The Lifeblood of Municipal Bond Investing
Tom Dalpiaz, Managing Director (October 12, 2016)
Except for a week or so at the end of September, the general direction of interest rates in the third quarter was up. Interest rate movements in the first week and a half of October have continued in that direction. Ten-year Treasury bond yields have risen 43 basis points from their lows in early July. Ten-year municipal bond yields have also gone up, but to a slightly lesser degree. The unraveling of the flight-to-quality trade, better payroll employment numbers, and somewhat more hawkish comments from the Federal Reserve have all contributed to higher interest rates.
Municipal bond market returns for the third quarter were generally flat to slightly negative depending on the part of the yield curve in question. The total return of the Barclays 5-year and 7-year Muni Bond Indexes reflected the better performing areas of the yield curve, with third quarter returns of -0.02% and +0.07%, respectively. The Barclays 3-year and Long Barclays Muni Bond Indexes had the most negative (though still hardly dreadful) third quarter returns for munis at -0.26% and -0.67%, respectively. Year-to-date through the end of September, the Barclays 7-year Index was up 3.29%. The Barclays Long Muni Bond Index was up 6.13% for the same period.
New issue volume in the municipal bond market was up 18.4% in the third quarter compared to last year. New issues for refunding purposes were down, but new muni bonds issued for new projects were up sharply. This additional supply was readily absorbed by the market due to a steady demand for munis that has not wavered. Net positive inflows into muni bond funds and ETFs have been consistently positive since last October.
Municipal bonds have had a reasonably good run for some time now, and that’s typically an appropriate time to review possible events and forces that might disrupt such benign conditions. The usual culprits tend to be a substantial credit spread widening, a large increase in muni bond supply, a sizable rise in Treasury bond yields, a sharp drop in demand for munis, or a major change in tax brackets or the tax exemption.
While there is always the possibility that these events and forces will surprise the market, some of them seem less probable than others. Unless there is a new, unforeseen credit problem in munis or recession-like conditions in the near future (neither of which seem a high probability to me), meaningful credit spread widening and the resulting negative impact on muni bond values also seem less likely.
Increases in muni bond supply tend to come from lower interest rates that encourage refundings or from muni bond issuers taking on large new money projects. Muni bond yields are not too far away from historical lows and new issue volume tied to refundings has been subdued. Infrastructure needs nationwide remain quite large and some issuers have shown, more recently, a willingness to take on new projects. That trend may continue. Offsetting this to some degree is the remaining cautiousness of some issuers. The long, arduous task of digging out of the hole of past budgetary challenges and ongoing pension challenges have made some issuers understandably cautious regarding increasing debt issuance.
A reasonable rise in interest rates generally has already occurred since July. The Federal Reserve does indeed finally seem ready to soon raise the Fed Funds rate target. I suspect future rate rises are likely to be discussed and telegraphed well in advance, and also have large amounts of time between them given the persistently gradual nature of economic growth and inflationary pressures.
The demand for municipal bonds has been consistently strong, and is a key reason munis have weathered additional supply and rising Treasury bond yields in reasonable fashion over the past few months. The strong demand for munis could be hurt if a surging stock market attracts investors’ attention and prompts re-allocations, or if a wide-spread buyers’ strike occurs due to persistently low muni yields. In my judgment, both of these possibilities appear to be lower level worries at this time.
The wild card in terms of affecting muni bond demand (as always) is the likelihood of changing Federal income tax brackets and Federal tax reform in general. If either of the suggested tax reform programs of the two main Presidential candidates are implemented as currently constituted, the top Federal tax bracket will be lower (under Trump) or higher (under Clinton). Generally speaking, lower Federal tax rates tend to lessen the demand for munis , hurting muni bond values, while higher tax brackets tend to increase muni demand thus helping muni bond values. Clinton’s tax reform ideas may also include a 28% limit on the tax exemption for munis (past Obama budgets had this limitation). That limitation, if it becomes law, will likely dilute the attractiveness of the tax exemption, particularly for the highest tax bracket investors.
Tackling major tax reform is a gargantuan task politically and much more complicated than the breezy platitudes of “tax simplification” or “tax fairness” invoked by both ends of the political spectrum. Who wins the White House, the size of that victory, the make-up of the House and Senate, how much political capital the next President wants to spend on tax reform, the intensity of lobbying efforts by groups affected by tax reform – all these variables make it difficult to know what tax laws might actually look like in 2017 or if they will be modified at all. The scenario of no changes to tax laws in 2017 is a real possibility too. Adjusting bond portfolios now in anticipation of unknown actual law carries with it a high degree of uncertainty.
One of the broader, recurring themes I’ve mentioned in these commentaries is the suggestion that investment grade, intermediate maturity municipal bonds can perform useful investment tasks and meet investment objectives for many investors throughout the interest rate cycle. Munis have certainly had a good run here, and events and forces could surface to undo the benign conditions that have contributed to attractive total returns. Some of those events and forces are more likely to occur than others. They may still take some time to materialize and could have more gradual, muted impacts than currently feared. I suggest the short/intermediate, investment grade muni space could weather a change in conditions reasonably well compared to other parts of the yield curve and other bond sectors.
Muni bond investors are happy to take attractive quarter-to-quarter total returns when they come but it is a coupon well bought and the yield captured over the life a bond that is the lifeblood of municipal bond investing. Effective, value-laden bond picking can be done in any interest rate environment. This core feature of municipal bond investing is important to remember when the month-to-month total return environment becomes less sunny.
Tom Dalpiaz manages an intermediate municipal bond strategy at Granite Springs Asset Management. The Intermediate Municipal Bond strategy was launched in September 2009.
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