Despite the volatility in the municipal markets in late 2017, the final tax reform law is far less impactful on the municipal markets than initially feared. Individual tax rates will remain similar to current law and supply will be reduced going forward. Investor demand for municipal bonds providing tax-advantaged income should remain robust, particularly in high-tax states.
Here is a recap of the key components:
- Tax-exempt advanced refunding deals eliminated. This will reduce tax-exempt bond volume in 2018. Pre-refunded bonds, created by advanced refunding deals and typically secured by U.S. Treasury-backed debt, will retain their tax-exempt status and may appreciate on scarcity value.
- Individual income tax rates only lowered slightly. Demand for tax-exempt municipal bonds should continue to be strong in 2018.
- Tax reform will hit taxpayers in high-tax states hard as state and local tax (SALT) and mortgage interest deductions are curtailed. Bonds in these states (e.g., New Jersey & California) have outperformed as investors in these states foresee future reductions in disposable income.
- Corporate tax rates drop to 21%. Non-retail buyers of municipal securities (banks and insurance companies) may be less inclined to invest in municipal bonds. We think this will be muted by reduced supply of tax-exempt bonds and the continued attractiveness of municipal bonds for diversification and relative safety.
A recent report by Moody’s Investors Service pointed towards a continuation of positive credit trends in the municipal market. The 3rd quarter report summarized their rating actions of 122 upgrades to 104 downgrades; this is an upgrade/downgrade ratio of 1.2 times (122 upgrades ÷ 104 downgrades). This brings the year-to-date totals to 655 upgrades to 348 downgrades; a 1.9 times upgrade/downgrade ratio. At this rate, it’s highly likely we will end the year with upgrades outpacing downgrades, which will be the third year in a row of this positive credit trend.
Tax-backed credits fared best over the year with 518 upgrades and 210 downgrades as revenue-backed issuers saw 137 upgrades versus 138 downgrades. Cities, counties and public school districts accounted for the bulk of upgrades while healthcare and private education issuers shouldered the brunt of these downgrades. While not aligned with our philosophy of favoring revenue bonds over general obligation bonds at this time, performance hinges on credit selection. BMO’s municipal portfolio managers are in constant interaction with our seasoned credit analysts to focus purchases on issuers with positive long-term outlooks.
Municipals end 2017 on positive note — slow start in the New Year
U.S. fixed income markets continued to be driven in the shorter term by policy moves of the Federal Reserve, as the Federal Open Market Committee hiked its Fed Funds target rate for the third time in 2017 at its December meeting (to 1.5%). With short rates moving higher, the U.S. treasury yield curve continued to flatten and municipal bonds followed suit both during Q4 and the year. The GOP tax reform proposals roiled the normally staid municipal market as the tax-exempt status of private activity bonds (PABs) and advance refunding bonds was initially targeted for elimination by Congress. In the final version signed by the President, the tax-exemption for advanced refunding deals was eliminated while PABs remained tax-exempt. The elimination of advanced refunding deals will cause a significant decline in municipal issuance in 2018. Additionally, individual tax rates were little changed as the top individual tax rate is now 37% versus 39.6% previously. Retail demand for tax-exempt bonds should remain healthy.
The proposed tax law changes resulted in a rush of new bond supply during the latter half of the quarter as issuers came to market in anticipation of changes in the tax code. December 2017 was a record month for new issuance as $62.5 billion came to market. For the year, gross issuance was over $435 Billion, up substantially from 2016’s $390 billion. Positive flows into municipal bond funds helped to absorb some of this increased supply as long-term funds took in over $32 billion in net flows over the year. With the elimination of advanced refunding deals, current estimates for 2018 gross issuance are in the $325 billion range, a substantial decline from the pace of recent years.
The total return for the Bloomberg Municipal Bond Index during Q4 was 0.75%, capping a good year for the Index, which finished up 5.45%. However, with an active Fed, the short-end underperformed longer maturities. For example, the Bloomberg Short (1-5 year) Municipal Index returned -0.65% for the quarter and 1.61% for the year.
As expected, January 2018 issuance is off to a slow start with many deals pulled into December 2017 due to tax reform. As mentioned above, advanced refunding deals have been eliminated from the tax-exempt market. These deals are refunding deals that occur more than 90 days before a bond’s call date (typically several years prior to the call) and accounted for a significant portion of municipal issuance over the past decade. We shall see how the market develops under tax reform, but we think the lower supply and a continuation of retail interest bode well for the tax-exempt market.
Higher quality bonds slightly underperformed BBB-rated bonds for the month. The Bloomberg Barclays Muni BBB-rated Index returned 1.20% while the AAA-rated index returned 1.01%. However, year-to-date, the BBB index outperformed higher quality bonds by over 400 basis points (8.74% versus 4.45%). Much of this outperformance is attributable to quality spread tightening. The BBB index does have a significant yield advantage over the AAA index (3.25 % yield-to-worst versus 2.10%, respectively). This yield advantage feeds into the total return of the index over the year.
Supply and demand
Municipal new issue volume was a record $62.5 billion, more than double a typical December’s issuance. Refunding deals surged over the month as it became more apparent that advanced refunding issuance will be eliminated by GOP tax reform. At $28 billion, refunding deals were up 400% from December 2016! New money issuance also increased due to the threat to tax-exempt Private Activity Bonds. New money deal volume was $27 billion in December; double what we saw in December 2016. Annual issuance for 2017 came in at $436 billion, down slightly from the $445 billion issued in 2016. Municipal market pundits are forecasting 2018 municipal bond issuance of around $325 billion.
The solid inflows municipal funds and ETFs have seen this year faltered in December’s volatility with $530 million of net outflows. Year-to-date, tax-exempt net flows ended at $31 billion. That tops 2016’s inflows of $29 billion. Equity funds and ETFs ended 2017 with $543 billion of net inflows as taxable bond funds and ETFs saw $345 billion of inflows.
For the month and the year, yield curve positioning was a key contributor to performance. Over the year, the two-year spot rose by 35 basis points while the ten-year spot fell by about 30 basis points. Longer bonds fared much better with limited pressure on yields due to low inflation and decent demand. In 2017, the Bloomberg Barclays Maturity Indices returned 1.56%, 5.83% and 8.19% for the 3, 10, and 22+ year spots, respectively.
- We continue to be shorter duration than our benchmark and peers.
- Despite limited supply in the first weeks of 2018, the positive performance we typically see in January (due to reinvestment of coupon payments and maturing bonds) has yet to materialize.
- Fixed income markets are being driven to higher yields by heightened concerns of inflation with the passage of tax reform. Additionally, U.S. Treasury yields have breached important technical barriers (for example, 2.40% on the U.S. 10-year Treasury note).
- Retaining municipal floating rate notes on the short-end of the curve. Avoiding fixed-coupon bonds on the shorter end of the yield curve due to expected Fed rate hikes. Continue to monitor inflation and expectations which remain subdued and below the Fed’s 2% target.
- Daily and weekly tax free floating rate notes remain at elevated levels providing attractive yields to interest rate sensitive investors. The weekly municipal floating rate index (SIFMA rate) is at 1.31% on 1/10/2018 versus 0.67% on 1/11/2017.
Credit and structure
- Lower-quality bonds posted the significant outperformance in 2017. 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, but continue to hold our lower quality overweight. Looking for opportunities in AA-rated bonds.
- 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 have reviewed our holdings and are comfortable with our hospital position.