PMC Weekly Review – October 12, 2018

A Macro View – Municipal Market Outperformance Explained

Through the first three quarters of the year, the US municipal market has outperformed the taxable market across the yield curve. The Bloomberg Barclays Municipal Bond Index is down 40 basis points through September, whereas the Aggregate Bond Index is down 1.60% and the US Treasury Index is down 1.67%. At the short end of the yield curve, the 1-3 Year Municipal Index is up 88 basis points, and the 1-3 Year Aggregate Index is up just 42 basis points. In long maturities, the 22+ year Municipal Index is down 1.13%, but the 20+ year Treasury Index is down 5.92%. Even in the noninvestment grade space, one of the few highlights in the taxable fixed income markets this year, the Municipal High Yield Index is up 4.45% through the end of the third quarter compared with just 2.57% for the Corporate High Yield Index. Although it is not at all unusual for the muni market to outperform the taxable market (2018 would be the seventh time in the last ten years the Municipal Index outperformed the Aggregate), the reasons for this year’s outperformance are almost entirely technical factors rather than improving credit fundamentals, and this has implications for 2019 and beyond.
Most of the factors for the municipal market’s outperformance this year stem from the tax reform bill passed at the end of 2017. One major provision of that bill eliminated the ability for municipal bonds issued after the end of 2017 to be “prerefunded,” or refinanced at a lower rate. This provision was announced prior to the bill’s actual passage by Congress, which spurred an enormous amount of issuance in late November and early December of last year to qualify for prerefunding in the future. It had the secondary effect of sharply reducing the amount of new issuance in the first quarter of the year. This was particularly pronounced in January, as most municipal bonds make their semiannual coupon payments in December or January, creating a significant demand for reinvestment. New issuance has remained well below average through the first nine months of the year. In fact, net issuance (new bonds issued minus bonds reaching final maturity) was negative from June through August and only barely positive in September. Meanwhile, more than $12 billion has flowed into municipal bond mutual funds of all types so far this year, creating a dramatic supply/demand imbalance. This has driven prices up, yields down (particularly in the short end of the curve), and created much of the year’s outperformance.

A secondary provision in the tax reform bill was a cap on taxpayers’ ability to deduct state and local income taxes paid (including property taxes) from their federal taxable income. This has had the effect of making national muni bond portfolios less attractive for taxpayers in states with high income and/or property taxes (such as California and New York, among others). California residents have poured nearly $1.5 billion into California-specific intermediate municipal bond funds. Other state-specific funds have not had flows like this, but that could change in early 2019 as taxpayers face suddenly higher tax bills.

Finally, in what might be a positive for the municipal market in the coming years, the sharp drop in the corporate tax rate has changed the valuation equation for institutional investors, particularly pension funds and property and casualty insurance companies. These institutions are the overwhelming majority of buyers of long maturity bonds (those without call provisions or limited probability of being refinanced). But with a sharply lower tax rate, current municipal bond issuance does not make sense for them on an after-tax basis. Removing this major source of demand in the long end of the curve is one reason the municipal curve is actually steeper on a 2/30 basis this year, whereas the taxable curve is significantly flatter. This may be a positive situation for the municipal market in 2019 and beyond, as these institutions have billions of dollars of bonds to sell into the market and could be a very necessary source of supply if new issuance doesn’t pick up

Because the municipal market’s outperformance this year has been almost entirely due to technical factors, which are generally more transient than credit-related events, municipals easily could give that advantage back next year, through either a surge in supply or a drop in demand (simply due to the tight credit spreads and lower yields), or both. This presents a much bigger risk factor for investors, even if the professional consensus is for this imbalance to continue well into 2019.

Nathan Behan
Senior Vice President, Investment Research

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