Muni Midyear Outlook 2019: Three Key Takeaways
The municipal bond market enjoyed a strong first half, with robust returns and a record $52.9 billion of inflows through the end of July, according to Lipper. Tight supply and increased demand arising from the cap on state and local tax (SALT) deductions have been key drivers of performance and flows, and the upcoming 2020 presidential election has raised prospects for higher taxes given many candidates’ progressive agendas, contributing to demand for tax-efficient investments such as munis.
Here we share three key investor takeaways from our 2019 muni midyear outlook to consider for the second half:
1) Muni valuations remain attractive despite some richening. While yields have fallen in recent months, we remain constructive on munis and think valuations still look attractive on an after-tax basis relative to corporate bonds and other credit markets. Given the broadly accommodative environment since the financial crisis and the Fed’s pivot to a more dovish policy stance, we see the potential for excesses in corporate credit valuations and an environment that could give rise to liquidity concerns if sentiment shifts. Lower rate expectations underpin a broadly supportive macroeconomic backdrop for munis.
2) To tap opportunities in the second half, an informed active approach is key. We’re seeing structural opportunities arising from steep muni yield curves and market mispricing of callable bonds, along with growth in private placements and unrated issues. Active credit selection and avoidance of economically sensitive assets, as well as the potential to exploit market confusion related to “special revenue” bonds, also present opportunities. While investing in these areas may be challenging for individual investors, they can be tapped by managers who meet the qualified investment buyer (QIB) standard (often required for private placements) and with the analytics capabilities to price call options and seek attractive bonds across the curve. A rigorous credit approach is crucial to discern attractive investments from potential pitfalls.
3) Tight supply is a performance tailwind, but rising unfunded pension liabilities bear watching. Net muni supply remains negative (see Figure 1) as issuance continues to lag bond maturities and calls, and with no major infrastructure plan on the horizon, new issuance will likely remain constrained. Factors including the Tax Cuts and Jobs Act’s elimination of advance refundings, which had represented roughly 20% of annual muni issuance, have contributed to recent tightening. However, budgetary pressure from growth in unfunded pension liabilities has also been a key factor constraining supply. The wide dispersion in pension concerns across the country highlights the need for a thoughtful framework for assessing appropriate credit risk premiums.