Western Asset examines recent trends in the muni bond market and provides its outlook about conditions ahead.
- The municipal bond market posted positive performance during the month of December and for all of 2017.
- The Bloomberg Barclays Municipal Bond Index returned +1.05% for December and +5.45% for the year compared with respective gains of +0.46% and +3.54% for the Bloomberg Barclays U.S. Aggregate Bond Index (the benchmark for the taxable market).
- Longer maturity and lower quality municipal bonds performed best for the month and the year.
- The municipal high yield index returned 1.3% for December and 9.69% for the year.
Revenue bonds outperformed G.O. bonds for all periods shown below
Source: Bloomberg Barclays, as of 12/31/17. 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.
- Muni market technicals were positive throughout 2017.
- Flows in 2017 were a little above the previous year with demand from institutions, retail and global investors all helping to underpin 2017’s solid performance.
- Supply was manageable throughout the year. Total new issuance during 2017 was just under $439 billion, close to the $446 billion during 2016.
- Yet in December, $64 billion of municipal bonds were rushed to market as issuers attempted to launch debt which they expected would be prohibited following passage of the tax reform package.
Muni issuance: 2017 vs. 2016
Source: Bloomberg Barclays, as of 12/31/17.
Monthly net new cash flows into long-term muni funds and ETFs
Source: Source: Investment Company Institute, Washington DC, as of 1/03/18. October flows are estimated as of the week ending 12/27/17.
- During December, the muni yield curve flattened with short-term yields rising as long-term yields experienced modest declines.
- The 10-year AAA muni to US Treasury ratio is currently near 84%, and on the long end is slightly below 96%.
Yield Curve Comparison: BBB Muni Revenue, AAA Muni & US Treasury
Source: Bloomberg Barclays, as of 12/31/17. 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 12/31/17. 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.
- Investors are asking what tax reform means for the municipal market. As we expected, the plan is a net positive for most municipal bond investors because the proposal does not strip municipal bonds of their tax-exemption, and other tax provisions will limit the amount of future municipal debt that can issued for certain types of municipal issuers, such as refunding activity.
- Major tax reform appears to be behind us. However, future assaults on the municipal sector are always possible. There is a long-term risk of fundamental credit quality erosion for general obligation debt, particularly at the local government level.
Key provisions in the new law relevant to municipal bond investors
- Lower corporate and individual tax rates makes tax-exempt income less valuable. Municipal issuers may see an increase in their borrowing rates to compensate investors.
- Increasing cost of capital may serve as a drag on states fiscal budgets, and renewal of infrastructure.
- Ironically, states that levy income taxes may benefit fundamentally because Congress eliminated or capped deductions permitting more income to be taxed. Some states may introduce legislation to mitigate this potential revenue windfall.
- At the margins, the state and local tax (SALT) provisions will increase cost of living in high tax states and the mortgage interest provisions can make owning real estate less valuable. Lower home values may reduce tax receipts, and can hurt the formation of new households. This will strain the budgets of local governments, and make it harder for state and local governments to increase taxes.
- Eliminating advanced refunding bonds will reduce future supply of debt yet it also prevents issuers from reducing future expenses, prolonging higher borrowing costs for municipal authorities, potentially being a long-term credit negative.
- Future municipal new issue supply should be lower than prior years due to the issuance restrictions in the new tax law and the near record amount of bonds rushed to the market during December 2017, in anticipation of tax reform passing.
- Provisions in the new law will likely keep household demand for municipals strong yet temper institutional demand for the asset class.
- Taxable debt will not be impacted from a supply/demand perspective.
- The benefits of municipal bonds go beyond tax savings alone. They are beneficial for many investors due to their generally high credit quality. Municipal bonds historically defaulted far less frequently than corporate bonds and that is likely to remain true going forward.
- We continue to favor revenue bonds over general obligation debt for relative value reasons.