Keeping You Informed: Municipal Commentary
The relative peace and tranquility in the municipal bond market through the first three quarters of 2017 came to an abrupt halt following whispers of tax reform changes in Washington. Proposed legislation in the last six weeks of the quarter raised questions on the tax exemption for certain types of municipal bonds. Ultimately, the legislation proposed in both the House and the Senate preserved the exemption, but limited the use and changed the tax brackets that could make tax exempt paper less valuable. Ultimately, volatility ruled the day (and the quarter) as issuers hurried to market to issue in 2017 to guarantee issuing paper in the tax exempt market.
Initial drafts of the House Tax Cuts & Jobs Act heavily restricted the tax exempt market, specifically eliminating Private Activity Bonds and restricting the ability of issuers to refinance their outstanding debt. Substantial lobbying in Congress in the fourth quarter resulted in changes to the final tax bill that preserved the ability of Private Activity (e.g. Private Universities, Hospitals) bonds to be issued, yet still eliminated issuers ability to advance refund their debt. This will limit issuance figures going forward and support bond prices caused by a lack of available supply.
The tax reform act also cuts tax rates for individuals and corporations. Individual rate changes will not have much effect on the overall municipal bond market, but the cut in corporate tax rates from 35% to 21% will make ownership of municipals far less attractive. Most of the ownership of municipals is represented by individuals, but 25% is owned by banks and insurance companies that may look elsewhere for fixed income securities. In the short-term we expect to see plenty of price discovery in the market to determine a new equilibrium level relative to taxable bonds. The net result of decreased issuance and lighter corporate demand will take some time, but long-term we expect demand to increase from individuals in high tax states.
In the rush to issue during quarter end, the market was able to absorb a record level of issuance in December and still post positive returns for the month. State and local government’s issued more than $60 billion in December and posted a healthy 1.05% return for the Bloomberg Barclays Municipal Bond Index. This brought returns of .75% for the quarter and a solid 5.45% for the year. Again this year, the best place to be positioned was the long end of the yield curve. The Long Bond Index returned 8.19% for the year with the 1 Year Index being the worst spot for 2017 at just .92%.
We began 2017 with Municipal ratios (Muni/ Treasury) being very cheap and skewed in favor of investment in tax free products, especially the first five years of the yield curve. By the end of the year, muni-to-Treasury ratios moved to the opposite side of the equation with municipal bonds expensive compared to taxable bonds. By example, the five year ratio of municipals to treasuries finished the year at 75% which is 35 ratios lower than we opened 2017. The long bond ratios were less dramatic and finished lower by 6 ratios to 92% of the comparable Treasury bond. With tax reform complete the market will be adjusting to new levels and ratios going forward and may take some time to find a new equilibrium point to reference.
While it may take time for the municipal bond market to find new equilibrium points given all the changes since tax reform, the market is still dealing with many other threats that remain from 2017. The political stalemate with North Korea and other world conflicts seem to have escalated during the year and pose a hazard to the financial markets. Interest rates appear to be headed higher on the front end of the curve as the Fed has telegraphed two or three rate hikes in 2018. We expect a flatter yield curve in the year ahead due to the Fed only being able to directly move short rates coupled with expected demand for longer dated paper could continue to level out the yield curve. Credit issues remain in the news after two hurricanes devastated an already weakened Puerto Rico economy dragging prices lower for the territory debt. Few acceptable answers to the issuer and bondholders have been presented to the island where less than half of the population have had power restored. Headline risk related to Puerto Rico could impact the overall market depending upon how the outstanding debt is resolved.
From a macro perspective, the municipal bond market dodged a bullet in tax reform that left the tax exemption unchanged. This is important for investors as well as issuers given the Trump administration’s desire to increase infrastructure spending. Unless and until we see a plan for this spending, we would expect to see a dearth of supply in the tax exempt market. Many issuers rushed to issue in 2017 to take advantage of proposed tax changes and expectations of new issue supply near $325 billion for 2018 (vs $400+ billion in 2017) should support bond prices relative to Treasuries. Opposing the supply side of the equation will be reduced institutional demand given the reduction of corporate rates from 35% to 21%. We expect institutional demand to be slowed unless ratios adjust in favor of tax exempt paper. Ultimately, we expect a muted year for tax exempt returns placing a premium on security selection and active management.