One third of the way into the new year, Senior Portfolio Manager, Albert Jalso, offers an update on the municipal bond market and how it has fared since his 2016 year-end outlook for the asset class.
Source: Bloomberg, Russell Investments
It appears that the muni market has come to the realization that it overestimated the Trump Administration’s efficacy at implementing certain campaign promises that could potentially hurt the muni market. Congress’ recent failure to agree on a bill to reform/replace the Affordable Care Act (ACA or “Obamacare”) helped reverse the technical sell off (a.k.a., The “Trump Dump”) that had caused investors to flee municipal bonds following President Trump’s victory in November 2016. Year-to-date as of April 24, 2017 both investment grade (Bloomberg Barclays Broad Municipal Index) and high yield municipal bonds (Bloomberg Barclays Municipal High Yield Index) have handily outperformed their taxable counterparts (Bloomberg Barclays U.S. Aggregate Bond Index and Bloomberg Barclays U.S. Corporate High Yield Index, respectively) by one to two percentage points. Investors who did not flee were rewarded and new assets are now flowing back into tax-exempt funds as of April 2017.
Where to next for muni bonds?
Even after their strong year-to-date showing, we believe municipal bonds continue to represent value relative to their taxable counterparts.
- Currently out-yielding taxable bonds
Tax-equivalent yields using the current top tax bracket rate (excluding ACA) show investment grade municipals out-yielding the taxable market by 1.5 percentage points, and high yield municipals out-yielding taxable debt by 4.0 percentage points. Even if the top tax bracket was cut to Trump’s recently proposed 35%, municipal debt would still out-yield taxable bonds by approximately 1.4 to 3.2 percentage points.
- Likely delays in tax reform keep muni bonds attractive today for many investors
It’s reasonable to expect that many investors can make use of municipal debt this year at current personal income tax rates, as it’s increasingly unlikely that any type of tax reform or reduction will happen before 2018. For example, even though the White House revealed the long-awaited memo outlining President Trump’s tax plan on April 26th, Mick Mulvaney, Director of the Office of Management and Budget (OMB), said this week that details won’t be disclosed until June. Indeed, Treasury Secretary Steven Mnuchin recently conceded that the tax reform time table is materially slipping as the administration continues negotiating with Democrats on ACA changes and funding for the construction of a wall between the U.S. and Mexico.
- Tax reform may not touch muni bonds’ tax status much
Potential delays notwithstanding, the April 26 White House tax memo reveals some important insights. First and foremost, the fact that it makes no mention of eliminating municipals bonds’ tax exemption is a strong signal that this will not be touched. Second, the proposal’s elimination of state tax deductibility of muni bonds may cause an increase in demand for municipals in high tax states (CA, NY, NJ). Finally, we think that the proposed reduction in the top rate from 39.6% to 35% is not enough to reduce demand for municipals, so they are likely to remain relevant tax efficient tools.
- Potential technical support for muni debt this year
In addition, technicals are anticipated to support municipal debt in 2017. New issue supply is expected to remain light this year due to a decline in refundings. Issuers are also tapping the brakes on new money issuance until there is clarity on economic policy.
The bottom line
The municipal bond market suffered after the election in 2016 but has since recovered. Further, Trump’s tax proposal does not spell the end for tax-exempt debt. In our view, there is not only still upside potential for muni bonds but also valid reasons to hold onto them for the long term.