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Has Tax Reform Robbed Municipal Bonds of Their JANUARY/FEBRUARY 2019 | FMSinc.org A PUBLICATION OF THE FINANCIAL MANAGERS SOCIETY The landmark tax reform initiatives that “Given the lack of demand (on the long- in issuance to be much the same for the near went into effect in 2018 inspired a great term end of the curve), we’ve seen longer- term in 2019, barring further changes in tax FEATURE deal of debate in many corners of the U.S. term municipal spreads widen,” says law, rising rates or market shifts. economy, ranging from the hallelujahs of Michael Davis, managing director of Fixed companies that saw their tax rate drop by Income Research Strategies at SunTrust “The end of the advance refunding bond nearly 15% to the hand-wringing of deficit- Robinson Humphrey, Inc. “Interestingly, program was a big loss for the market,” watchers and those who saw the whole retail investors have shown robust demand Urtz notes. “Not only did it remove one of endeavor as a handout to corporations at on the short-end of the curve, which has the issuers’ main ways of refinancing debt the expense of individual taxpayers – not to helped to keep spreads somewhat in check. when interest rates drop, it eliminated a mention the consternation of those banks These shifts have led to a steepening of key source of supply for the market. Over that found themselves subject to a costly the municipal curve – a trend we expect to the past decade, advance refundings revaluation of their deferred tax assets. continue going into 2019.” have comprised roughly 15% of annual issuance. Much of the drop in 2018 can But a quieter conversation also stirred in Abigail Urtz agrees with Davis’ take on how be attributed to lower refunding activity, municipal bond circles – from investors things are shaping up on either end of the since new money issuance was actually up who long held the assets for their now- yield curve. At fifteen years and longer, tax- 26% over last year. Unless this program diminished tax savings to the issuing exempt municipals have been suffering from a gets reinstated, I would anticipate that entities that previously enjoyed the now- softening in demand from banks and insurance supply will disappoint to the downside eliminated tax-exempt status of advance companies that have less incentive to buy again in 2019.” refunding (which issuers had used to pre- tax-free bonds at a 21% tax rate. On the short refund outstanding debt that had more than end, meanwhile, continued strong demand INVESTMENT ATTRACTIVENESS TO BANKS 90 days to the next Despite their lower call or maturity). The tax-equivalent discussion, quite If the yield curve inverts, it’s usually a sign of yields, Davis simply, centered on believes municipals how the municipal a slowdown in the economy. Paying careful remain a good bond market would attention to credit trends and demographic investment option react to this potential for banks, still sea change of tax data will be important going forward, as will offering a better reform. Would being aware of the pension issue. yield than their issuance take a agency counterparts plunge? Would Michael Davis, Managing Director, Fixed Income in many instances. investors move away Research Strategies – SunTrust Robinson Humphrey Urtz adds that from a market where an institutional yields suddenly appetite for seemed much less attractive? And what from retail investors has caused the already tax-exempt municipals in light of lower of banks, which historically have had up to steep municipal yield curve to steepen further. corporate tax rates really comes down 25% of their investment portfolios tied up to their ability to extend out on the yield in municipals – would they move along to a “We expect the municipal yield curve to curve. For example, she notes that tax- better option? continue to take its cues from retail and exempt municipals no longer make sense institutional buying patterns in 2019,” for institutional buyers against alternatives As investors and other market players explains Urtz, a senior VP in the Municipal inside of ten years, as buyers would be continued to work through the ramifications Credit Strategies Group at FTN Financial. better off in high-grade corporates or of the tax changes, none of these questions “Unless the new Congress makes some even taxable municipals that can provide were fully settled as 2018 came to a close. headway on reversing corporate tax cuts, higher yields and, in the case of taxable But a few clear trends were starting to the municipal curve should remain steep municipals, the same credit considerations. emerge that were likely to set the scene for and provide the best value to institutional The story is different on a longer time municipals in 2019 and beyond. investors that are able to invest in 15-year horizon, however. and longer maturities.” A STEEPENING YIELD CURVE “Outside of 15 years, tax-exempt municipals As municipal demand has shifted – with LOWER ISSUANCE are still the cheapest investment option banks and other institutions showing less With municipal bond supply down by about out there, and we continue to see strong muniMUTINY? interest in issues on the longer-term end of 15% as 2018 wound down – due, in large demand from banks and insurance HAS TAX REFORM ROBBED MUNICIPAL BONDS OF THEIR APPEAL AS A BANK PORTFOLIO STAPLE? the curve – higher Treasury rates and wider part, to the elimination of advanced refunding companies that can participate in this spreads have led to falling values. bonds – Urtz and Davis both expect the trend space,” Urtz says. For those institutions moving on from constant. But there are a number of municipals, Davis is seeing a number of factors that buyers will need to keep an popular alternatives emerge to fill that eye on. portfolio gap, including Fannie Mae’s multifamily product, FNMA DUS, which “If the yield curve inverts, it’s usually a comes with balloon-like maturities sign of a slowdown in the economy,” he of 7 years, 10 years and beyond, and points out. “Paying careful attention to carries yield maintenance to provide credit trends and demographic data will call protection in the event that interest be important going forward, as will being aware of the pension issue. We suggest avoiding local governments located in poorly We don’t think funded pension states that have a high investors are being reliance on state aid as a revenue source.” paid enough for With municipal credit spreads having compressed over the past year, Urtz these (pension) says the down-in-credit trade has lost risks, so it’s best some of its luster, which is why she too leans toward investments in higher- to keep any quality governments that have effectively governments managed liabilities to retirees, or in revenue bond credits with clear claims with chronically on dedicated collateral. Like Davis, she underfunded plans adds that although headlines surrounding underfunded public pensions have quieted at arm’s length. somewhat this year, investors should understand that many governments aren’t Abigail Urtz, SVP, out of the woods quite yet. Municipal Credit Strategies Group “Those with the weakest funded plans, – FTN Financial like Illinois and New Jersey, remain highly susceptible to a recession or further equity rates fall. Another possible municipal market losses that could compromise tax replacement are discount callable receipts needed to make contributions agencies, which likewise offer the or pension assets built up to pay retiree opportunity to add duration with extra liabilities,” she says. “We don’t think spread and call protection. investors are being paid enough for these risks, so it’s best to keep any governments “These are callable agency bonds that with chronically underfunded plans at were issued in a lower-rate environment, arm’s length.” and now are offered at deeply discounted prices,” Davis explains. “The call option At the same time, Urtz notes that the for these is well out of the money, so municipal market is notorious for painting they model more like bullet agencies, but problems with a broad brush, so the offer spread over bullet agencies. In the headlines that will inevitably resurface in event they get called, investors typically pension-burdened states could also bring experience a yield boost, as the discount is about some unforeseen opportunities. accreted all at once.” “Investors should be on the lookout for MUNICIPAL OPPORTUNITIES HEADING INTO 2019 names that may trade at a penalty for being Taking all of this into account, Davis associated with an irresponsible parent believes the best bets in the municipal government, but that have minimal direct market in 2019 will continue to be further financial reliance on their state.” § out on the curve, where bonds will be priced more attractively if demand holds forward, a publication of the Financial Managers Society Published for: Financial Managers Society, Inc. 1 North LaSalle Street | Suite 2225 | Chicago, IL 60602-3916 FMSinc.org | 800-ASK-4FMS Copyright 2019, Financial Managers Society, Inc. All rights reserved..
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