Since the Tax Act was approved, short duration, tax-efficient portfolios have seen a notable shift toward corporate bonds. These investment allocation decisions are being made based on more attractive corporate yields vs. duration-neutral, tax-adjusted municipals. In today's blog, we explore the factors that have influenced municipal relative value in the past and provide some additional insights for crossover buyers.
Over the last 10 years, the relative ratio on a two-year, AAA-rated, general obligation (GO) municipal bond vs. a comparable maturity Treasury has fluctuated between a low of 57% and a high of 328%:
Source: Refinitiv TM3/MMD
This ratio is quite simply a function of anything that affects the supply / demand dynamics for municipal bonds. For example, changes to tax rates, the absolute level of interest rates and real or perceived (thank you, Meredith Whitney) credit quality, can all lead buyers toward or away from municipals. Seasonality of municipal bond reinvestment also plays a role in demand, with significantly higher amounts of bonds maturing in June, July and August. This imbalance fades in the September to November period and can result in some underperformance during these months. While the impact of supply is best viewed on a "net" basis, the range of absolute issuance has been staggering. We reached record levels of municipal new issuance in 2016 at nearly $450B, but have also experienced some droughts with less than $300B in 2011.
Tax reform has challenged the municipal market in 2018 on both sides of the supply / demand equation. The provision in the Tax Act restricting advance refunding issuance is responsible for a sharp reduction in new issue volumes during 2018. Secondary bid lists have helped the availability of bonds in the longer end of the curve somewhat (and hence the relative values) but not so much in the short end. The much lower 21% corporate tax rate has materially reduced demand from corporations. It is important to note, however, that individuals continue to make up the majority of the municipal bond buyers and changes to the personal tax rates were more muted. Further, it appears corporations and property casualty insurers are bigger players in the long end of the curve. Concerns over their future participation in the market may actually be increasing overall demand for short-duration municipals, as more traditional muni buyers elect to stay shorter and avoid that uncertainty.
Looking forward, what could change these dynamics and lead to more attractive relative valuations for municipals? Democrats have regained control of the House, and there is some speculation one of the first items on the agenda may be a massive infrastructure deal, potentially reaching $1-$1.5 trillion. There seems to be common ground on infrastructure needs and spending, however the growing national debt presents a big challenge to overcome at the federal level. Twenty new governors were elected during the mid-term elections, with both Republican and Democratic candidates running on campaigns promising to rebuild infrastructure. So even if Congress is not successful with a massive program, we should still see an uptick in new projects in 2019 led by state and local governments, which may in turn lead to relative value improvements.
Bloomberg, "New Governors Eye Infrastructure as Trump's Plan Languishes", Amanda Albright and Danielle Moran, November 14, 2018
CNBC, "'Another Trillion in Debt, Here we Come': Cohn Sees Trump Working with Democrats on Infrastructure", Thomas Franck, September 18, 2018