Investors May Benefit as Muni Issuers Turn to Taxable Markets

Despite strong (and growing) investor appetite for municipal bonds, the size of this market has remained static at roughly $3.8 trillion since the financial crisis – in marked contrast with the more rapid expansion of the U.S. Treasury and corporate bond markets (see chart). Supply-side dynamics are the main culprit in the limited growth: Since 2009, issuers have faced a backdrop of 1) rising pension costs and other post-employment benefits (OPEB) liabilities, which have crowded out municipal discretionary spending; 2) limited direct federal investment in U.S. infrastructure, which has restricted new-money issuance; and 3) an inability to advance-refund debt in the tax-exempt market after the Tax Cuts and Jobs Act of 2017.

As a result, issuers are increasingly refinancing tax-exempt munis in the taxable market, leading to less tax-exempt supply. But we see advantages to actively investing in both tax-exempt and taxable munis.

Muni issuance has remained flat compared to other segments of the U.S. fixed income marketImage Pop Up

Why are issuers drawn to taxable debt?

With tight credit spreads and absolute yields near all-time lows, the taxable markets are appealing to issuers for a number of reasons, including the historically low cost of capital, investor base diversification, and the ability to use taxable bond proceeds for non-tax-exempt purposes – including advance refunding. In an advance refunding, an issuer calls a bond that has a call date 90 days or more in the future, often with the goal of lowering the cost of capital by defeasing (exchanging) higher-cost debt with lower-cost issuance. Given current absolute yields, issuers have been able to call tax-exempt debt issued five to 10 years ago, when U.S. Treasury yields were 100 or more basis points higher than they are today, with taxable debt. Taxable refunding issuance this year totals more than $30 billion to date (through November) and is on pace to exceed $45 billion by year-end.

Absent a sharp increase in interest rates or a change in tax policy that once again allows for tax-exempt advance refundings, we expect issuers to continue to defease tax-exempt issues with taxable debt.