From Our Briefings Newsletter
The article below is from our BRIEFINGS newsletter of 26 November 2018:
Briefly . . . on the Evolution in the US Muni Bond Market
Last year’s US tax law altered the supply-and-demand dynamics of the muni bond market, creating potential opportunities for investors. We sat down with Goldman Sachs Asset Management’s Municipal Bond Portfolio Managers Ben Barber, Scott Diamond and David Alter who explained the near- and long-term trends that are shaping one of the oldest and largest fixed income markets in the world.
Muni bonds, municipal bond funds and muni ETFs have long been an attractive investment because they offer interest that’s tax-free at the federal level and at most state and local levels. How did last year’s tax legislation affect demand?
Ben Barber: For corporations, whose tax rates fell to 21% from 35%, holding the tax-exempt bonds became less appealing, so we saw a moderation in demand from institutions, pensions and endowments. At the same time, retail demand for muni bonds increased because the tax law limited the state and local tax deduction, spurring residents of high-tax states, such as California, to invest in municipal bonds to be more tax efficient. As a result, we believe the technical environment became – and remains – relatively strong, despite the outflows in October amid a broader risk-off sentiment and interest rate concerns. Today, the overall demand picture has remained anchored, with demand shifting materially towards retail buyers. At the same time, supply remains light and supportive of bond spreads, after a couple years of net negative issuance and a longer downward trend in supply after a rapid growth during 2009-2010 to help finance the post-crisis fiscal stimulus.
How has the economy affected the fiscal health of the cities and states issuing bonds? Are there any concerns about credit deterioration at this point in the economic cycle?
Scott Diamond: We believe credit fundamentals are in solid shape, supporting the case for munis alongside fair valuations after cheapening since the summer months. The downgrade and default outlook for the municipal market continues to look benign, with municipalities boasting a lower default rate than similarly rated corporate bonds. And state and local revenue trends remain constructive, though trends vary across states. California’s economy, is showing signs of moderation, but from a strong 5% growth rate. The reduction in state and local tax deductions is having an incremental impact on fiscal policies in high tax jurisdictions, such as California, but the upshot is that demand for in-state bonds could increase. With some exceptions, most municipalities are exhibiting healthy credit metrics and remaining fiscally austere.
Amid a changing interest-rate environment, can you explain the relationship between interest rates and muni bonds?
David Alter: The pickup in interest rate volatility has had an outsized negative impact on retail demand for muni bonds, especially in longer-dated products where duration1 is longer and liquidity is lower. But overall, we believe that higher rates as a function of better economic growth prospects should actually be interpreted as a positive sign for muni investors in the current environment, as yields look more attractive and the relative cheapness of municipal bonds to US Treasuries should provide a cushion to investors in the event of continued rate volatility.
The correlation between rates and municipal bonds has changed dramatically, however, since the crisis after municipal bonds largely lost their AAA-rated2 status after February 2008. Today, a much smaller share of the market is AAA-rated as well as insured, driving a massive recalibration of the muni market relative to other fixed income sectors. A less stable correlation between rates and munis may provide greater potential opportunities to find value by investing across the quality spectrum and varying duration exposure.