Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- The municipal market is hitting on all cylinders. Modest domestic economic growth, a reasonable level of inflation, lackluster new issue supply, and sound fundamentals continue to drive investors into the tax-exempt bond market.
- The recent stellar performance further stems from new limitations on state and local tax deductions (SALT) which increased the value of tax-exempt income. Also, tax-adjusted municipal yields are attractive for maturities beyond ten years, in our opinion.
- The Bloomberg Barclays Municipal Bond Index posted a total return of +1.38% during the month of May, trailing the +1.78% return in the Bloomberg Barclays U.S. Aggregate Bond Index (the benchmark for the taxable market).
- The muni index performance for the year-to-date period was also solid at 4.71%, but again slightly behind the 4.80% return for the taxable market.
- Over the previous twelve months, both the municipal index and the taxable index generated total returns of 6.40%.
- High yield municipal bonds outperformed investment-grade bonds during May and over the past 12 months. The Bloomberg Barclays High Yield Municipal Index posted a return of +1.62% in May and 7.76% over the trailing 12-month period.
Revenue bonds outperformed G.O. bonds in all periods shown below
Source: Bloomberg Barclays, as of 5/31/19. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. For illustrative purposes only and does not represent the performance of any specific investment product.
- Under most conditions, demand remains good during times of steady returns and low volatility, yet it fades when investors confront negative returns and high volatility.
- We don't expect the current market to be any different. If anything, munis could benefit from any flight to quality from riskier assets.
- Demand, as measured by long-term flows into mutual funds and ETFs, was positive for the sixth consecutive month in May.
- New Issue supply totaled $132.4 billion for the first five months of the year, up slightly from $132.1 during the first five months of 2018.
Muni issuance: Year to date
Source: Bloomberg Barclays, as of 5/31/19.
Monthly net new cash flows into long-term muni funds and ETFs
Source: Source: Investment Company Institute, Washington DC, as of 6/12/19. May flows are estimated as of the week ending 6/05/19.
- We like the fundamentals in the market yet are cautious on credits with prices that already reflect such.
- Shorter maturities are showing tight quality spreads yet yield ratios look more attractive today given recent U.S. Treasury outperformance.
- We continue to see spreads tight to fair value in high yield, making that segment of the market more vulnerable to an outflow cycle.
- Also, additional income offered on bonds subject to the alternative minimum tax (“AMT”)1, versus non-AMT bonds, narrowed throughout the year yet many investors may continue to look to the additional income offered by AMT bonds because most will no longer be at risk of falling into the AMT category. Four percent coupons offer a spread to five percent coupons which fits nicely into our broader income strategy, too.
- Another current topic for discussion is the municipal yield curve2 has exhibited remarkable flatness in recent months. A flat municipal curve is consistent with our current investment strategies, and our short-term outlook.
- 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 because 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, we could see them soften slightly before they go lower.
- In maturities shorter than 5 years, the slope of the curve is extremely flat, and we expect that area of the curve to experience a modest steepening.
- Shorter maturities are also showing tight quality spreads yet yield ratios have cheapened given U.S. Treasury outperformance.
- We see value in floating rate bonds because they offer higher yields than most short duration fixed coupon bonds.
- The 10-year AAA muni to US Treasury ratio was 77.9% at the end of May, and on the long end was 93.3%. These ratios are calculated by dividing the respective muni yield by the respective US Treasury yield.
Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury
Source: Bloomberg Barclays, as of 5/31/19. Past performance is no guarantee of future results. For illustrative purposes only and does not represent the performance of any specific investment product.
Muni/Treasury Ratios and Taxable Equivalent Yields
Source: Bloomberg Barclays, as of 5/31/19. Past performance is no guarantee of future results. For illustrative purposes only and does not represent the performance of any specific investment product. Taxable Equivalent Yield (TEY) is based on 37% top tax bracket. An investor may be subject to the federal Alternative Minimum Tax, and state and local taxes may apply. Capital gains, if any, are fully taxable.
- The smooth sailing we have experienced recently may get interrupted by elevated price volatility due to fiscal and monetary policy uncertainty, uneven US and/or global growth, volatile inflation sentiment, or geopolitical uncertainties.
- Other factors to watch include fiscal discipline continues to vary across regions and investors must remain vigilant for signs of outsized, unsustainable spending programs. Yet, so far, steady tax receipts combined with reasonable spending is a good sign for municipal budgets. Budget reserves are a first-line defense against revenue shortfalls and many states have an adequate capacity to make fiscal adjustments in response to a downturn.
- Given a steady fundamental backdrop, any muni underperformance relative to U.S. Treasury’s will likely, in our opinion, be more of a modest correction which could produce investment opportunities in duration and credit.
- Steeper curves, higher yields, and wider spreads can act as a catalyst to add duration and credit risk, unless broader macro signals become more worrying.
- We don’t see any fundamental justification for avoiding munis so if there are near-term risks to valuations they will likely come from less favorable balance between supply and demand.
- From current low levels, one might be tempted to think that steepness will return to the municipal yield curve soon. However, with the Fed3 currently on hold, and inflation subdued compared to levels reached during previous economic cycles, an outlook of a moderate economic environment is consistent with today’s data.
- If anything in this data seems amiss, it is that the flat municipal curve is mispricing potential interest rate volatility, denying long duration investors a sufficient cushion of income to compensate for higher sensitivity to rate changes. In sum, these observations are consistent with an outlook of moderate growth, benign inflation and muted actions from the Fed.
- In our opinion, the municipal market will continue to evolve due to changing economic realities, but we believe one thing will remain consistent with the past: the municipal market will successfully adapt to meet challenges, as they surface.
1 The Alternative Minimum Tax (AMT) is an income tax imposed by the US federal government on individuals, corporations, estates, and trusts. AMT is imposed at a nearly flat rate on an adjusted amount of taxable income above a certain threshold.
2 The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
3 The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.