Tax reform iced, then heated issuance in final two months

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Long-term issuance in the municipal market virtually matched its record high set in 2016, against the backdrop of tax reform that produced an end-of-year flood of volume, but the outlook for 2018 is less rosy.

The rush to market in November and December resulted in a total of $447.13 billion of issuance in 11,983 transactions – coming so close to the record of $451.64 in 13,550 deals witnessed in 2016. The $45.03 billion and $69.44 billion in November and December respectively were easily the biggest months of the year, with December being the largest month of issuance in the muni market's history – breaking the record set the last time there was comprehensive tax reform.

There were whispers that the tax exemption could be in the Treasury’s crosshairs as it looked to cut the deficit but that was ultimately left untouched. Then in November, details of a new tax bill became public and among the changes proposed were the elimination of tax-exempt private activity bonds, which were ultimately spared, and advance refundings, which were not.

When all was said and done, the market saw $154.29 billion of issuance in the fourth quarter.

“The muni market was caught off guard but it rallied quickly and persevered,” said Dawn Mangerson, senior portfolio manager at McDonnell Investment Management.

Mikhail Foux, director of research at Barclays Capital, said December's "rush to issue, was the highlight of 2018.”

“Initially most investors believed that there would be only a marginal increase in issuance as new advance refundings and PAB rules came out of nowhere, surprising everyone," said Foux. "However, given how much supply was placed in such a short period of time, it has become clear that the muni market has become much more efficient than before.”

Foux also added not only the market has become more efficient, but also much more resilient; as record-breaking supply was absorbed by muni investors without any major hiccups.

Jim Grabovac, senior portfolio manager at McDonnell, said "the municipal market, because of its unique characteristics, can be subject to large swings in investor demand."

"For much of the past several years, the market has been characterized by a surfeit of demand and insufficient issuance to accommodate the potential investor base," Grabovac said. "We expect this legislation will further exacerbate this trend by immediately reducing supply and perhaps only marginally impacting demand from investors subject to the 21% corporate rate; particularly if the supply of corporate issuance is ultimately impacted."

PABs will be left alone for now but there already has been talk of the possibility of some change with them, perhaps most likely taking away stadium bonds.

“We believe that PABs most likely are safe for the time being until policymakers get back to redoing the tax code, which will take a while,” said Foux. “Moreover, we think that the odds are higher for the PAB program to be expanded as part of a new infrastructure package, than to be curtailed or terminated.”

The loss of advance refundings, however, will be felt across the market.

“The loss of the option to advance refund will reduce the financial flexibility for state and local issuers, increase their cost of capital and likely result in a substantial reduction of issuance going forward,” said Grabovac. “Tax-exempt issuance for advance refunding has been a significant source of new issue supply, generally ranging between 15% to 25% of total new issue volume in recent years.”

Grabovac continued to say that the municipal market may also experience some shift in demand from bank and insurance company portfolios as buyers target longer-maturity spread sectors of the market offering more attractive ratios versus taxable alternatives.

There was a decline in refundings for the year, which were down 16.2% to 151.42 billion in 3,847 transactions. That compares with $180.73 billion in 5,631 transactions in 2016. New-money deals were up to $206.54 billion in 7,064 deals compared with $176.59 billion in 6,692 deals.

Taxable bonds were up 26.3% for the year to $38.92 billion in 1,151 transactions compared with $30.81 billion over 1,153 deals. Private placements rose 37.6% to $38.57 billion from $28.04 billion. Long-term variable rate with no puts increased 76.3% to $8.90 billion from $5.05 billion and variable rate with short puts gained 13.1% to $14.84 billion from $13.13 billion.

“Taxable issuance increased to the highest level in the post-BAB era,” said Foux. “We expect taxable muni supply to continue increasing going forward.”

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