The winning streak ends
We expected more volatility this year, and that’s just what we received—and plenty of it—in the first two months of 2015. After the surprisingly sharp decline in yields in January, rates rose in February and in the process, ended the streak of 13 consecutive months of positive tax-free returns.
As rates rose, the yield curve steepened, also reversing a long-standing flattening trend. The short end of the yield curve was unchanged as two-year yields rose just 3 basis points (bps). Yields in the intermediate and longer segments of the curve rose from 25 bps for five years to 30 bps or more for ten years and beyond. The result of the back-to-back monthly swings was essentially winding up back where we started the year. Other than the two-year maturity, which is 4 bps lower than at year-end, 10s and 30s are within 2 bps of year-end levels.
One catalyst for the reversal in rates in February was the monthly payroll report. The Labor Department reported 267,000 new private sector hires in January, accompanied by positive revisions for each of the two prior months. Although the unemployment rate held steady at 5.7%, it did so for the right reason as the civilian labor force expanded by an encouraging 703,000 workers. If hiring continues at a similar pace for the next few months, the odds of a June fed funds rate hike will improve, since the futures market still places the odds at well below 50%. Federal Reserve (Fed) Chair Janet Yellen reiterated in recent Congressional testimony that the Fed’s timing will be data dependent. However, investors are increasingly sure of one thing: the likelihood of maintaining a zero fed funds rate all year declines with each strong employment report.
While the Fed has said repeatedly they will be “patient” before raising the fed funds rate, tax-free investors demonstrated last month that they too can be patient in putting money to work. The sentiment in early February was that yields had fallen too far, too fast in the prior month and tax-free demand was tepid. Unlike the taxable market, which is much larger than the tax-free market and driven by institutional investors whose buying motives may differ dramatically from those of individual investors, the tax-free market remains largely subject to the sentiment of retail investors. Institutional investors in the taxable market may buy to match an index, or to align assets with liabilities, regardless of yield levels. Consider the current strong demand for European sovereign yields despite the fact that an estimated $1.5 trillion of eurozone debt is trading at negative yields. Certainly, some investors are motivated by the belief that yields may become even more negative, creating the opportunity for capital gains as the European Central Bank steps up their quantitative easing purchases this month.
Many others are involved, however, regardless of the return expectation. Money simply may have to be put to work to maintain currency exposure or to avoid the risk of even larger losses in other asset classes.
Regardless of the motives for institutional demand, the predominant motives in the tax-free world remain safety and income. When either of these are perceived to be in short supply, investors have demonstrated over and over again, at least for a time, a willingness to step back and re-assess current conditions. Either they ultimately come around to accept that the new, lower yields are justifiable given the economic and inflation backdrop and begin to invest once again—or they don’t. Last month, investors chose to once again put money to work, but only after yields had moved higher. Dealer buying and selling activity improved and new issue demand was relatively strong. What we witnessed in February confirms our cautious stance toward the market. Even if Treasury yields were to fall once again and perhaps retest the lows of January, we believe the tax-free market would lag, with yields falling at a much slower and more muted pace than the Treasury market.
Thankfully, cash flow has been positive into the municipal market over the last two months. Combined with the significant reinvestment demand from bond calls and maturities, the demand has been generally sufficient to meet substantially higher issuance levels this year. Total new issuance through February was over $58 billion, more than 67% ahead of 2014 levels. Last year, issuance started off very slowly so year-over-year comparisons are relatively easy, but refunding activity has helped boost supply this year. Current market yields are roughly 200 bps lower than where debt was being issued seven to 10 years ago.
So issuers now have the ability to call bonds and refinance the debt at lower levels, or to prerefund the debt prior to the stated call date. We expect that even if yields rise moderately this year, that new supply might achieve the $400 billion totals some are estimating, exceeding last year’s $340 billion by a good margin.1
Tax time value
As all taxpayers know, the April 15 deadline is rapidly approaching. Having taxes on their minds is usually a good thing for owners of tax-free municipal bonds or bond funds, or those considering a purchase. The municipal market remains one of the very few ways to avoid not just the federal income tax, but in some cases state income taxes as well.2
As taxpayers found out when filing their 2013 tax returns, the top marginal federal income tax rate for many had risen to 43.4%, not the 39.6% peak level they knew in 2012.
The additional 3.8% is a tax on “unearned income” above a $200,000 threshold for individuals. Municipal bonds are one of the few investments that are exempt from federal income taxes as well as this additional tax and it helped boost demand for tax-free income around the tax date last year. We’ll see if it has a similar impact this year.
For 10 years, from 2003 to 2012, the top marginal federal tax rate held steady at 35.0%. Obviously, the higher tax rates go, the greater the value that a tax-free investment may offer. Consider, for example, a 10-year AAA rated tax-free yield, currently at 2.02% according to the Municipal Market Data scale. For an investor in the 43.4% tax bracket, the pre-tax equivalent yield of the 2.02% tax-free yield is equal to 3.57% ((2.02/(1 – .434)). Since the AAA tax-free yield is currently almost exactly the same as the yield on a 10-year Treasury (2.01%), investors in the top tax bracket are able to buy a very highly rated municipal security and earn the equivalent of 157 bps of yield before taxes, which is more than a 10-year Treasury. This simple example helps illustrate the value in tax-free yields relative to taxable alternatives in the current environment. If an investor is willing to accept the additional credit risk of lower rated issues, such as AA or A rated issues, the pre-tax advantage for municipals becomes even more compelling.
In this issue:
- The winning performance streak for the municipal market ends at 13 months after yields rose in February and the curve re-steepened
- Investors were patient last month, waiting to invest more significantly only after yields adjusted to meet their target levels
- New supply is running 67% ahead of year-ago levels, thanks primarily to heavy refunding supply
- Current municipal/Treasury yield ratios strongly favor tax-free bonds for higher income investors; April tax filers will hopefully take notice
- Republican governors are seeking to swap lower state income tax rates for higher sales tax and user fees, potentially raising the risk profile of state credits in the next economic downturn
- Local municipalities are increasingly seeking additional revenue by taxing what we have traditionally considered nonprofit entities
Strategy and performance
- Remain moderately short duration and look to barbell around the 3- to 5-year maturity segment of the yield curve
- Maintain a credit overweight, but focus on the shorter maturities to minimize spread duration risk
- Remain overweight revenue-backed issues over general obligation debt
Data for the journey
1 Source: Bloomberg LP, based on consensus estimates.
2 This information cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. This information is being used to support the promotion or marketing of the planning strategies discussed herein. BMO Financial Group and its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors.