Keeping You Informed: Municipal Commentary
Apathy ruled the first quarter following the hurried pace of issuance at the end of 2017 due to changes in the tax code that would limit issuers access to the tax-exempt market. Market participants took a deep breath to digest the changes to the tax code and the short- and long-term impact on the municipal bond marketplace.
With many of the changes still not fully analyzed, we look for the market to go through an extended period of price discovery until we fully comprehend the after-tax impact on all market participants in the tax-exempt bond space.
The impact of tax reform will continue to be debated for the foreseeable future, but for the municipal market, the biggest threat has passed. The high-valued tax exemption of municipal bonds remains intact, albeit with some changes. Private Activity Bonds (PABs) were kept under the reform package allowing for many of the infrastructure spending projects that President Trump had advanced during his campaign. Unfortunately, the same package eliminated the ability of issuers to advance refund (refinance) their outstanding debt and ultimately passing on those potential savings to its constituents.
As we mentioned in previous writings, the largest impact of the tax bill on the municipal bond market comes not from changes in the individual holders of bonds, but rather the billions of dollars held by banks and insurance companies. Corporate tax rate cuts from 35% to 21% will likely change buying patterns of stakeholders in the market as lower tax rates may motivate them to look elsewhere for fixed income securities.
Tax reform impact on municipal bonds
Largest first-quarter loss in 20 years due to interest rate concerns
Ongoing market uncertainty
The fourth quarter of 2017 proved to be quite volatile, yet performance was positive as the market was able to absorb the massive amount of new issuance in the run-up to tax reform. Many expected the market to continue to perform well in the first quarter of 2018 due to the expected lack of supply. Issuers in position to bring deals to market did so in the 2017 calendar year with so much uncertainty surrounding the tax reform bill being floated at the time. Long-term issuance did in fact drop for the quarter by 29%, however, performance did not continue the momentum of the previous quarter.
Municipals saw the largest first-quarter loss in more than 20 years as interest rate concerns from the Federal Reserve (Fed) drove performance, despite the supply/demand imbalance and strong technicals created by the 2017 record fourth quarter issuance. For the quarter, the Barclays Bloomberg Municipal Bond Index was off by 1.11% with the worst spot on the yield curve being the ten-year spot which posted -1.61%. The best place to be positioned was the one year, which was positive for the quarter at .38%.
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. Banks and insurance companies, which make up a large portion of our market, are certainly addressing the math of the benefit to adding, holding, or selling municipals in their portfolios based on the new tax laws. We have seen very little selling from these traditional buyers in the wake of these new tax rates. As we move past corporate and individual tax filing dates, we expect to gain some clarity on the direction and magnitude of what could be a dramatically new investor base. As we do, we will contend with the potential for a pickup in issuance and ongoing headline credit risk in municipals (Puerto Rico) as well as macro issues with interest rate (Fed) and geopolitical risk (North Korea).
Uncertainty and spring holidays have kept many on the sidelines, opting to remain in cash until they see more clarity on the impact of the recently enacted tax reform bill. The net result of expected decreased issuance and lighter institutional demand will take some time, but long-term we expect demand to increase from individuals in high-tax states. Recent equity volatility and better municipal bond technicals have offered a better entry point for those looking for a relative safe haven in the tax-exempt space.