U.S. and Japanese central banks both declined to rush out of the gate with policy-rate changes.
Top Five Muni Trends on Our Radar for 2H17
In this blog post, we count down the top five muni trends we’re watching for the second half of the year. While some of these trends can draw lessons from years past, others are uncharted territory for the muni market.
- Credit Contagion from Weaker States
The potential downgrade of Illinois general obligation (GO) bonds from investment grade to high yield is one of the most concerning issues facing the muni market. Prices for Illinois GOs have fallen sharply.
In addition to Illinois, Connecticut and New Jersey have also seen negative credit headlines, underscoring the fact that pension and budgetary challenges are now being faced by multiple states. Also, the recent distress in Puerto Rico has involved questions of seniority between Puerto Rico sales tax bonds (also known as Cofina1 bonds) and Puerto Rico GO bonds. This has caused some investors to further question the resilience of GOs or other parts of municipal security structures.
Ongoing state credit issues have led ratings agencies to become quicker to take negative action against states. Additionally, investor concerns about state GOs have prompted more scrutiny on local credits that may be impacted by state credit risks.
Importantly, we’re seeing these state risks in an environment where bond insurance is less prevalent versus pre-crisis.2 We believe that in-depth, fundamental credit research is important to managing rising state credit risks.
In recent months, the muni market has benefited from muted supply and strong demand. Year-to-date, new issues have fallen roughly 14 percent versus the same period in 2016.3 On the demand side, redemptions have risen, supported by positive inflows of $5.3 billion year-to-date.4 Strong technicals have caused new issues to be quickly absorbed by the market, with new deals often being multiple times oversubscribed.
If supply picks up or demand wanes in the second half of the year, the municipal market may lose its most prominent tailwind for muni performance year-to-date. Importantly, the strong technical has driven valuations higher. The five-year ratio is currently about 72 percent, while the 10-year is at 87 percent.5 Less attractive valuations may result in less demand.
Potential Tax Reform
Many potential changes to the tax code could impact municipal bonds negatively, including:- A reduction of individual tax rates, which could modestly impact retail demand;
- Removal or capping of the municipal tax exemption; and/or
- A reduction in corporate taxes, which could decrease the incentives for corporations to invest in tax-exempt bonds.
In the aftermath of the U.S. presidential election last November, tax risk is no longer being priced into municipal bonds, in our view. With significant uncertainty as to the timing and magnitude of tax reform, investors may be faced with unforeseen shifts in demand or pricing as the new legislation plays out.
Low muni yields have driven some investors to reach for yield by increasing duration and/or by dropping lower in credit quality.6 7 Year-to-date, investors have mostly benefited from going lower in quality, as BBB municipals have outperformed other ratings categories, per Barclays (Figure 1). However, this has led to more expensive entry points for lower-quality bonds. Given the length of the current expansion and some stress at the state level, some municipal investors could be taking additional municipal credit risks without being adequately compensated.
Outflows from Some Combination of Numbers 1-4
Muni outflows are typically prompted by rising Treasury rates—particularly in periods when fundamental muni risks are increasing (e.g., outflows in June 2013 that followed the “Taper Tantrum” and preceded the Detroit bankruptcy filing). While Treasury rates currently remain low, outflows could increase if rates start to rise. There are other catalysts for a decline in investor demand, such as Fed tightening/balance-sheet reduction, and/or an Illinois downgrade to junk. An increase in outflows could cause municipals to underperform.
- The municipal market continues to include uncertainties, such as the five trends outlined above, that should be closely monitored. Municipal investment should be approached carefully.
- That said, investors can still benefit from municipals by maintaining a diversified portfolio of bonds that offer value.
- Municipals are still attractive on an after-tax basis, and beneficial opportunities are still available in the market. For example, our recent white paper A Credit View of Illinois’ Past and Future provides insight into ways that investment in Illinois may make sense for some muni investors.
- Even though we can highlight risks in some states, the vast majority of states remain fundamentally solid, in our view.
 Puerto Rico Sales Tax Corporation.
 With the financial crisis, Triple-A insurance on bonds declined sharply. For 2016, only roughly 5.7 percent of the muni bond market was insured, versus 39.5 percent in 2000. Source: The Bond Buyer.
 The Bond Buyer, as of June, 2017.
 Lipper, as of June 28, 2017. Based on combined weekly and monthly flows.
 Thomson Reuters, Municipal Market Monitor (TM3), as of June 30, 2017.
 Tracy Alloway and Eric Lam, “Seven Charts That Show the Search for Yield Is Alive and Well,” Bloomberg Markets, March 9, 2017.
 Lian, Chen, Yueran Ma, and Carmen Wang. Working Paper. “Low Interest Rates and Risk Taking: Evidence from Individual Investment Decisions”.
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. An investor should consult with their financial professional before making any investment decisions.
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.