The final days of 2017 find municipal bond investors looking back on a year of unprecedented volatility, mostly driven by political change in President Trump's first year in office.
It was a year marked by price fluctuations, yield curve flattening, spread compression, credit quality concerns, supply and demand imbalances, and most of all, political wrangling over tax reform, strategists and fund managers said.
“The political backdrop provided an overriding influence for the municipal bond market in 2017,” said Jeffrey Lipton, head of municipal research and strategy at Oppenheimer & Co. “Its reach was broad and touched so many aspects of the market, from future tax efficiency and supply and demand dynamics to funding critically needed infrastructure and reassessing the relationship between the Federal government and the 50 states.”
As it turned out, the $1.5 trillion tax bill preserved tax-exempt private activity bonds and governmental use bonds that are issued to finance professional sports stadiums, but eliminated tax-exempt advance refunding bonds and tax credit bonds issued after Dec. 31. President Trump signed the bill Friday morning before leaving for his Christmas break in Florida.
“Tax-reform is a game changer and has catalyzed a rush to market in November and especially in December with advance refundings, and, to a lesser extent, private activity bonds ahead of the December 31 2017 termination date,” Lipton said. “Much of this supply -- $40 billion to $50 billion -- represents pull-aheads from anticipated early 2018 volume.”
The municipal market saw $364.60 billion of long-term municipal issuance in 10,252 deals between January and Nov. 30, according to Thomson Reuters. That was down from $430.83 billion over the same period in 2016.
December volume then soared to almost $58 billion -- breaking the record for the month of $54.7 billion of issuance set in December 1985 -- as issuers rushed to complete advance refundings and private-activity bonds by year-end, on concern that both would be banned under the tax overhaul.
“Two thousand and seventeen was a difficult year for municipal bond investors – both retail and institutional – because of low rates and a supply shortage,” said Rick Calhoun, first vice president of sales and trading at Crews & Associates, Inc..
“It was even more difficult for investors in high-tax and thinly-traded specialty states,” Calhoun said.
Meanwhile, on heavy demand and low supply for municipal product, benchmark triple-A general obligation yields dropped to 2.12% in 10 years and 2.70% in 30 years as of Dec. 21, 2017, after starting the year out at 2.32% and 3.05%, respectively, back on Jan. 3, according to Municipal Market Data.
“Supply continues to be wild and woolly,” said John R. Mousseau, director of fixed income at Cumberland Advisors. This year’s seasonal patterns have reversed from the typical scarcity between late December and early January, because of the rush to close refunding deals, he said.
Mousseau predicted many issuers planning PABs financings will now “pull deals and wait for a more orderly market next year” after hoping to expedite those deals to the end of 2017 when PABs were in previously in jeopardy.
Lipton said the impact of tax reform transitioned from little change expected for the municipal market to potentially major market-moving consequences.
“Both retail and institutional portfolios have spent much of the year re-evaluating portfolio strategy,” Lipton said. Those accounts anticipated lower individual and corporate taxes, changes to state and local tax deductibility, as well as possible shifts in credit diversification and sector exposures given the expected repeal of tax-exempt advance refundings and private activity bonds, he noted.
While law-makers spent months hammering out the largest overhaul of the U.S. tax code in three decades, investors were kept busy adjusting their strategies to adapt to market changes and volatility, Crews agreed.
“We saw more investors reaching for yield by either pushing out longer on the curve or considering lower quality bonds,” he said. “We also saw some money managers and individual investors sell shorter maturities and buy back longer maturities in anticipation that the Federal Reserve will continue to raise short rates.”
“I think that some of the most impactful events for the municipal market this year have come at the tail-end, including, the worsening situation in Puerto Rico and the tax reform legislation,” said David Tawil, president of Maglan Capital. “And, since those matters are unresolved, they will continue to play large parts in 2018 municipal bond investing strategy.”
Tom Doe, president of Municipal Market Analytics, said a significant change this year has been the challenge for investors to obtain product in order to execute portfolio strategies.
“Amid fee compression there is a greater difficulty to display distinctive performance,” he said. “Performance may have less importance to garnering assets than in the past. This is best reflected in the ability of the betterment platform to quickly amass assets to invest in municipal exchange-traded funds.”
Credit risk was certainly a concerning factor for many investors facing this year’s volatility, and challenges such as pension funding.
“The imbalance of supply and demand for much of 2017 obfuscated the credit risks to bond holders where less protection was provided in offering documents,” Doe said. “More risk is building as weaker credits gained greater access to capital and bond holders accepted less protection.
“The local general obligation risk also edged to a greater concern, especially as the predominance of the sector has been held by a market segment with fewer resources to discern the subtlety and nuance of the risk,” Doe continued.
Although many municipalities have seen healthy local economies help their balance-sheets this year, there are still many large cities -- Chicago, Hartford, and Dallas – and states -- New Jersey, Illinois, and Connecticut -- that have massive leverage problems and desperately need pension reform, Tawil of Maglan said.
Technology was another area of change for the municipal market and its investors in 2017, participants said.
“The increase in internet-based trading seems to have pushed bond prices higher as more individuals are attracted by the convenience of online trading,” Calhoun of Crews said.
“While Amazon and Walmart strive to reduce prices in order to increase demand for their goods," he said, "municipal bond platforms have increased demand and driven bond prices even higher.”
