The municipal market was blindsided by tax reform proposals recently released by the House and Senate GOP.
While the tax-exemption of municipal bonds remains intact, a significant portion of the municipal market could disappear next year under the current GOP proposals. Specifically, the House plan would eliminate private activity bonds (PABs) and advance refunding bonds. The Senate plan calls for the elimination of only the advance refunded bonds. On average, these sectors combined have accounted for about 25% of tax-exempt issuance over the past ten years. More recently, the percentage has been closer to 40% due to the increase in advance refunding deals with prevailing low interest rates. With the threat of that size of decline in tax-exempt issuance, munis rallied quickly the first few trading days after the proposals’ release with long municipal yields dropping over 20 basis points (bps).
We could speculate on whether the language will be in finalized legislation, however, the market has to assume it is a possibility. As such, we may see a year-end spike in advance refunding deals, which we would view as a buying opportunity if municipal yields increase on the outsized supply. With regard to private activity bonds, under the House plan, all PABs issued after 2017 would have to be taxable bonds. This sector comprises bonds issued for qualified 501(c)(3) organizations (nonprofits) including many hospitals, airport terminal facilities, low-income housing and higher educational facilities.
The market was not surprised by several other items in the proposals that could impact the municipal market. Lowering the corporate tax rate to 20% was widely expected. This could reduce purchases of municipal bonds by banks and by property & casualty (P&C) insurance companies. Combined, banks and P&C companies own about 25% of outstanding tax-exempt bonds and tend to prefer longer maturity bonds. This decline may cause a reduction in demand for long munis, but we are skeptical on that outcome at this time. Banks and P&C companies buy munis not only for the tax-exemption, but also for diversification in a very safe asset class.
Under both proposals, the highest personal income tax rate will stay close to the current 39.6% level — 38.6% under the Senate proposal, and the House proposal would be unchanged at 39.6% for incomes above $1 million. Either proposal is positive for municipal bond demand. Additionally, with many existing itemized deductions being capped or eliminated, tax-exempt municipal demand may increase for retail buyers.
This mixed bag of potential changes will cause volatility in the municipal market over the next couple of months. GOP leaders would like to see final legislation by year-end. As mentioned, the muni market has outperformed due to the potential drop in municipal supply with the elimination of advance refunding bonds and PABs. We will see how a final plan develops as Senate and House GOP leaders mix and match provisions of each proposal to ensure passage. Stay tuned!
The credit health of states in the U.S. is at a crossroads. Eleven states have a negative rating outlook by Moody’s or S&P; only one state has a positive outlook. State officials are challenged on both the revenue and expenditure side of the income statement. With the slowly growing economy and tighter labor markets, state budget officials are expecting modest revenue growth in 2018 from improving income tax and sales tax receipts. On the other hand, pension costs continue to be a growing burden as pension funds roll back their return assumptions. Pension funding continues to be a threat to the fiscal well-being of many states. States have largely been unable to change existing pension benefits, and for those that can, changes are met with legal action. This has led some states to balance budgets by raiding “rainy day” reserves and looking for one-off savings.
While states have benefited from the slow trudge higher of the economy, the recovery has not been the same across the country. Energy dependent states have not realized the same gains as states with more diversified economies. The recent stabilization in oil prices and the growing number of operating rigs should provide near term benefits for lagging energy states including Alaska, Louisiana, New Mexico, North Dakota and Oklahoma. More broadly, public officials are looking for innovative ways to increase revenues through the expansion of the sales tax base more in line with today’s e-commerce economy.
As for now, the continued sluggish growth in revenues is being eclipsed by more rapidly growing fixed costs leading to the negative outlooks noted in the table below. Eleven states have negative outlooks while four have already been downgraded over the past year. As mentioned, the energy dependent states are under stress due to the decline in oil prices a few years ago. Other states face various issues including pension funding, political infighting, tax cuts with no offsetting revenue sources and fundamental changes in state economies. To stay ahead of potential downgrades and price deterioration from these challenges, BMO GAM’s municipal team monitors regional economic trends along with state financial profiles when assessing risk at the state and local level.
October muni curve flattens slightly on Fed expectations
The Bloomberg Barclays Municipal Bond Index returned a positive 0.24% in October as the treasury and municipal market yield curves flattened slightly. Year-to-date performance increased to a robust 4.92% through October 31. Municipal yields increased 7 bps in the five-year spot and decreased slightly on longer maturities. This type of movement in yields is known as a “yield curve flattening” where the spread between short- and long-term interest rates decreases. Shorter maturity yields were pressured by an anticipated increase in the Federal Funds Rate for a third time this year in December. This potential hike would move the Fed Fund Target Rate to a 1.25% to 1.50% range. Longer fixed income maturities were helped by the decline of inflation we have seen year-to-date as well as scant evidence for future increases.
The continuing supply and demand imbalance in the municipal market (discussed on the next page) is causing significant outperformance of municipal bonds versus other fixed income sectors. For example, the ratio of the ten-year municipal bond yield to the treasury yield has fallen from 95% at the beginning of the year to 84% at the end of October — munis richer by 11 ratios. This is also apparent in returns, as the Municipal Bond Index outperformed a similar duration U.S. Government Index by 141 bps (4.92% vs. 3.58%). The Municipal Bond Index also outperformed the Bloomberg Barclays Aggregate Index by about 172 bps.
With yield curve flattening, higher quality bonds underperformed BBB-rated bonds for the month. The Bloomberg Barclays Muni BBB-rated index returned 0.38% while the AAA-rated index returned 0.19%. Year-to-date, the BBB index outperformed higher quality bonds by about 350 bps. Much of this outperformance is attributable to quality spread tightening; however, the BBB index has a significant yield advantage over the AAA index. This yield advantage feeds into the total return of the index over the year.
Supply and demand
Municipal issuers sold about $35 billion in bonds last month, down about 34% from October 2016. Refunding deals dropped 52% from a year earlier. New money issuance, however, was slightly higher than last year at approximately $17 billion, up 3% from last year. Year-to-date total issuance is $322 billion, down 18% from the same period last year.
This year’s trend of strong inflows to municipal funds and exchange-traded funds (ETFs) continued in October. Over the past month, $2.6 billion flowed into municipal funds and ETFs. Year-to-date, tax-exempt net flows are at $30 billion. That is down almost 50% from the historically strong flows we saw last year for this period, but still represents solid demand for the tax-exempt market. With more talk about a potential Fed hike in December, recent flows have been positive for shorter municipal funds and negative for longer funds. Equity funds and ETFs have seen $162 billion and taxable bond funds $314 billion in net inflows year-to-date.
For the month, returns were flat to slightly negative in the one-to-five-year portion of the municipal curve, while longer bonds saw returns slightly better than the coupon return — that is, some positive price performance along with the income that accrued over the month. The best performance in the Bloomberg Barclays Indices was the 22+ year index at 0.47%.
- We remain slightly short our benchmarks and peer groups due to a potential December Fed hike, ongoing economic growth with solid labor market and perhaps some nascent signs of upward wage movement.
- The market is currently pricing in an 85% probability for a Fed hike this December. With a continuation of sub-2% core inflation at this time, our concern for higher interest rates is focused on maturities eight years and shorter. We are maintaining exposure to short, floating rate notes in the funds.
- Barbell structure with municipal floating rate notes on the short end and fixed coupon bonds on the longer end of the fund’s investment horizon. We earn more incremental credit spread on the longer end but remain short duration.
- Daily and weekly tax free floating rate notes remain at elevated yields providing attractive yields to interest rate sensitive investors. The weekly municipal floating rate index (SIFMA rate) is at 0.92% versus 0.63% in October 2016.
Credit and structure
- Lower-quality bonds posted the significant outperformance year-to-date. Most of this was due to spread tightening, that is, relative price appreciation versus high quality bonds. Due to compressed spreads, we are finding very few opportunities at this time.
- We continue to monitor the President’s actions to encumber Obamacare. Changes through executive order and/or regulatory means could be negative for the hospital sector. However, we are very comfortable with our hospital bond holdings.