By Cooper J Howard
The municipal bond market is off to its hottest start in five years, led by the lower-rated segments of the muni market. It may be tempting to chase returns, but we suggest that investors instead take a cautious approach and focus on higher-rated issuers during the second half of the year. We see heightened risks on the horizon, with the possibility of a prolonged trade war, uncertainty about Federal Reserve policy, and the possibility of a decline in tax revenues caused by a slowdown in the economy.
It's not all bad news, though, for the muni market. The combination of low supply and strong demand should continue to serve as a tailwind for performance. The strong pace of returns should slow over the second half of the year, but we believe munis will provide higher after-tax yields for high-income earners and can help to buffer against potential volatility in the equity markets.
So what should muni investors do, given all the uncertainty? Here are three strategies that we think make sense for the rest of the year:
- Stay invested
- Focus on higher-rated issuers with stable credit characteristics
- Consider a combination of taxable short-term bonds and longer-term munis
Year-to-date, the municipal market has returned 4.9% due to a combination of favorable supply-and-demand dynamics and falling Treasury yields. We expect the favorable supply-and-demand dynamics to continue in the near term, which should support prices for municipal bonds. The 2017 tax law changes eliminated municipalities' ability to issue certain types of bonds, resulting in supply that has been below historical averages. It also capped, or completely eliminated, many popular tax deductions for individuals, resulting in higher tax burdens for some higher earners. As a result, nearly $45 billion flowed into municipal bond mutual funds and exchange-traded funds (ETFs) from January through May - an increase of 420% over the same period in the previous year.
Money has been flowing into muni ETFs and mutual funds at a robust pace
Source: ICI, as of 5/29/2019. Note: Total for May 2019 is a sum of the estimated weekly fund flows.
While the pace of fund flows may slow, we expect demand for municipal bonds to remain strong over the rest of the year. Meanwhile, the amount of new issuance should remain low relative to historical averages, which in combination should support prices and total returns.
The yield on a 10-year benchmark AAA-rated muni has declined to 1.6% since peaking at 2.8% last fall.1
It may be tempting to wait for yields to increase from current levels before investing, but we think that is a poor strategy, as we do not anticipate rates will rise much further from here. The yield on a 10-year Treasury bond - which 10-year muni yields tend to follow closely - is currently priced for two rate cuts by the Federal Reserve, based on our calculations. There's a 99% probability of one rate cut and a near 50% probability of at least two rate cuts by the end of the year, according to Fed Futures implied probabilities.² If the market is correct and the Fed cuts twice this year, we don't expect rates to move much higher.
Focus on higher-rated issuers with stable credit characteristics
We generally have a positive view on the credit conditions for most municipalities, but believe that we are in the later stages of the economic cycle and that risks abound. A prolonged trade war has the potential to slow economic growth and therefore tax revenues.
The good news is that the prolonged economic recovery has benefited most state and local governments. Tax revenues for 41 states have fully recovered from their Great Recession lows, according to Pew Charitable Trusts. The prolonged economic recovery has benefited the credit quality of municipal issuers, as credit ratings upgrades have topped downgrades for four straight years.3 Moreover, all but two states (Illinois and New Jersey) have the financial flexibility and reserves to manage a moderate recession without a "significant adverse credit impact," according to Moody's.
Although credit conditions are generally favorable and have been improving, we think we're near the peak in the economic cycle. We don't believe now is the time to begin to invest in lower-rated issuers, because spreads - that is, the additional yields investors typically require for investing in lower-rated issuers - are historically low.
Spreads for lower-rated munis are near historical lows
Source: Difference in yield-to-worst between the Bloomberg Barclays AA, A, and BBB Municipal Bond Indexes and the Bloomberg Barclays AAA Municipal Bond Index, as of 6/6/2019. Note the difference in yields may be due to other factors such as maturity, durations, coupons, or call features.
We also suggest caution with lower-rated issuers, because they have historically underperformed higher-rated issuers during rate-cutting cycles. Normally, the Federal Reserve cuts rates when the economy is slowing in an attempt to boost growth. Tax revenues - the primary source of revenues for most municipalities - also historically have declined during periods of slow growth. This is a negative for lower-rated issuers, as they tend to have less financial flexibility to pay debt service.
In this environment, investors should focus on issues with more stable credit characteristics, like water and sewer revenue bonds, special tax bonds, or select state and local governments with diverse revenue streams. We would suggest caution on issuers like not-for-profit hospitals, as their finances tend to be riskier than other issuers. Also, spreads for an index of hospital revenue bonds have been narrowing lately, meaning investors aren't getting as much additional yield as they have in the past.
We are also cautious on issuers that would be negatively affected by a prolonged trade war, such as issuers highly reliant on the agricultural industry in the Midwest, southern border cities, or port cities.
Consider a combination of taxable short-term bonds and longer-term munis
To take advantage of our view on interest rates, we suggest a barbell approach. A barbell is a combination of short- and longer-term bonds. A potential benefit of a barbell approach is that short-term bonds allow for flexibility in case interest rates increase, while longer-term bonds historically provide greater diversification from stock market volatility. Investors who are not in the top tax brackets should consider taxable short-term bonds in place of munis, because they may be able to achieve higher after-tax yields with taxable alternatives even after accounting for taxes.
The chart below shows the yield curve for a AAA-rated benchmark muni (blue line) relative to Treasury bonds before (yellow line) and after federal taxes (yellow dashed line). Even after adjusting for taxes, short-term Treasuries yield more than short-term munis. The implication is that some investors should consider pairing short-term taxable investments, like Treasuries or certificates of deposit (CDs), with longer-term munis for higher after-tax yields. Investors in very high tax brackets could still achieve higher after-tax yields with munis alone.
Consider a barbell with an average duration between five and eight years
Source: Bloomberg, as of 6/6/2019. Munis are represented by the BVAL (Bloomberg evaluated pricing service) Muni Benchmark Curve. Interest payments on Treasury bonds are generally exempt from state income taxes, so a state tax rate was not included.
A ladder approach can also make sense now. A ladder strategy invests incremental amounts in bonds with maturities that are equally spaced apart. Unlike the Treasury market, the yield curve for highly rated munis is positively sloped, giving investors higher yields for extending duration.
1 Source: As represented by the Bloomberg BVAL 10-year Muni Benchmark, as of 6/7/2019
² As of 6/11/2019
³ Moody's Investors Services, as of 3/8/2019
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.