looking ahead to municipal bonds in 2017
Tom Dalpiaz, Managing Director (January 18, 2017)
In terms of total return, the municipal bond market through the first eight months of 2016 was a fairly pleasant place to be. By the end of August of last year, the year-to-date total return for the Barclays 7-Year Municipal Bond Index was +3.44% -- a result almost nice enough to mention at cocktail parties. Even with the rise in muni bond yields in September and October, the year-to-date total return of the Barclays 7-Year Municipal Bond Index at the end of October was +2.50% -- not worthy of cocktail party conversation but still not unreasonable for intermediate maturity Muniland.
Then November happened. Ouch. Financial markets scrambled to assess the impact of widely unexpected election results. Volatility reigned. The municipal bond market followed the lead of sharply rising Treasury bond yields. Muni bond prices were also negatively affected by substantial outflows from muni funds and ETFs and the concern over potentially damaging tax reform in the next administration. By the end of November, year-to-date positive total returns had disappeared. With some price recovery in December, the Barclays 7-Year Municipal Bond Index finished 2016 with a total return of -0.50%. So much for annualizing returns before the year is out.
The Granite Springs Intermediate Municipal Strategy had a total return in 2016 of +1.02% on a gross basis (+0.52% after fees). Our generally defensive strategy was particularly helpful in months where the muni market had negative total returns (March, May, September, October, and November).
This quick review of muni bond market total returns is not meant to elevate total return as the prime objective of muni bond investors. In fact, my 30+ years of experience in munis have shown me that most muni bond investors tend to measure their satisfaction by a host of factors including original yields captured, modest volatility, capital preservation, safety, professional execution, and access to bonds as well as total returns. The examination of total returns from period to period is a good way to tell the story of the markets’ journey and to gauge the interim volatility bondholders have experienced.
Given an abrupt change in potential market influencers, markets often react quickly to work their way to a level that seems to reflect the new information. After that initial adjustment period, it is not unusual for markets to walk the previous sharp movement back a bit as things are digested. For muni bonds, some of that “walking back” process occurred in December and has continued into early January. Is there more “walking back” in store for the rest of 2017?
At this point, the negative factors that have beaten up muni bond valuations for the past few months are well known and out on the table: above average supply, large outflows from funds and ETFs, sharply rising Treasury bond yields, and worries about damaging tax reform legislation in 2017. The muni market has already taken, in a sizable way, the slings and arrows from these sources of worry. To the extent any of these factors becomes less troublesome going forward, municipal bonds have the potential to perform in a reasonable fashion in 2017, certainly compared to the negative sentiment that prevailed at the end of bloody November.
Regarding future muni bond supply, analysts’ projections suggest it is likely to be lower than last year’s record level. These projections take into account the upward trend in rates (likely to reduce refunding possibilities) and the higher level of new project financings last year. Regarding demand for munis, the pace of outflows from muni funds and ETFs has begun to slow from the high level of October and November. Muni bond buyers may stop their flight from these vehicles and reverse course after seeing some recovery in their December and January muni bond statements, and after taking a second look at the taxable equivalent yields that municipal bonds are now providing (about 160 basis points higher than the lows of last July). Given the sizable 100 basis point rise in 10-year Treasury bond yields already baked in since last summer, and the Federal Reserve’s often-stated data-dependent caution, future rate rises may proceed at a measured pace. We cannot know of course if these trends will take the benign course I’ve just outlined. We can say, given the messiness that muni bond investors endured in the fourth quarter of last year, that at least there is room for reconsideration of the most severe sentiment and reactions of two months ago.
Political/governmental factors have always been one of the inputs to consider when thinking about future economic growth, inflation, and interest rates. With a new president and congress preparing new policies and legislation, political/governmental factors will be more of a focus than usual for investors. Questions abound. What will the new administration make a priority? Will congress have the same priorities? How much agreement or pushback will congressional Republicans have with a president from their own party? What will the specific legislation that’s passed looked like? How quickly will it take shape and be passed? What will be the impact of these new policies and laws on economic growth and inflation? As the answers to these questions become evident, financial markets will confirm, possibly expand, or walk back the post-election moves of a few months ago.
For munis, as always, the wild card is tax reform. Here a separate set of questions arise. Will tax reform be a priority of the first year of the new administration? Will successful tax reform efforts be more likely on the corporate side, the individual side, or both? On the individual side, will it just be a lowering of tax brackets or will it be more comprehensive to include a limitation on exemptions and deductions? Which exemptions and deductions might be spared? Will there be grandfathering involved? How will the new president’s recently stated support for the municipal bond exemption at the U.S. Conference of Mayors square with congressional efforts at comprehensive tax reform?
If you are exhausted merely by the list of questions outlined in the last two paragraphs, then you have a sense of the sizable uncertainties and difficulties attached to any kind of financial market prognosticating at the current time. These uncertainties don’t have to paralyze investors, but caution and a deliberate pace of investing cash would seem prudent.
Regarding the potentially meaningful effects of tax reform on munis, we simply cannot know now what the actual changes to tax law will be (or if in fact there will be any). If we imagine a severe (but I think unlikely) scenario where the exemption of interest on muni bonds is completely eliminated with no grandfathering, then we can look to the existing taxable municipal bond market to see how formerly tax-exempt muni bonds might behave. Using the existing spreads of +80 to +125 basis points of taxable munis to Treasuries that could apply to formerly tax-exempt muni bonds, we can estimate a decline in value of 2% to 5% on investment grade muni bonds with 7-year maturities. Different maturities might experience different sized declines in values. There are a lot of factors which could affect the size of spreads to Treasuries for taxable munis in the scenario I’ve just described, so it should not be viewed as a water-tight assessment of worst case tax law changes. In fact, if the severe scenario outlined above takes place, it is quite probable the muni bond market would experience heavy, almost indiscriminate, selling pressure. Depending on the severity of the reaction, municipal bonds – even in that new tax environment – could reach a point of representing a value. On the other side of the spectrum, any grandfathering of the current tax-exemption could create a scarcity in traditional tax-exempt bonds and support valuations in a meaningful way.
When the level of uncertainty in financial markets is higher than usual, there is something to be said for resolutely sticking to the task of uncovering value one step at a time. This is one of those times. The prospects for attractive or unattractive total returns will come and go but capturing attractive yields from undervalued bonds should provide benefits to bond portfolios in any scenario. Effective, value-laden bond picking can be done in any interest rate environment. We can never know for sure what kind of markets we will get. We can, through difficult markets, remind ourselves of the benefits of staying in the game and thoughtfully moving through the markets that are given to us.
Tom Dalpiaz manages an intermediate municipal bond strategy at Granite Springs Asset Management. The Intermediate Municipal Bond strategy was launched in September 2009.
Granite Springs Asset Management, LLC is a privately held SEC-registered investment advisor that specializes in fixed income portfolio management and tactical asset allocation investment strategies for private clients, family offices, financial advisors, insurance companies, pension plans, and other institutional investors. Granite Springs Asset Management, LLC is a Registered Investment Advisor with the U.S. Securities and Exchange Commission and qualified to do business in various state jurisdictions where required.
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