Supply and demand imbalances have been the key to understanding the municipal market this year. Strong demand, year-to-date mutual fund inflows of $2.4 billion and low supply have affected the relationship between U.S. Treasury yields and municipal yields. Relative yields, especially in the two-to-five-year bonds, are unattractive. The relationship in longer bonds is closer to long-term averages. Projected supply for the rest of the year and early 2018 is low. The House of Representatives’ tax bill proposes changes to the municipal market that, if enacted, may bring an end-of-year glut of new issuance as issuers try to get deals done before the law changes on January 1st.
If the House bill is enacted, the outstanding supply of municipal bonds will likely fall by 20-30%. Reducing the corporate tax rate will decrease the attractiveness of municipal bonds to banks and insurance companies, the owners of 25-30% of outstanding bonds. The elimination of SALT deductions—state and local taxes—would theoretically make bonds from high-tax states more attractive to in-state residents.
If the House’s bill is enacted, the outstanding supply of municipal bonds will likely fall by 20-30%.
Many things need to happen before a final bill is produced. As of late November, this process is still underway. The House passed its version of a tax bill, but the Senate must pass a tax bill, and finally, the two bills must be reconciled. The possibility of no bill being passed must be considered also.
The Federal Reserve will be an active participant in the markets in the near future. How active is a matter of discussion. Changes in the tax code, if stimulative to the economy, could lead to a more aggressive Federal Reserve. Currently, the market is only pricing in two rate hikes until the end of 2018, while the Federal Reserve is indicating that it will raise rates four times. How this discrepancy plays out will affect bond yields. The market will also watch for changes in Federal Reserve policy under new chairperson Powell. Numerous vacancies on the Federal Reserve’s board need to be filled. 2018 should see more changes on the Federal Reserve’s board since 1936.
While most issuers have recovered from the Great Recession, credit quality in the municipal market has reached a plateau.
While most issuers have recovered from the Great Recession, credit quality in the municipal market has reached a plateau. Credit spreads are tight and bear watching, especially with 2018 projected revenues being flat and expenses expected to climb. New accounting standards affecting the treatment of OPEB (Other Post-Employment Benefits) will begin to be implemented in 2018. While the implementation of the new standards will not affect the economics of local municipalities, it will shine a spotlight on potential problems.
Many factors will influence fixed income markets in the next year besides tax reform. The expiration of the temporary debt limit deal in December will be an event to watch. Foreign central bank actions in the face of synchronized global growth could also move markets. U.S. trade policy changes could affect the economy. We will continue to monitor markets as these events take place and will respond as needed.
This communication contains the personal opinions, as of the date set forth herein, about the securities, investments and/or economic subjects discussed by Mr. Bittner. No part of Mr. Bittner’s compensation was, is or will be related to any specific views contained in these materials. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed.
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