Municipal Bonds Benefit From SALT Limitations And Congestion Pricing

by: Legg Mason
Summary

The U.S. municipal market is hitting on all cylinders - modest growth, reasonable inflation and solid fundamentals are all drivers.

Congestion pricing is becoming a major force.

New limitations on state and local tax deductions increase the value of tax-exempt income.

By Rob Amodeo, Portfolio Manager, Western Asset

The U.S. municipal fixed income market is hitting on all cylinders. Modest domestic economic growth, reasonable inflation, lackluster new issue supply and sound fundamentals continue to drive investors into the tax-exempt bond market.

This performance further stems from new limitations on state and local tax deductions (SALT), which increases the value of tax-exempt income. Also, tax-adjusted municipal yields are attractive for maturities beyond 10 years.

The muni market has distinct seasonal trends which can make investing timing important. Demand for tax-exempt income overwhelmed the usual selling in the secondary market during tax season, specifically in April, when flows into municipal bond funds and separately managed accounts surged.

Although the breadth of the market feels thin, we expect municipals to continue performing relatively well. Under most conditions, demand tends to remain good during times of steady returns and low volatility. Demand tends to fade when investors confront negative returns and high volatility.

Solid price returns, along with low market volatility, support further gains. If anything, munis might benefit from a flight to quality from riskier assets.

Of most interest to investors, we are pursuing these broad strategies:

  • Our sensitivity to rate risk, or duration, is neutral to their respective benchmarks.
  • For intermediate and long-duration portfolios, we continue to have a bias to the 10 to 20-maturity range of the municipal curve. A steep ratio curve makes them look attractive versus other maturity ranges.
  • We expect long ratios to be in a tight range during the intermediate future. In the short term, they may soften slightly before going lower.
  • In maturities shorter than 5 years, the slope of the curve is extremely flat. That area of the curve is a little more vulnerable to modest steepening.
  • Shorter maturities are also showing tight quality spreads and lower yield ratios.
  • We see value in floating rate bonds. They offer higher yields with less rate risk than most short-duration fixed coupon bonds.
  • We continue to see spreads tight to fair value in high yield, making that segment of the market more vulnerable to an outflow cycle.

Matters that may interrupt smooth sailing include elevated price volatility due to fiscal and monetary policy uncertainty, uneven U.S. and/or global growth, volatile inflation sentiment or geopolitical uncertainties.

So far, steady tax receipts combined with reasonable spending are good signs for municipal budgets.

Any near-term risks to valuations will likely come from less favorable balances between supply and demand.

Congestion pricing is becoming a major force. The long-suffering New York City Metropolitan Transportation Authority (MTA) will employ congestion pricing as a powerful new revenue source, with vehicle traffic in parts of Manhattan subject to fees. This will help cover MTA’s large capital improvement needs, as well as repay debt. We do not expect MTA bonds to outperform the market in the short term. However, we may buy into elevated debt supply from new loans that are likely to come to the market.

In Puerto Rico, the U.S. Appeals Court for the First Circuit upheld the ruling that upended the protected status of special revenue debt in Chapter 9 bankruptcies. This may affect the ratings for some special revenue bonds, providing ample reason to have professionals conduct credit surveillance of municipal credits. Some fret this will impact all revenue bonds.

When applied to the broader market, the ruling has the potential to reduce liquidity for stressed credits in economically challenged regions. It should not impact liquidity for well-managed essential service revenue bonds.

Munis also may have financed a unicorn. “Unicorns” are start-up companies that reach $1 billion in value by private or public investment. They are generally not seen in this market.

But the Florida Development Finance Corp. conducted a $1.75 billion debt roadshow in March for the first U.S. private passenger railroad in more than a century. In April, muni investors ravenous for higher yields snapped up the securities. This trend bears watching and further analysis.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Robert E. Amodeo is the Head of Municipals at Western Asset Management, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.

All investments involve risk, including loss of principal.

© 2019 Legg Mason Investor Services, LLC. Member FINRA, SIPC. Legg Mason Investor Services, LLC and Western Asset Management are subsidiaries of Legg Mason, Inc.