Bond markets have experienced meaningful volatility following Donald Trump’s surprise win over Hillary Clinton. In a two-week timespan, the 10 Year Treasury yield rose by approximately 50 bps, with benchmark municipal yields also rising by a similar amount. The move in Treasury yields can be attributed to Trump’s contemplated stimulus, likely funded with significant additional debt issuance, which should help economic growth and increase inflationary expectations. Municipals generally outperform Treasuries in sell-offs, meaning market yields do not rise in tandem due to the effect of the tax exemption. However, this time municipals sold off by a comparable amount as investors grew wary of various fiscal policy risk elements (i.e., changes in tax rates) that could impact the future attractiveness of municipals. We discuss several main risks below.
Plan to Lower Federal Income Tax
Lower income taxes would reduce the value of the tax exemption offered by municipal bonds. However, there are several considerations when analyzing the potential impact of this risk.
Individuals and mutual funds are the biggest buyers of municipals, currently owning close to 70% of all outstanding supply. Banks own just 14%, with insurance companies at 13%. Proposed tax cuts for individuals are smaller than those for corporations, which should help support market valuation. Additionally, individuals purchase municipals bonds not just for the tax exemptions, but for other reasons, like the safety of principal.
The likelihood, in our view, that all of Trump’s tax reform proposals are implemented in their original form in a relatively short timeframe is fairly low. For the parts that are implemented, it could take several quarters, if not years, to be fully integrated into the tax code.
Status of Tax-Exemption Cap or Elimination
There is speculation in the market that higher budget deficits could threaten the tax exemption of municipal securities. This is a very low probability in our view as it would sharply increase borrowing costs for municipalities, which Congress would strongly oppose. In the remote chance the exemption is capped or reduced, a likely grandfathering of outstanding securities would be very positive for the market.
Increased Market Supply from Infrastructure Spending
There is already a considerable drop off in projected refunding issuance for 2017 due to the recent rise in yields. Additional supply of new money bonds would be an offset to this decline. Just like with the economic stimulus package of 2010, there are very few “shovel-ready” projects, and it will take a considerable amount of time for these initiatives to translate into issuance. There is also quite a bit of uncertainty about how these projects will be funded, i.e., tax credits and public/private partnerships, which could further reduce municipal bond issuance. Naturally, lower supply would help improve municipal bond valuations.
Near-term Market Volatility
Investors should expect a meaningful amount of market volatility as investors digest the various scenarios and their potential impact on the municipal market. A quick bond math exercise illustrates that a 50 bps increase in market yields would result in approximately 5% market value depreciation of a security with 10% effective duration. Most premium coupon municipals of 15-20 year maturities would also exhibit an approximately 10% effective duration. Assuming a municipal bond portfolio of $10 million with 10% duration, it would experience a roughly $500,000 swing in unrealized gain/loss given an increase in market yields of approximately 50 bps. Investors in intermediate and longer-dated municipal securities should expect this type of change in valuation when comparing their month-end November reports vs. the previous month. Similar duration Treasury securities declined by a comparable amount as municipals over the same period with much lower market yields.
To recap, this change in market values for municipals was a direct result of two things. First, Treasury yields increased stemming from Trump’s economic plan pricing in higher economic growth and spending, and also higher inflationary expectations. Secondly, Trump’s fiscal/tax plan assumes a probability of lowering corporate tax rates, which would cause tax-exempt municipal yields to rise. Most importantly, changes in market values of municipals were driven by changes in market yield not related to credit risk, and therefore are not signs of impairment.
Municipals Offer Excellent Relative Value
Tax-exempt municipals have been a very good asset class for bond portfolios over various time horizons due to wider spreads, very low loss rates, call protection, and favorable price performance vs. taxables. Not surprisingly, higher-performing portfolios generally have a higher municipal weighting. Today, investors are being rewarded with additional spread in excess of the norm. We feel this is especially attractive even when compared to some loans. The best opportunity today is in high-grade general market municipals with tax-equivalent yields between 4.50% and 5.50% depending on duration. This is particularly attractive given 20% risk-weighting (for general obligation bonds) and 10 year cumulative default probability of 0.01%. As a comparison, a cumulative default probability for a commercial loan with 1.25x Debt Service Coverage is 8.4%, much higher than 0.01% for high-grade municipals.
Conclusion
We feel the sell-off in municipal bonds is overdone and presents buying opportunities on the intermediate and longer parts of the curve, especially with premium coupons. We anticipate market volatility to continue in the near-term, which will be apparent in the November month-end bond accounting valuation. For long-term investors, we view this period as a good entry point from an absolute and relative value perspective. This also includes investors with existing municipal bond portfolios, allowing them to dollar-cost average into the market.
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