As the market prepares to ring in 2017, municipal experts predict changes to tax laws, interest rates, inflation, and volume will drive the market in the year ahead.
Tax reform under the Trump presidency will continue to dictate demand in the municipal market in the New Year, since tax cuts can reduce the attractiveness of tax-exempt income, said Jeff MacDonald, director of fixed income strategy and a portfolio manager at Fiduciary Trust Co., in a Nov. 29 interview.
Trump's plan calls for the reduction of the current seven tax brackets down to three, lowering the top marginal rate to 33% from 39%, eliminating the 3.8% Affordable Care Act tax, and capping itemized deductions at $100,000 for individuals and $200,000 for couples.
"The tax exemption will compress to some degree in a lower tax environment and it certainty has implication for muni investors in 2017," MacDonald said.
The potential tax changes could result in a five-basis point drop five point price drop on longer term bonds – even though yields recently corrected and normalized following the November selloff, according to Michael Belsky, senior portfolio management director at Morgan Stanley Wealth Management's Vector Group.
Other concern is that inflation might rise quickly if there is an infrastructure bill passed "without any real way to pay for it," Belsky said.
Longer term, Belsky said, "investors might dip their toe in and commit some funds if they have flexibility or cash."
"If there is no grand tax bargain agreement, we might see a rebound," Belsky said. "Of course, if stocks sell off at a time when current yields are higher, then there might be strong interest in munis."
Jon Mondillo, portfolio manager and head of municipal trading at Alpine Funds, said depending on how and when infrastructure spending is implemented, investors need to remain cautious going into 2017.
Demand could depend on volume, experts like Tim McGregor, director of municipal fixed income at Northern Trust Asset Management in Chicago, said. Supply began to moderate in late 2016 after the big wave of refinancing supply was done at attractive record low yields in the early fall.
"Starting 2017, volume will be down; there are not that many bonds left to refinance given the higher rate environment," McGregor said, noting that $220 billion of the total 2016 volume total will account for refinancing debt. In addition, McGregor expects Trump's potential infrastructure investment plan to reduce some municipal financing and have an impact on state and local governments' future traditional borrowing.
Chris Brigati, head of municipal trading and managing director at Advisors Asset Management, advised investors heading into 2017 to maintain a lower duration bias and look for the best value between 10 to 15 years, maturing from 2026 and 2031, with five to seven-year call protection.
"Those bonds have benefitted from a back-up in rates and have enough yield to justify" participation, according to Brigati. They also provide a cushion in a rising rate environment, he said.
Others are advocating investors to seek out value before future supply tapers off significantly.
Impending bond calls, coupon payments, and redemptions should provide ample opportunity for cash flush investors ahead in 2017, MacDonald said.
"We will have a healthy cycle of maturities in the next few months and they can reinvest in a yield environment that is more favorable than we witnessed in the early part of 2016," MacDonald said.
Michael Pietronico, chief executive officer at Miller Tabak Asset Management, also advocates investing in the coming year.
"We recommend investors add cash to the tax-free market as pundits are oversimplifying how the economy will play out in 2017," Pietronico said in a Dec. 7 interview. "Mr. Trump, the President, is likely to act in a manner quite differently than Mr. Trump, the Republican Presidential candidate," he said. "We anticipate a healthy positive return in municipals next year as the market has gotten too bearish on the potential for greater inflation and growth."
McGregor, meanwhile, said he anticipates being able to diversify his portfolios in the coming year.
"Volatility creates more activity and more opportunity and I see more of the same in 2017," he said. "The muni market will overreact with the best of them and I am sure we will see it again.
"I'm looking for tax-free income flow to be higher and that's the silver lining – being able to reinvest cash at better yields and hope it offsets some of the initial pain," McGregor said.
He advises investors to keep cash levels higher to take advantage of new investment opportunities, keep credit quality high, and tactically add single-A securities.
In 2016, McGregor remained underweight in single A credits and overweight in triple-A and double-A paper, with the assumption that redemptions push spreads wider, creating buying opportunities.
"If we continue to see some outflows in mutual funds the industry will eventually start selling lower credit quality," which will prompt credit spreads to widen in 2017, he said.
McGregor said he will look to add solid, single-A airport revenue bonds, for instance, if they cheapen to a 100 basis point spread to the generic triple-A scale, from 70 basis points currently.
Other fund managers and investors may take a wait and see approach when it comes to reinvesting in the municipal market as the New Year gets underway.
"The tax-exempt market will also take its cue from Treasuries, which, for the time being, remain solidly in bear market territory," Triet Nguyen, head of public finance credit at NewOak Capital, said on Dec. 7. "Although everyone's hanging their hat on the January reinvestment effect, one should keep in mind that investors may decide not to fully reinvest in the muni market as they chase other opportunities that are part of the Trump rally."
Mondillo said he built liquidity and shortened duration for his funds at the start of 2016, and will be well positioned for expected volatility in 2017.
"We could see a little bit of a rebound, as we saw in 2016 in January and February, but overall I think we will see interest rates rise over the course of 2017," Mondillo said.
He described that volatility in terms of many "unknowns" that could impact the market, such as potential fiscal spending enacted, infrastructure, and tax reform policies.
"I would look for yields to back off even further," given that the sell-off was "overdone," and interest rates abroad are ticking up, Mondillo said.
