Given the enormity of the tax reform law, we appreciate that the coming year will be one of the most different in a long time. Here’s how the imminent New Year’s developments may create some opportunities.
Flatter is Better? There is little doubt that the yield curve will keep moving towards a flatter configuration if the Fed has anything to do with the picture. In the old days, we used to yearn for a flatter curve so that advance refundings would be more in the money. Negative arbitrage would be conquered. Alas, advance refundings are no more, and more creativity will be required in addition to the workhorse of current refundings in order to find savings for Issuers. We are heartened by the fact that a rise in shorter rates tends to attract more retail interest. Retail needs a place to put all of the gains that have been secured over the past year. What better place to put some of the upside into reliable municipals.
On the institutional side, participants will be bidding up the market in an environment of lower supply. The rollover in January will probably portend what will happen for the rest of the year and at key maturity times. The secondary market also stands to be bid up. Older seasoned positions will be prime candidates to be traded to keep performance up when supply is on the wane.
We don’t see a rationale for an inverted yield curve at this time. Nor do we yearn for same. The supply outlook can be very challenged by such a development, even though long rates would be below short rates.
We must remain diligent about credit concerns. The expansion has persisted over nine years, but the feeling is that some credits should be experiencing more robust revenue growth than what is being realized.
Budgets also remain quite tight. One only has to think of Connecticut and New Jersey as examples. On the other end of the credit spectrum, high yield has been sought after with continuous fretting about high yield supply. We do not believe that these concerns will ebb in the near term. With no recession being seriously contemplated at this time, the trade out of high yield is postponed for a time to come.
We would encourage sound use of private activity bonds while we still have use of them. The fact that Tax Reform has already contributed to discussion of finding savings elsewhere in the federal budget augurs more potential attention to making changes to municipals in the future. The recent process continues to demonstrate that municipals can be viewed as “easy pickings” for savings in federal budget deliberations. Medicare, Medicaid and Social Security are much more difficult entitlements to reduce without major consequences. That means that all other categories except for Defense and Homeland Security (Anti-Terrorism) remain vulnerable.
Diminished supply will have many implications for the municipal market. Estimates of 2018 volume have ranged from $275 billion to $400 billion. We are in the camp that supply will probably be in the low $300 B range. After the last tax reform, supply in the subsequent year came in at about half. Circumstances are different now, so there is a better than even chance new money supply will grow, holding other factors constant.
We had our anticipation level on red alert last year in regards to a forthcoming infrastructure plan from the administration. Once again, we are being informed that a plan is in the works. However, it would seem that this plan may be even more difficult to launch given the funding pressures and given that bipartisan cooperation will be required. The latter should be forthcoming despite any political considerations. We are even more vexed this time about where the funding will come from if states and localities will be pressed harder for their match funding. Most states are not in a position to raise taxes or add fees and charges to produce a match. If this tenet is adhered to in the final version of any bill, the origination for projects may come in lower than expected.
On the regulatory front, we anticipate a greater emphasis and the implementation of existing regulations and requirements. Markups, municipal pricing and enhanced disclosure are all sufficient to garner a lot of attention. What is gaining more traction is reviewing recent enforcement actions for more clear direction about where the lines are drawn on specific regulations. Being desirous of complying and actually complying are two different concepts last time we checked.
Liquidity is an ever present focus in our market. The good news is that liquidity is quite good at present. After all, there is even a market in Puerto Rico bonds, though it is probably not as wide and deep as one would want. This is a good market for crossing bonds. We have not heard as much this year about tax swapping, but we can only assume that it has been business as usual. The activity in equities has tended to drown out a lot of other discourse. Sound liquidity has been maintained in the face of greater regulation and more limits on dealer inventory. We have not had a real test on the liquidity side in some time and we do not anticipate one in the near term.
We all know that many projects are pending. Funding and rates are always a consideration. Public private partnerships can continue to evolve given that the attack on PABs has been called off for now. Given the paucity of funding opportunities, P3s must be considered as an alternative. Perhaps, we should be reassured about the approach that higher education and healthcare have taken over the recent past. These entities have gone taxable when the spread of tax exempt to taxable has not been that wide. While it is generally harder for a general obligation credit to justify taking this route, it should be considered more. We know there is solid demand for taxable municipals.
We resolve to keep nurturing the municipal market as one of the most efficient on the globe.We wish all a very productive 2018 that will continue to demonstrate how critical municipals are in the overall economic growth drive.