By Adam Stern
The prospect of a junk-rated state is a concerning development for the municipal market.
While we wouldn’t call municipal markets irrational, we might say that some pockets are being illogical. The municipal market is experiencing strong tailwinds of low bond supply, low absolute yields and relentless flows of funds into the municipal market in search of bonds to buy. These conditions have created what has sometimes felt like endless demand.
In high-tax states, the cap on state and local tax (SALT) deductions is increasing the challenge of buying suitable bonds. As reported,1 municipal bond yields have fallen and prices have risen to levels that offset, or even inverse, the very tax benefit for which they are typically bought to provide, relative to taxable options.
The challenge of finding appropriate tax-advantaged investment opportunities has increased, particularly for investor accounts with restrictive state mandates. Nevertheless, demand for municipal bonds is so high that buying has continued unabated through the early weeks of 2020.
The circumstances once again highlight the fact that being a prudent portfolio manager isn’t just about what you buy, but also what you don’t buy. Take the case of a recently issued municipal bond as an example of the high market demand for bonds and its impact on valuations. At the end of January, a southern California-based regional transportation commission (rated AAA) raised $75 million in funds through a negotiated bond deal; maturities ranged from 2021 to 2048. Like most California issues, demand for the deal was strong and initial orders totaled $575 million; 7.63x oversubscribed, which means demand exceeded supply by a factor of over seven times. Given the market demand during the order period, the underwriter repriced bonds higher, forcing the yield lower. Nevertheless, most buyers remained in the deal, which closed with final orders totaling $425 million (5.64x oversubscribed). The 5-year bonds priced at a yield of 0.66 percent (3x oversubscribed) and the 10-year bonds priced at a yield of 0.92 percent (11x oversubscribed). In this example, even as the price of the bond increased and the yield fell, investor demand remained extremely high.
Considering the increased demand for municipal bonds, we believe the current environment has made Municipal/Treasury (MT) ratio evaluation and crossover trade consideration more important than ever.
M/T ratios are one important way Breckinridge views opportunities and valuations. Simply put, this ratio is calculated as the percentage of a municipal bond’s yield to a similar-duration Treasury. Using the previously mentioned deal as an example, we can calculate an M/T ratio of 46% (see table below).
Although subject to federal taxes, Treasuries are exempt from state and local taxes. There is a straightforward breakeven or hurdle rate calculation that can be completed for every municipal buyer using their own federal tax rate to compare tax-equivalent yields (TEY) against other investment options.
The M/T ratio is a quick way to identify if a municipal bond’s tax benefit may be present, eliminated or – as we have seen more recently – inverted in relation to buying a U.S. Treasury. For example, if a municipal bond’s TEY is lower than that of a similar duration Treasury, then the municipal bond is offering both a lower TEY and lower liquidity because Treasuries are easier to sell than municipals.
In the case of the deal example, the 5-year bond was priced at a yield of 0.66 percent, which was a 46 percent M/T ratio. It would take a 54 percent federal tax bracket to put a similar-duration Treasury bond into parity with that bond for a California investor. Since that tax bracket doesn’t exist, buying a similar duration Treasury bond would have produced a higher TEY. This is true and can be calculated whether the client is an in-state resident or an out-of-state resident, such as an investor taxed in Pennsylvania,3 for example, as Treasury crossover breakeven or hurdle rates are derived using the federal tax rate, after adjusting for any applicable state tax implications.
While we argue that the relative value of municipals to Treasuries as measured by the M/T ratio is important on a yield basis, we recognize that some buyers are more focused on total return, as many bonds are not held to maturity. To this we’d ask, when a municipal bond is already trading through the tax benefit by trading at a lower yield than a Treasury on a tax-equivalent basis, how much additional upside in relative value will such a bond have? We contend the answer is little to none.
Breckinridge believes that even when tax-exempt municipals are preferred, other options should be considered by an investor. In addition to U.S. government securities, opportunistic trades can include taxable municipal bonds (in-state and out-of-state), out-of-state tax-exempt municipal bonds, and even risk-adjusted corporate bonds. In all cases, math is math and breakeven/hurdle rates can be calculated. In-state taxable municipal bonds are subject to federal income taxes; out-of-state taxable municipal bonds and corporate bonds are fully taxable; and tax-exempt out-of-state municipal bonds are subject to state and local taxes.
Breckinridge has developed tools that are integrated into our proprietary trading systems that identify breakeven. The tools help us to efficiently determine what bonds may provide a more favorable tax-adjusted return for our clients in their customized accounts. While some states have specific caveats and taxation for out-of-state bonds, the analysis determines opportunities that fit and structures to avoid. While we typically prefer in-state exempt municipals, the current market environment requires that we be more discerning and take a more thoughtful approach for our clients.
Breckinridge faces the same supply and valuation challenges as other municipal buyers, but we believe that our approach and capabilities are differentiators. Particularly for the separate accounts that we manage, we have the opportunity to determine if a ratio is prudent on an account-by-account basis. Our investment team is experienced with using our proprietary systems to conduct breakeven/hurdle rates analysis to compare opportunities among in-state tax-exempt municipals, out-of-state tax-exempt municipals, taxable municipals, corporate bonds and Treasuries. The same level of customization is not available to managers of commingled funds that have many investors with varying tax circumstances.
The research team at Breckinridge consists of 16 professionals, 10 of whom are dedicated solely to high grade municipal issuers. The team follows over 3,000 credits, reviews new deals prior to participation and boasts regional and sector-based expertise. This allows us to consider deals that other managers may deem too small.
As an illustration of the value of being able to look deeper into the market and select opportunities across the spectrum of deal sizes, consider this. Based on our research, we found that, in 2019, in par value, 63.9 percent of deals for bonds rated A- or better were less than $250 million in total size. Further, 38.7 percent of total issuance came from new deals that were less than $100 million in total size. Drilling down even further, a notable 23.8 percent of total issuance came from new deals that were less than $50 million. (See Figures 1 and 2.) A manager who is limited to selecting only larger deal sizes or securities eligible to be included in broad municipal bond market indexes would not have been allowed to participate in these deals.
As we navigate the current market, secondary liquidity risk has decreased and the opportunity cost of ignoring available opportunities is high. Having a large breadth of research coverage is particularly important in high-tax states, where diversification, opportunity and valuations are a growing challenge within the market. With our focus on independent fundamental and ESG research, we believe Breckinridge can participate in relative-value opportunities that other managers may overlook or choose to forego. Further, our analysis of M/T ratios and crossover trade opportunities are important elements in making investment decisions on behalf of our clients.
The examples provided are for illustrative purposes only and not intended to be investment or tax advice. Due to differences in individual tax rates and financial situations, individual results and benefits may differ significantly from what has been shown.
Illustrative example results are based on tax rates as of January 29, 2020. Federal and local tax laws and rates can change at any time; changes to tax laws and rates can impact tax consequences for investors. Investors should consult with their tax professionals prior to making any investment decisions for tax purposes.
 “Low Bond Yields Are Killing Muni Tax Breaks,” Barron’s, January15, 2020.
 For the examples, the tax-equivalent yield (TEY) is calculated as follows: yield on tax free bond multiplied by 1 – out-of-state tax rate, if applicable divided by 1-federal tax rate. For example, a taxpayer in the 25 percent tax bracket would subtract 0.25 from 1 and, if the bond in question yields 3 percent, use the equation (3.0/0.75) = 4 percent.
 The use of the state of Pennsylvania for comparison in this example is based on the fact that personal income tax rates in Pennsylvania are relatively lower than California and some other states, while relatively higher than some but not all other states, thus offering a broad illustrative example for consideration of mathematical calculations for out-of-state residents. Breckinridge would not typically advise a PA investor to buy CA bonds
 Crossover Trade Benefit means that even after paying taxes, the taxable bond purchased should offer a higher income than what could have been earned on the tax-exempt bond.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. Investors should consult with their financial professional before making any investment decisions.
While Breckinridge believes the assessment of ESG criteria can improve overall credit risk analysis, there is no guarantee that integrating ESG analysis will provide improved risk-adjusted returns over any specific time period.
Some information has been taken directly from unaffiliated third-party sources. Breckinridge believes such information is reliable but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
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By Adam Stern
The prospect of a junk-rated state is a concerning development for the municipal market.
Podcast recorded November 7, 2017
Our investment team weighs in on the proposed House tax reform act and its implications for the municipal market.
Engagement with bond issuers is an essential element of our research process. A recent Wall Street Journal article highlighted the importance and influence of our engagement.