How the tax law will help munis beat the market
Municipal bonds are attracting investors from high-tax states, in a ripple effect from last year's tax law that fund managers say may help munis outperform other fixed-income securities in the second quarter.
The $1.5 trillion tax cut came with a ban on advance refundings that cut into the supply of municipal bonds in 2018. At the same time it capped state and local tax deductions at $10,000 a year, making the tax exemption more valuable in high-tax states such as California, New York and New Jersey, as evidenced by demand for munis ahead of the April 15 tax deadline.
Ratios of municipal to Treasury yields have dropped to the lowest levels in a decade and may further tighten in the second quarter, based on the demand stemming from the state and local tax deduction cap, said Chris Brigati, managing director and head of municipal trading at Advisors Asset Management.
“The wealthier investors will tend to partake in munis, and anything that can be done to avoid unnecessary payment of taxes they will flock to,” he said.
As of April 4, the 10-year municipal to Treasury ratio was 76.8%, down from 77.3% on March 29 before the start of the second quarter. The 30-year ratio slipped to 92.3%, from 92.4%, according to Municipal Market Data. The 10 and 30-year ratios were as high as 85.1% and 100.7% at the start of the year on Jan. 1, according to Refinitiv Municipal Market Data.
“We are seeing very tight ratios similar to what we saw in and around the financial crisis 10-plus years ago,” Brigati said. “We are already at tight ratios, so it would be tough to significantly outperform Treasuries and taxables as we have in quarter one, but I can see a slight outperformance and we could dip to tighter ratios.”
In spite of the tight ratios, low yields, and overall richness of the yield curve, technical factors such as supply and demand continue to make the case for municipals as a tax-exempt alternative for wealthy investors, municipal experts said.
“The high quality aspect is a traditional draw, as we have seen in quarter one,” and the seasonal demand should continue to push even more investors into the municipal market, Brigati said.
Both solid demand and potentially growing volume in the quarter could act as catalysts in an already favorable climate as individual investors continue to pour money into the market, and as issuers consider taking advantage of lower rates, Brigati said.
Weekly fund flows reported by the Investment Company Institute and Lipper Inc. totaled more than $1 billion from January through March That should leave buyers more opportunistic in the second quarter, Kim Olsan, a senior vice president of municipal trading at FTN Financial wrote in a March 29 daily market commentary.
So far in 2019, ICI’s weekly flow figure has reached or exceeded $2 billion seven times, surpassing the three weeks in all of 2018 with similar flows, Olsan said, citing ICI's figures.
Second quarter volume should increase over quarter one given the low yield climate, analysts said.
“The rally has been a near-straight line path since mid-January, shaving 30 basis points off intermediate and long yields — just at the point flows began to accelerate,” Olsan wrote in the report just before the official start of the second quarter on Monday.
While the 10-year Treasury yield rose from a 2.36% late-March close to the current 2.50%, the comparable 10-year AAA BVAL yield has moved six basis points higher, leaving the municipal to Treasury ratio below 80%, she said in an April 4 report.
Though the rally sparked an inversion of the three-month to 10-year Treasury yield curve, Jeff MacDonald, head of fixed income strategies at Fiduciary Trust Company International, said it was slight and short-lived and he doesn’t expect much impact in quarter two.
An inversion of the two and 10-year Treasury benchmarks — as well as the Fed’s predictions — are better indicators of a potential recession in 2020 or 2021, he said.
“The Fed has done the right thing in the current environment to pause,” MacDonald said. “Inflation is behaved and the economy is doing pretty well — and they are being patient with the monetary policy going forward.”
Brigati said rates should remain on their downward path, buoyed by the supply-demand imbalance in the current quarter.
Market technicals and safe haven
Brigati said the more dovish tone of the Federal Reserve Board should help remove some of the uncertainty over the direction of rates, and give investors a “safe haven” in municipals this quarter.
Meanwhile, supply, fund flows, and credit spreads will be helped by the strong market technicals in the second quarter, according to Olsan.
“Prior to [last] week, the month’s gains would have been an impressive result for a period that is usually challenged to show meaningful positive performance,” Olsan wrote in her Mar. 29 report. “But, an additional five to seven basis points rally pushes quarter one returns in the broad market to nearly 3% — bested only by 2009 and 2014 within the last 10-year period.”
Intermediate yields have rallied nearly 100 basis points from last October based partly on benign supply conditions, Olsan added.
“There was a trend upward in 3Q18 in supply, which brought the 10-year AAA BVAL yield trading to 2.75% on monthly supply that topped $35 billion,” she wrote. “Along with a broad-market rally in 1Q19, average monthly supply of just $23 billion is holding a lower yield range.”
Due to the supply-demand imbalance, Brigati said liquidity has been very strong, as evidenced by the compression of bid-offered spreads in the secondary market with portfolio managers actively seeking bonds due to the influx of cash in their portfolios.
“When you have heavy demand in quarter one and continued expectations of that going forward, I expect liquidity will be quite robust,” he said.
For investors with new money to put to work, the environment will be challenging with a lot of dollars chasing few bonds, MacDonald said.
He said the absence of advance refundings is making the supply shortage even worse, as the market is more reliant than ever on new issues.
“The technical mismatch in investor demand and dealer supply is a dislocation that continues,” MacDonald said.
Chasing yield and changing dynamics
MacDonals said 2019 has been the best start to a year in terms of municipal inflows since 1992.
With low yields and low supply, MacDonald expects investors to extend on the curve to search for better returns and higher ratios, as well as dip in quality.
“Rates have moved down and yield is tougher to find, so investors will continue to move out on the curve to capture what yield they can,” he added.
Brigati suggested investors be cautious and upgrade their credit quality while spreads are narrow in order to “weather the storm” and prepare for any unforeseen market volatility. In a rising rate environment, he said, lower-rated credits underperform the most.
“It’s a good time to take some value off the table with lower-rated credits that had spreads narrow and rally, so [investors] can minimize potential future downside risk,” Brigati said.
While he says the entire municipal yield curve is rich, Brigati is biased to the belly of the curve between seven and 15 years, because that is where he finds the most value and best risk to reward potential for investors.
He said bonds with maturities under seven years are more expensive than those in the intermediate range. However, investors that lock in rates on the long end could risk underperformance if and when yields rise unexpectedly, Brigati said.
“That being said, moving out on the curve between seven and 15 years balances out the absolute richness on the front end versus the long end and provides a little ballast for portfolios,” Brigati said.
“Any incremental pickup in yield above triple-As removes some of the sting of 1.50% to 1.60% yields,” Olsan of FTN wrote in her March 29 report.
A trade of Michigan State Grant Anticipation 5% coupon bonds due in 2024 illustrates the compression in recent months, she said. The bonds are rated A1 by Moody’s Investors Service and AA-minus by Standard & Poor’s, and currently trading at 1.70% -- a spread of 13 basis points above the generic triple-A scale.
That compares with a December 2018 trade at 2.24%, or 18 basis points higher in yield than the triple-A benchmark scale, as well as an October trade at 2.45%, which was 17 basis points over the triple-A scale, according to Olsan.
In the second quarter, municipals should follow the general downward pressure being led by the Treasury market following the Fed’s recent decision to pause rates hikes for the remainder of 2019, Brigati said.
“We have seen a real change in the dynamic and are seeing a strong rally” he said in late March.
Overall, demand remains strong in spite of the latest rally, the managers said.
Wealthy investors either facing large tax bills this April as a result of the SALT deductions or generally in need of a tax-free shelter for their assets will gravitate to the municipal sector.
“When they are looking at alternative investments, the municipal market looks like a relatively attractive way [to shelter their assets] within the fixed income sector,” Brigati said. “Buy dips if rates rise and prices go down -- it may be a short-lived, brief occurrence in quarter two. Take that opportunity to buy at cheaper prices than had been available previously.”
MacDonald suggests investors remain invested, yet be sensitive to the flatness of the yield curve and be cautious when it comes to extension risk.
If the yield compensation is not enough to justify going out longer on the curve, skip it, MacDonald said.
For instance, he said a recent example in the secondary market delivered 32 basis points in extra yield between a 10-year bond that recently yielded 1.92% versus a five-year bond that yielded 1.60%.
“You’re not being compensated to put on five additional years” in the current market climate, he said.