Investors should seize the opportunity to reinvest December redemptions or use available cash to stock up on municipal bonds as the prospect of changes in the tax law drives issuance in the final weeks of 2017, strategists said.
Though munis rallied Thursday and Friday following a report that House Ways and Means Committee Chairman Kevin Brady said he might agree to preserve private activity bonds in upcoming negotiations over a final tax bill with the Senate, the market is still suffering from anxiety, they said.
“The tax reform issue is front and center for the market’s focus,” said Jeff MacDonald, head of fixed income at Fiduciary Trust Company International in New York City.
“There are some competing influences here in terms of how the muni market is likely to trade -- some creating a favorable technical and others creating more a negative technical,” MacDonald said.
“We are still dealing in maybes regarding proposed tax bills at the federal level,” added John Donaldson, vice president and director of fixed income at The Haverford Trust Company.
Top-rated municipals were stronger to close out Friday after Brady’s comments, as the yield on the 10-year benchmark muni general obligation was eight basis points lower to 2.07% from 2.15% on Thursday, while the 30-year GO yield was down 11 basis points to 2.68% from 2.79%, according to a final read of Municipal Market Data’s triple-A scale.
Even after the market’s two-day rally, experts highlighted the advantages of the current seasonal buying opportunity.
“There is a lot of money out there in our economy, and a lot of money posturing for this calendar,” Jason Ware, managing director and head trader at 280 Securities, said in an interview on Tuesday. “In these coming weeks, if you are a muni investor this is the right time to get in there and put some of that money to work with this influx of supply and yields.”
He encouraged investors with cash on the sidelines to make the most of the next four weeks given the volume, variety, and availability of bonds coming at higher yields in the last month of the year.
“Over the past couple of weeks munis have sold off 20 basis points in the face of this incoming supply and I think they still have room to go,” Ware said.
Analysts said upcoming new deals have the potential to come as much as 30 basis points cheaper than where an investor could have bought the same bonds three weeks earlier.
Municipal issuers have started crowding into the new issue market ahead of the potential elimination of advance refunding bonds and the House proposal to make private activity bonds ineligible to tax-exempt issuers.
This week may well set a record for issuance with $17.4 billion on the calendar.
The San Jose Redevelopment Agency Successor is expected to hit the market with $1.7 billion of senior taxable allocation refunding and subordinate tax-exempt allocation refunding bonds on Wednesday in the largest deal of the week. The County of Miami-Dade is scheduled to bring $959 million of water and sewer system revenue and refunding bonds, Trinity Health is expected to come with $889 million of revenue and refunding bonds, New York City is slated to bring $850 million of general obligation bonds and the Illinois Finance Authority is expected to come with $687 million of revenue bonds.
Advance refundings and PABs together accounted for 40% of total gross issuance over the past three years, according to a Nov. 27 weekly municipal report by Peter Block, managing director of research at Ramirez & Co.
He said as much as $60 billion of additional supply is predicted to come to market by year end, which could increase 2017’s year-to-date total of $339 billion to $397 billion.
New issue volume swelled to 84.5% above average in the week of Nov. 27 when an estimated $14.1 billion of issuance arrived, according to Block’s report.
November municipal bond volume was the third biggest this year, up 10.6% from the same month in 2016. Data from Thomson Reuters shows monthly volume rose to $36.79 billion in 971 transactions from $33.27 billion in 1,070 deals in November 2016.
Block said the heavy supply may cause tax-exempt bonds to cheapen further and continue to underperform Treasuries in December.
In addition, the scarcity of tax-exempt bonds in 2018 is on the minds of investors heading into year end, Block said.
“Because of these factors and a probable uptick in bid-wanteds to fund new issues, we expect most new deals to be well placed -- albeit at higher spreads,” he said.
The supply bonanza puts more urgency on reinvesting December maturities and calls due to the likely reduction in supply expected in 2018, according to Donaldson.
“Available supply and reasonable pricing are a rare combination for this time of year,” he said in a Nov. 21 interview.
Investors should take advantage of the buying opportunities on bonds that need to find a home “at a time of the year when its quieter and market participants maybe aren’t as focused,” MacDonald said in a Nov. 22 interview.
“That opportunity may go away after the first of the year if some of these issuers are shut out of the market,” he added. “When you look past this influx, you will see a contraction of muni supply, and you will have a potential for yields to go down,” he said. “It could be a real game changer in terms of the structure of the muni market."
Rare Abundant Value
Donaldson said smaller deals priced at $5 million to $15 million are getting overshadowed amid the current heavy supply calendar.
“We have seen solid, high-quality, double-A issues priced with at least 10-to-15 basis points more yield than they should,” Donaldson said.
“We have tried to be very selective in purchasing bonds recognizing spreads are very tight and the curve is flat,” MacDonald said. Fiduciary, the private wealth division of Franklin Templeton Investments, oversees approximately $6 billion in fixed income assets – mostly municipal assets.
MacDonald is trying to uncover yield opportunities and keep his clients’ portfolios defensively positioned by using structure to capture yield as opposed to taking on extra interest rate risk. He has accomplished this, for example, with callable securities and housing bonds that trade to an average life, rather than extending with longer duration bonds.
“Even though the curve has flattened and performed well, and funds have been coming into the sector, we’re still not in favor of that really long-end of the curve,” MacDonald said.
“We think if yields do start to back up in the longer maturity bonds investors who have put on a lot of interest-rate risk could be vulnerable if longer maturity yields drift higher in 2018,” he said.
MacDonald said he has under-weighted GOs in his holdings based on some of the budgetary pressures and pension challenges in many states.
Ware, meanwhile, recommends investors stick with higher-quality bonds due to the tight credit spreads to the high yield sector, as well as potential credit deterioration on lower quality bonds in a tax reform scenario.
“If they have to issue taxable debt, I can see their total interest costs over time going up if they can no longer issuer tax- exempt debt,” Ware said. “There is a potential for further credit erosion on those lower-rated entities that don’t have solid balance sheets.”
He yield spreads between the 10 and 30-year munis have tightened, and recommended investors us a "laddered" portfolio in a maturity range that fits their investment goals, as that structure provides investors with principal payments coming due that can be reinvested at higher rates if yields rise.
Opportunities vs. Concerns
Other strategists agreed that municipal investors should take advantage of what could be the last issuance of advance refunding bonds and PABs, as those securities may no longer exist in 2018 -- if the House tax reform proposal takes effect.
“It's the last round up for advance refundings,” said John Mousseau, managing director of municipals at Cumberland Advisors.
With issuers continuing to market deals originally slated for 2018, investors should expect the unusually heavy supply flurry to continue, offering unique opportunities, such as higher yields – especially on the short end – and potentially wider spreads in the high-quality sector, Mousseau and Ware said.
The yield curve has flattened from a month ago, according to Ware of 280 Securities.
“It looks like value is creeping back into the front end of the curve,” he said, noting that the short end is yielding between 80% and 90% of the comparable Treasury curve, compared with 70% four weeks ago. “That relationship could continue, with less value on the long end and more value on the front end,” he said.
“Something’s gotta give and that's yields,” Mousseau said. “Issuers can't afford not to do it. Otherwise they're rolling the dice with a current refunding.”
Ware said these issuers “need to be prudent for managing billions of dollars of outstanding bonds and need a plan."
Advance refundings bring down issuers’ total interest cost, so they will want to do as much of that as possible now."
As a result, some predicted business will be uncharacteristically brisk in the municipal market this month.
“Year-end is usually a more quiet time in the municipal market because of the holidays and people being out of the market, but it could be a much busier December with issuers that are in those affected sectors trying to come to market before the end of the year,” MacDonald said.
“We are seeing potential for significantly more new-issue supply than is typical for the calendar year.”
New Year, New Landscape?
As 2017 winds down, the market is waiting to see how tax reform proposals will ultimately play out, municipal experts said.
On one hand, MacDonald said lower taxes may reduce the demand for tax-exempt income. On the other hand, a larger segment of issuers might be shut out of the tax-exempt market – which may overshadow demand pressures.
“Certain issuers no longer being able to access the tax-exempt market has implications moving into 2018,” MacDonald said. “We are going to have a faster shrinking municipal market than we have ever experienced over the last couple of years.”
The vulnerable issuers, including airports that issue PABs, represent at least a third of the municipal market. “We think that creates challenges for those issuers that are left out,” he said, while potentially improving the borrowing environment for those [issuers] that get left in.”
Still, decreasing demand is a chief concern that could have a long-term impact on the municipal market, including making the taxable market potentially more appealing to higher tax paying individuals, MacDonald pointed out.
“That’s a potential theme that could develop over 2018 if the supply is choked and we get supply and ratios that continue to compress and come under pressure relative to Treasuries,” he said.
Meanwhile, the potential impact of the loss of deductibility of state and local taxes is the number one priority as Donaldson prepares his investors for 2018.
“We want to ensure that we meet any changing client objectives regarding tax efficiency, particularly for clients domiciled in high tax states,” he said. “We believe that a loss of deductibility will make income that remains exempt from state and local taxes even more valuable.”
Others said the municipal market will grapple more with the loss of supply.
“A number of folks maybe will have a lower tax bracket, and that takes away a little bit of the demand for tax exempt income,” though the lack of new issue supply in 2018 will far overshadow that phenomenon, MacDonald said.
He said the supply before year end won’t eliminate the pressures.
“We may get some opportunities between now and year end as some of that supply gets front run," he said. "But we are going to be challenged in 2018 in terms of finding good after-tax income for clients.”