by a maturity- and rating-specific segment of the Bloomberg Barclays Municipal Bond Index. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

 

What about the other side of the equation—supply? Once again, the new tax legislation looms large, for the bill has both short- and longer-term influences on the supply of newly issued municipal securities. From a short-term perspective, as we have previously noted, issuance was heavy in the fourth quarter of 2017, and leaner than usual as the calendar switched to 2018. The original draft of the tax bill contained provisions of eliminating an issuer’s ability to pre-refund (a way of refinancing prior to the call date) bonds as well as striking the tax-exempt status of so-called private-activity bonds. As a result, issuers pulled forward many deals earmarked for 2018, into 2017 (see Chart 2), boosting supply to a record $154 billion for the final quarter of 2017. Ultimately, the final version of the bill did eliminate the ability for issuers to pre-refund, but spared the tax-exempt status of private-activity bonds.

 

Chart 2. U.S. Tax Legislation Had a Whipsaw Effect on Muni Issuance in Late 2017/Early 2018
Municipal bond issuance by month ($ in mil.), May 1, 2008–April 30, 2018

Source: The Bond Buyer. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

The race to borrow at the end of last year has left issuance thus far in 2018 comparatively lean. Over the first four months of 2018, total issuance in the municipal bond market was approximately $91 billion, or 21% below last year and 23% below the trailing five-year average ($128 billion), according to JPMorgan.

While tight primary market conditions are expected to largely persist through the summer, there are longer-term effects from the tax legislation that will affect the market. The elimination of advance refunding bonds reduces what was, historically, roughly a quarter of new-issue supply. As the existing pre-refunding issues mature, the weighting of such bonds in the Bloomberg Barclays Municipal Bond Index is expected to fall to zero over time. This weighting already has dropped, from 16.85% of the index in May 2016 to just 7.38% as of April 30, 2018. However, the catalyst for the reduction has more to do with higher interest rates making refinancing less attractive rather than any impact from tax reform.

To recap, then, while indicators point to modest demand for munis at the present time, the supply of new muni bonds in the marketplace has fallen, and looks to remain tight over time. Meanwhile, as investors look to put new money to work, the attractive yield (both on an absolute and tax-equivalent basis) currently on offer in municipal bonds, especially as compared with where they were in the middle of 2016 and relative to their taxable counterparts, could help spur a notable increase in demand for munis over the coming months.

And there are other factors that could provide support for municipal bonds in the months ahead. In a recent Muni Matters, Lord Abbett partner and director Dan Solender, in listing the key attributes of a resilient, healthy muni market, notes that overall municipal bond credit quality is strong, and that some experts’ forecasts of a continued climb in interest rates may not come to pass, given a still-moderate pace of U.S. economic growth.

As any first-year economics student can tell you, lower supply, when accompanied by healthy demand, is typically supportive of prices in any market.  In particular, professional muni-bond managers with strong credit research and security-valuation capabilities are particularly well positioned to capitalize on such an environment.

 

MARKET VIEW PDFs


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