Muni strategists see a turning point as year-end nears
Municipal investors are looking to turn 2018’s volatility into opportunity heading into in the new year.
“We think the worst is over for bond investors after a difficult 2018," and fourth quarter, 2017, Anthony Valeri, investment strategist at Zions Bancorp, said in a Dec. 3 interview. “Yields may likely peak in 2019, so it makes sense to lock in yields that are 0.75% to 1.0% higher across the board.”
Amid sharply declining volume and other market weakness and volatility, yields on high-quality, long-term tax-exempt bonds increased over 50 basis points since the start of 2018.
The 30-year generic, triple-A general obligation bond yielded 3.10% in 2048 as of Dec. 11, compared to 2.55% on Jan. 2, according to Municipal Market Data.
“The recent market volatility driven by yields moving higher and mutual funds experiencing redemptions has created opportunities to invest at valuations we consider more attractive,” Sheila Amoroso, director of municipal bond department at Franklin Templeton Fixed Income Group, wrote in a Dec. 3 report entitled “The Case for Municipal Bonds in a Rising Rate Environment.”
She said municipals are attractive and 2018’s opportunities should lead to future gains.
Ms. Amoroso said the firm entered 2018 with its portfolios more conservatively positioned, which allowed it to be active and opportunistic during the year’s bouts of volatility.
As interest rate and economic uncertainty persisted, unrelenting outflows from municipal bond mutual funds plagued the market starting in October following the September Federal Reserve Board meeting that signaled the end of its “accommodative” era and the continuation of a rate hike cycle.
A late November stock market rally muted the reaction in the bond market to Federal Reserve Board Chairman Jerome Powell’s suggestion that the Fed may slow expected rate increases from original expectations.
Market uncertainty increased after Powell’s announcement at a Nov. 28 Economic Club of New York meeting indicated that interest rates are nearing the neutral level — the rate that neither stimulates nor restrains economic growth.
His latest announcement followed Powell’s remarks a month earlier stating that the Fed is probably “a long way from neutral,” and was seen as a sign the Fed will tighten less than had been expected.
“As we move into 2019,” Ms. Amoroso said, “we will continue to be opportunistic with an eye toward using periods of volatility to potentially enhance the income profile of our portfolios while maintaining discipline when it comes to issuer selection.”
For some investors, the decision whether to shorten or extend duration, upgrade quality or search for yield, and be defensive or aggressive hinges on rate expectations and economic forecasts. Others are monitoring volume predictions, fund flows, relative value and other changing market technicals to gauge their year-end investment decisions.
The market is factoring in one additional 25 basis point increase to Fed target rate after the Fed’s last meeting Dec. 18 and 19, which would leave the target rate in a range of 2.25% to 2.50%, said Bill Walsh, president of Hennion & Walsh in Parsippany, New Jersey.
Walsh said rising rates are unlikely to affect the interest that bond holders receive on their holdings, and shouldn't hinder investors from receiving par value on their securities at maturity.
He suggested investors should maintain higher levels of credit quality and not sacrifice income levels as they strategize for year end.
“Investors should be careful not to miss out on the income and diversification opportunities offered by bonds by trying to time future, potential changes in interest rates,” Walsh said in an interview.
“We believe that recent dovish comments by Fed Chair Powell, coupled with an expected slowdown in earnings and economic growth in 2019, will slow the original plan for three additional rate hikes in 2019, to perhaps two, or maybe just one, during the first half of the year,” Walsh said. “This slowdown in economic growth and interest rate hikes should be factored in accordingly by investors.”
Howard Mackey of NW Financial in Hoboken, New Jersey, said investors in general are most focused on the direction of rates when strategizing for year end and the coming first quarter.
Those who think the Fed will continue to tighten are using tax loss swaps to lock in rates or invest on the long end, Mackey said in an interview. Others who aren’t sure about the direction of rates are putting money to work on the short end to minimize duration and volatility risk, he added.
“If the strength in the market does tend to persist, it will be most heavily felt in the 10 year range and lower just because of the volatility in that area, and the value of the bonds out further,” Mackey said.
Rate stability, healthy primary volume, and mutual fund outflows have created appealing municipal entry points for fixed income investors in 2018, analysts Matthew Gastall and Monica Guerra of Morgan Stanley Wealththe wrote in a Nov. 27 monthly report.
“Additionally, tight credit spreads and a flatter yield curve have helped tax-loss investors to clean up accounts from both a credit and interest rate perspective,” they wrote.
They encouraged investors to stay ahead of next year’s potential January Effect and advocate using three objectives between now and year-end.
Investors should take advantage of pre-holiday entry points while interest rates are higher and new-issue volume is still healthy, while also completing any residual tax-loss swaps before market liquidity wanes.
In addition, they recommend maintaining a household focus on high-quality, front-end securities, both taxable and tax-exempt.
“Yield levels throughout our target range now reside either at or near five-year highs following this autumn’s fixed income weakness,” they said. “This dynamic was further exacerbated in our market by a string of municipal bond fund outflows and the receipt of this fall’s new-issue supply.”
Others said the massive outflows of 2018 should continue to moderate by year-end and won't interfere with investors’ late year investment strategies.
“While outflows are likely to remain present during the final month of the year, we expect fund flows to finish the year in a net-positive position, which should assist market recovery and performance,” Jeffrey Lipton, head of municipal research and strategy and municipal capital markets at Oppenheimer & Co. Inc., commented in a Dec. 3 weekly municipal report.
Though some uncertainties still exist, the future looks bright for municipal bond investors, according to Valeri of Zions. His forecast calls for increasing duration, or interest rate sensitivity, for most clients, but still remaining slightly defensive relative to the broad market.
“We generally find municipal valuations attractive and an economic slowdown coupled with continued reduced supply as a result of the new tax legislation should limit supply while demand may increase,” Valeri said.
Walsh said an economic slowdown means the economy is likely to grow at a rate closer to 2% rather than its recent 3% to 4% levels.
“A growing economy, coupled with historically low interest rates and inflation levels, should be beneficial for certain areas of the stock and bond markets in 2019,” Walsh said.
Meanwhile, Valeri expects future bond prices to be supported by the eventual end of Fed rate increases, as well as an economic slowdown, lower inflation, and lingering tariff concerns.
He is among those who have little expectation for a recession in the near term.
“If there’s a recession, that ends up boding well for bonds because if inflation is moderate then fixed income instruments will perform well,” Mackey of NW Financial said.
But Mackey doesn’t see any evidence on the horizon.
“The Fed is managing inflation and controlling and preventing the economy from going into a recession,” he said.
Prepping and Positioning
The Morgan Stanley analysts said investors can prep for the so-called January effect, when primary volume often declines while redemption-driven reinvestment demand increases.
“We recommend that household investors leverage the current period of interest rate stability to methodically add some exposure before the holidays, particularly those who have yet to do so already,” Gastall and Guerra wrote.
They advised against overcommitting at current levels due to the still-lingering presence of catalysts that may cause interest rates to rise again.
“Currently tight credit spreads and a flatter yield curve suggest that this period is among the most advantageous in 10 years to increase credit quality and/or shorten final maturities.”
They suggested household investors should favor high-quality securities with short final maturities by focusing on high-quality bonds with above-market coupons and final maturities laddered under 11 years.
While more “nimble, aggressive participants” may consider more risk-taking tactics, Gastall and Guerra said the additional compensation offered for taking both interest rate and credit risk stands near a 10-year low.
The price depreciation for riskier securities may soon occur if interest rates rise or economic growth slows, they said.
“Participants should also maintain the appropriate exposures to cash and look to blend high-quality taxable counterparts throughout the very shortest maturities where yields have risen more throughout the taxable arena — particularly investors in low federal brackets and/or states with below-average income tax rates,” they advised.
As 2019 approaches, investors should not anticipate the return of advance refundings anytime soon, the experts said.
After the structuring vehicle was eliminated in late 2017 as part of the tax reform bill, there has been some talk its return with the new Democrat-controlled House of Representatives in place.
Walsh of Hennion & Walsh said political gridlock surrounding the recent election of a split Congress remains a barrier to the return of advance refundings.
“One area that we do see potential for is around a new infrastructure spending bill which, if passed, could have implications on the supply of municipal debt to help fund the agreed-upon infrastructure projects,” Walsh said.
Even though it would find a lot of market support, Mackey of NW Financial said it is premature to suggest there might be a return of this part of the tax reform package so soon after a new Congress was elected.
Overall, investors can end the year with strategies focused on their investment goals and overcoming headline risk, the experts said.
“While there are many political and economic headwinds confronting investors during the last month of 2018, and likely throughout 2019, muni retail investors would be wise to revisit their longer strategic plan,” Walsh said.
He said they should also ensure that their portfolio is still positioned to keep them on track towards meeting their shorter term objectives and longer term goals, while staying within their own comfort level with risk.
Income investors should focus on principal protection when held to maturity, while growth-oriented investors, seek out downside protection and diversification, especially in a highly volatile market where additional, measured, short-term flights to quality are likely, according to Walsh.
“Growth oriented investors would also be wise to ensure that they have the diversification in place to withstand shorter term bouts of volatility ahead while also looking to take advantage of more attractive valuations and likely areas of growth in 2019,” Walsh said.
Lipton added: "The asset class will likely outperform UST and corporates for this year. Given that there will be no new tax changes and there is likely to be a more consistent flight-to-quality, supportive technicals and perhaps a more dovish Fed, we do believe that munis have the potential to produce stronger returns and to outperform both UST and corporates in 2019. So we do think that munis can earn those modest single digit returns next year," Lipton added.