Volatility whipsawed the municipal bond market in 2016 as the election of Donald Trump was followed by a swift and severe sell-off in the fourth quarter.
"If you're a muni bond investor in 2016, the first 10 months of the year felt like New Year's and the last month felt like the hangover the morning after," said Jon Mondillo, portfolio manager and head of municipal trading at Alpine Funds.
Inflows into municipal bond mutual funds drove the market for most of the year, against a backdrop of the expectation of rising interest rates, Puerto Rico's fiscal debacle, and isolated credit concerns in the Midwest. Then came a historic sell-off prompted by Trump's victory.
"The last month it's been a nightmare for municipal bond investors – especially for those who invested outside of a three-year duration," Mondillo said in a Dec. 14 interview.
Since Nov. 8, municipal returns have been in the red. Concern over rising interest rates and uncertainty over tax policy led to spikes in municipal yields, including a 22 basis point jump on Nov. 14 and a 10 basis points surge on Nov. 30. At the same time, ratios of triple-A municipals to Treasuries soared above 100% from 10 through 30 years, according to Municipal Market Data.
Tim McGregor, director of municipal fixed income at Northern Trust Asset Management in Chicago, called the sell-off in municipals "violent," but said it created an opportunity in November "when things got oversold."
"Municipals sold off more than Treasuries, which is very rare for them to underperform – they usually outperform in a rising rate environment," McGregor said in a Dec 13 interview.
"It was similar to the Meredith Whitney sell-off, bigger than Taper Tantrum in 2013, but not as bad as the 2008 market volatility and deleveraging," McGregor said. He referred to earlier slumps when banking analyst Whitney raised credit concerns about municipals, when investors worried the Federal Reserve would taper its bond buying program, and during the financial crisis.
McGregor manages $30 billion in active municipals, including separately managed accounts, and $6 billion in mutual funds, as well as additional institutional accounts and custom individual high net worth accounts.
Municipals were flat and total returns were zero heading into year-end on the heels of the massive back up, McGregor said.
"The market built steady returns through November, and that washed away the gains," he said. "It's going to be an overall year that's unchanged from a total return standpoint."
Other fund managers said volatility drove the global and domestic financial markets, including municipals in 2016.
"We started off the year with quite a bit of volatility in risk markets and a global slow down; rates around the world became compressed and investors were encouraged to reach for yield probably in the first two-thirds of 2016," Jeff MacDonald, director of fixed income strategy and a portfolio manager at Fiduciary Trust Co., said in a Nov. 29 interview.
"Early in the year, Puerto Rico and the challenges of what was happening in the economy, politics, and the commonwealth were getting play," though it had little impact on the overall municipal market.
In the municipal market at large, longer-maturity bonds outperformed as the yield curve flattened amid muted expectations for economic growth ahead of the presidential election, MacDonald said.
"The outlook for interest rates was lower for longer and in a market place where investors were starved for yield and emboldened to extend both in terms of maturity and going down in credit quality to capture more incremental yield," MacDonald said.
His firm opted to buck that trend, however, and advised the high net worth, families, institutions, and foundation clients of the investment and wealth management firm to avoid reaching for yield and instead keep interest rate risk low, MacDonald said.
"We encouraged investors to stay disciplined and we feel our investors will be rewarded for that discipline because they saw less negative price movement," he said.
MacDonald said the election was a "game changer."
"Before the election, when the market was discounting Clinton winning and being a Republican-controlled Legislature, we still did see the yield curve begin to steepen a bit," MacDonald said. "The third quarter started to see some consistent signs of pricing pressure and inflation moving higher," albeit slowly.
While the Clinton platform had some fiscal stimulus via infrastructure projects and stable-to-tighter regulation and higher taxes, the Trump win changed the interest rate and economic outlook, and had a significant impact on the market, including a 50 basis-point rise in the 10-year Treasury yield, MacDonald said.
The municipal market was shocked after many predicted a Hillary Clinton win that would bring stability to the municipal market and the overall financial markets, Chris Brigati, head of municipal trading and managing director at brokerage and advisory firm Advisors Asset Management wrote in a Nov. 28 interview.
"With Trump as the outcome, we have seen a great deal of volatility," he said. Aside from infrastructure investment and boosting the economy, he said, the president-elect lacks a strongly articulated plan.
Muni yields, which move inversely to price, surged on concern that Donald Trump's victory in the presidential race and Republican control of the House and Senate would open the way to tax reforms that dissipate the value of – or eliminate – the bonds' tax exemption.
The S&P Municipal Bond Index finished down 3.46% in November, the worst monthly total return since September 2008, according to S&P Dow Jones Indices.
"There was a lack of understanding and then the volatility of the election led to somewhat of a different market dynamic – therefore the sell-off in rates and absolute rates in terms of ratios of munis to Treasuries," Brigati said.
As of Dec. 31, 2015, AAM managed about $800 million in total separately-managed accounts, of which $160 million, or roughly 20%, consisted of municipal assets, according to data from the firm.
"Even though municipal yields have risen sharply, interest rates are still in historically low ranges," Dorothy Thomas, senior vice president and director of tax-exempt fixed income for Regions Investment Management, said in early December as the market was correcting after the sell-off. "We expect rate increases to resume if the economy continues to improve, and investors raise their inflation expectations."
Concern over fiscal and tax policy drove the volatility, others said.
"Bonds took it on the chin in general because of perceived fiscal spending, and possible inflation, as well as tax cut implications," John Mousseau, director of fixed income at Cumberland Advisors told The Bond Buyer in a Dec. 7 interview.
Aside from the election, Brigati and others pointed to the 54-week flood of inflows into municipal mutual funds among the significant drivers of the muni market this year.
The high-grade market saw a robust amount of that demand, especially from overseas investors in Japan and Germany, for instance, who were seeking yields higher than the low absolute rates in their own countries, Brigati said.
"The relative safety of the higher-grade market is something they enjoyed," he said.
Fiduciary, the private client unit of Franklin Templeton, participated in the high-grade muni sector in 2016 as it was more attractive than the investment-grade corporate bond sector than the prior year, according to MacDonald.
He said the firm remained overweight in high-quality revenue bonds backed by sewers, toll roads, water systems, and transportation systems in 2016 and expects to keep that exposure in 2017.
He said in the last 12 months, the firm "almost exclusively avoided the long end of the yield curve" and had very little to no exposure 10 years and beyond.
Post-Trump victory, MacDonald said he is not yet ready to shift into an overweight position in interest rate risk, but rather remain underweight in the belly of the curve between three and five years, which is a favorable position in a steepening yield curve environment.
Others suggest the final days of the year are the time for positioning portfolios with a cautious and prudent approach to credit selection.
Brigati of AAM said investors who want to harvest tax swaps as a result of losses in their portfolios by offsetting them with gains elsewhere should do it before Dec. 31.
"They should participate early when there is ample liquidity in the market," he advised. "Getting the benefits of a tax loss swap should be done sooner rather than later."
It is also a good time for investors holding long duration bonds to sell and reap rewards, since Brigati said "their losses could become more pronounced should they wait."
The post-election impact was noticeable in the municipal market and beyond – and will continue to dictate the markets going forward, the fund managers said.
"Lower taxes, a wider deficit platform, a larger infrastructure spending platform, an inflationary platform – changed expectations for interest rates," MacDonald said. "All those – should they be implemented – are suggestive of higher inflation and higher interest rates in the future.
"The back end of the yield curve tends to be more sensitive to inflationary expectations," he said. "If those are growing faster than the Fed is intending to raise rates, you could see a steeper yield curve."
