Despite 'technical conundrum,' munis may outperform

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The municipal market will outperform Treasuries and continue to be a haven for risk-averse investors, even amid demand shifts linked to tax law changes, according to Jeffrey Lipton, head of municipal research and strategy and fixed income research at Oppenheimer & Co.

“Munis continue to contend with a technical conundrum in that year-to-date volume trails year-over-year issuance activity and demand from certain institutional participants remains muted thanks to new tax law provisions,” he wrote in a weekly municipal report on March 13.

“The one silver lining can be found with anticipated reinvestment needs, as we do not expect to see breakout muni issuance any time soon,” he added.

While issuers seem to be keeping their “powder dry,” Lipton said they could benefit from the window of opportunity for new issuance at the current rates.

“While we recognize the pull-ahead advance refunding deals in December in anticipation of program termination, interest rates are now heading higher and we would think that issuers would want to lock in on the lower end of the new range,” he said.

Lipton said the lower year-to-date new-issue volume is occurring amid a shift in conventional demand patterns. New limits on deductibiity of state taxes has elevated the desirability of in-state paper from high tax states, he said.

“We have seen cheaper ratios, but perhaps there exists an opportunity if convictions calling for supportive technical conditions materialize and munis begin to grow richer relative to U.S. Treasuries,” he said. “If a perfect muni storm emerges that pairs light supply with advancing demand, we would expect relative value ratios to drop from current levels.”

Meanwhile, some of the pressure from supply hangover in the secondary market may be set to alleviate, according to Lipton.

“Dealer inventories, which were inflated going into year-end in anticipation of a pronounced January effect that never happened, are reverting to more normal levels,” he said.

Despite being wary about some post-tax reform consequences, Lipton’s overall outlook on municipals is positive.

We have to remain cautious over future institutional buyer preferences given tax reform’s lower corporate tax rate,” he wrote. “Any appreciable institutional shift to buying corporates along with active retail resistance could undermine our expectations.”

Lipton expects banks and property and casualty insurance companies to factor the more favorable default and recovery rates provided by municipals into their investment calculus.

“Life insurance companies can still be expected to consider tax exempt munis over taxable alternatives when yields become compellingly cheap,” he said.

Overall, Oppenheimer remains optimistic that municipals will outperform U.S. Treasuries for the year and still envisions single-digit positive returns at year-end.

Municipals are a “logical haven when the ‘risk-off’ trade emerges,” he wrote. “Whether or not munis begin to see more normalized technical conditions or perhaps technical characteristics take on a new normal, we can say with confidence that the asset class will remain an important component to a systematic asset allocation strategy.”

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