As expected with the cut of the corporate tax rate, banks have sold some of their tax-exempt bond holdings. The most recent data for the end of the first quarter shows that banks reduced exposure to munis by about $16 billion from the end of 2017.
To put that into perspective, U.S. banks hold $554 billion of municipal bonds, or about 14% of the $3.8 trillion muni market. While it sounds like a big number, the sales represent a 3% decline in their total holdings. We think it’s likely that banks continued to reduce holdings at a similar pace in the second quarter.
Nevertheless, bank sales have not stopped munis from outperforming other fixed-income investments this year. Through August, Bloomberg’s Treasury bond index was down 0.74% while the Bloomberg Municipal bond index was up 0.25%. Short muni bonds, which investors tend to prefer in a period of Fed tightening, performed even better returning 1.04%.
So, why did muni bonds have good relative performance with a major market participant selling? It comes down to supply and demand. Through August, municipalities have sold 13% fewer bonds than the same period last year. As we stated in prior comments, the decline is due to changes in the tax law that curtail the ability for issuers to advance refund outstanding bonds. So, while issuance for new bonds is up about 30% this year, a 50% drop in refunding deals has dried up issuance and helped munis outperform.
Additionally, the municipal bond market is shrinking — the number of outstanding municipal bonds declined by $20 billion in the first quarter as more municipal bonds matured than were issued. Estimates are comparable for the second quarter. And when you have investors plowing about $19 billion of net flows into municipal funds and ETFs, muni prices hold in very well despite what is going on in other fixed income sectors.
As for the future, we expect banks to continue to sell munis, but we don’t expect it to be much of a drag on performance. At $554 billion, they hold a significant chunk of the market, but it’s not all for sale. Banks like to diversify their collateral, and with relatively high average quality, low default rates and low price volatility, municipal bonds are a crucial component of that diversification.
Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a Fund’s portfolio.
Credit risk is the possibility that an issuer will default on a security by failing to pay interest or principal when due. Lower credit ratings correspond to higher credit risk.
Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors.
Interest income from Tax-Free investments may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes.
Bloomberg Barclays U.S. Municipal Bond Index is an unmanaged index of a broad range of investment-grade municipal bonds that measures the performance of the general municipal
Bloomberg Barclays US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.
Bloomberg Barclays Short (1-5 Year) Municipal Index includes investment-grade tax-exempt bonds that are issued by state and local governments and have maturities of 1 to 5 years.
Investments cannot be made in an index.