PMC Weekly Review - April 22, 2016

A Macro View – Munis have had a great run. How long can it last?

Municipal bonds (or “munis”) have posted solid performance for a while now, providing investors with stable and attractive returns compared to other asset classes. Over the past five years, the Barclays Municipal Bond Index has had only four quarters of negative performance, and generated an average annualized return of 5.6%. That’s roughly 50% more than that of the Barclays Aggregate Index over the same period, and understates the actual return, as the coupon portion of return is exempt from federal (and often state and local) taxes. In 2015, a year that saw negative returns in both the investment grade and high yield sectors of the corporate bond market, municipal bonds returned 3.3%, outperforming not only the Barclays Aggregate and every domestic fixed income sector, but the S&P 500 as well. Such strong returns in this normally sleepy asset class beg two important questions: What has been driving recent performance? And how long can it last?

There are a number of reasons why munis have done so well recently, but they essentially come down to favorable credit fundamentals and a supportive supply-demand dynamic. From the fundamental perspective, municipal governments in general have seen their creditworthiness increase with higher tax revenues. According to the U.S. Census, the two largest sources of state revenue nationally—individual income tax and sales tax—have been rising since 2010, driven by the economic recovery in which a rising stock market and falling unemployment have given consumers the means to spend (and thus be taxed). The housing market has taken longer to recover, but successive rounds of monetary stimulus have coaxed home values and property tax receipts for local governments higher since 2012. While municipalities have enjoyed stronger revenues, 2015 saw only three Chapter 9 bankruptcy filings—the fewest since 2008. With the exception of such fiscally troubled places as Chicago, Illinois, New Jersey, and of course Puerto Rico, the municipal market appears to be on solid footing fundamentally.

From a technical perspective, both the supply and demand sides of the equation have also created a favorable environment for investors of late. Regarding supply, after peaking at approximately $279 billion in 2010, new municipal bond issuance has not reached its 20-year average of $190 billion since, according to JP Morgan Securities data. Although new money issuance reached its five-year peak of $165 billion in 2015, net new issuance (issuance after accounting for maturities and refinancing) was essentially zero. This lull in issuance has reflected an austere approach to municipal finance since 2008 in spite of the historically low cost of funds. Demand for municipal bond-focused separate accounts and mutual funds, on the other hand, has remained robust due to increasing capital gains and income tax burdens. Both channels experienced inflows in four of the past six years, and a net inflow of nearly $50 million, according to Morningstar data. Depressed levels of issuance, combined with strong demand, have helped to make munis a one-way trade recently, driving up their valuation.

But how long can these factors stay aligned to drive positive returns? From the supply side, with monetary policy supposedly on a tightening path, which would increase the cost of funding, and political opposition to greater expenditures (at least for now), the lukewarm supply environment should remain intact in the near term. The demand picture is by nature quite volatile and difficult to predict. Historically, however, headlines surrounding municipal defaults have led to selloffs. Moreover, municipal fundamentals, represented by tax receipts, are inextricably linked to the health of the economy. If the U.S. enters a recession, the currently solid backdrop for munis would quickly shift for the worse as sales and income taxes drop and properties lose value. Conversely, an upswing in growth and a tighter labor market would boost revenues and prolong the municipal credit cycle. Although the longer-term outlook for many of these underlying factors is unclear, we believe the continued strength of the municipal market will undoubtedly be tied to the overall health of the U.S. economy.

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