By James L. Iselin
The income tax has made liars out of more Americans than golf.” - Will Rogers
Municipal bond returns were positive across the yield curve in 2017, with particularly strong results on the long end of the market. As you may recall, one year ago the bond market experienced a sharp sell-off right after the presidential election as interest rates rose sharply on the belief that President-elect Trump's pro-growth policies would lead to an uptick in inflation. In addition, concerns around income tax reform caused uncertainty in the municipal bond market as it related to future demand.
We believed back then that the market was oversold and represented an extraordinary buying opportunity. With AA rated munis trading at around 100% of Treasuries, the asset class compared very favorably to other quality segments of the fixed income market from an after-tax and risk-adjusted standpoint. Even with our constructive view, performance for calendar year 2017 exceeded our expectations. In our opinion, there were three key reasons for the impressive returns. First, despite some ups and downs, the 10-year U.S. Treasury yield was virtually unchanged for the year. Second, for much of 2017 the muni market was undersupplied when compared to the previous year. Lastly, the market came to the realization that tax reform was not going to meaningfully lessen the demand for munis from the largest buyers: individual investors.
Usually, the last month of the year is relatively quiet as market participants transition to holiday mode. Surprisingly, December 2017 may have been the most frenetic month that any of us can recall. As Congress negotiated the details, it became apparent that various iterations of the Tax Cuts and Jobs Act of 2017 (TCJA) had the potential to severely limit future supply of tax-exempt bonds. As a result, we saw unprecedented levels of supply in December as issuers rushed to market before pending tax changes potentially restricted them. While not all of the proposals ultimately became law, the tax reform package signed by President Trump will likely result in a meaningful reduction in new issue supply in 2018.
A Mixed Picture
Looking ahead, there are things to be excited about as well as some warning signs. The U.S. economy finished the year on very firm ground and a late-cycle tax cut should provide an additional boost. It is the first time that synchronized global growth has gained traction since the Great Recession. The short end of the muni yield curve has moved meaningfully higher since the election, as the Federal Open Market Committee (FOMC) continued to raise rates, providing roughly an additional 60 basis points of yield on short-dated munis during 2017. This is welcome news as that part of the maturity spectrum has been starved for yield for so long. Demand should remain solid as taxes at the federal level remain high for individuals, still pushing 40% for top earners.
In addition, investors in high tax states will look for munis as a way to protect income from state and, in some instances, local taxes that now will be more onerous with the cap on state and local tax (SALT) deductions. Lower-rated credits should continue to perform well as less supply pushes more investors into single A and BBB rated bonds. The biggest challenge for the muni market could come if inflation were to accelerate more than anticipated. In addition, the tax cuts should lead to much larger deficits, which will require additional Treasury borrowing. Investors could demand higher rates to compensate them for digesting increased supply.
From an investment standpoint, we saw the abundant supply at year-end as an opportunity to invest in attractively priced securities. We believe that strategies focusing on the short to intermediate points on the yield curve should be well positioned to protect principal in the event that rates continue to rise. A high-quality bias and focus on defensive coupon and call structures should, in our view, continue to be a central theme going forward. Finally, we feel that investors shouldn't be afraid of rising rates. In the long run, higher yields will create a better backdrop for fixed income returns. In the meantime, we favor a continued focus on preserving capital and staying nimble.
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A bond's value may fluctuate based on interest rates, market conditions, credit quality and other factors. You may have a gain or a loss if you sell your bonds prior to maturity. Of course, bonds are subject to the credit risk of the issuer. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the investor's state of residence. High-yield bonds, also known as "junk bonds," are considered speculative and carry a greater risk of default than investment-grade bonds. Their market value tends to be more volatile than investment-grade bonds and may fluctuate based on interest rates, market conditions, credit quality, political events, currency devaluation and other factors. High-yield bonds are not suitable for all investors and the risks of these bonds should be weighed against the potential rewards. Neither Neuberger Berman nor its employees provide tax or legal advice. You should contact a tax advisor regarding the suitability of tax-exempt investments in your portfolio.
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