Greg Gizzi, Senior Vice President, Senior Portfolio Manager, Fixed Income
It was one year ago that we suggested that taxable municipal bond spreads in 2018 might be more resilient than their investment-grade (IG) corporate bond counterparts and, due to a strong technical factor, outperform US credit in a rising rate environment. In fact, the Bloomberg Barclays Taxable Municipal Index (unhedged) outperformed the Bloomberg Barclays US Investment Grade Credit Index (unhedged) by approximately 200 basis points by November 2018, despite being a longer structured asset class. A combination of strong credit fundamentals, low supply, attractive yields, and consistent demand for the asset class collectively drove performance during the year. This all occurred with muted participation from non-US investors.
These developments lead to the question: Where do we go from here? The crucial factor driving performance was the supply/demand technical, which should continue to be supportive in 2019. Below we detail this technical factor and provide our outlook for the asset class into 2019.
Supply: Effects of infrastructure proposals
As prospects for an infrastructure bill from the Trump Administration faded over the past year, we anticipate taxable municipal issuance is on pace to come in at approximately $US37 billion* for 2018, below our optimistic forecast of $US50 billion*. A Democratic win for control of the US House of Representatives in the midterm elections, however, has fuelled speculation that infrastructure may be one of the few areas of common ground where President Trump could get a deal done. This hope will most likely prove to be unachievable as the two sides differ conceptually on the structure and, most importantly, where the money to support such a program will come from.
A deficit-financed program is unlikely to be backed by Republicans. This reality will continue to put the onus for infrastructure financing squarely in the lap of state and local governments. While aggregate numbers indicate that state and local tax revenues have risen in 32 of the past 35 quarters during the current economic expansion (source: Bloomberg), nonetheless expense growth, pension, and other postemployment benefits (OPEB) obligations vary. Therefore, layering on additional debt for some governments may not be feasible.
Advance refundings may have an impact on supply
The supply technical may also be supportive over the next two years after a recent Internal Revenue Service (IRS) clarification on the advance refunding of taxable municipal issues. The IRS stated that taxable municipal issues can be advance refunded by tax-exempt issues unlike those tax-exempt issues prohibited from advance refunding under the Tax Cut and Jobs Act. (This 2017 tax law generally prohibited the practice of issuing advance refunding bonds to refinance older, more costly debt. The advance refunding method allowed municipalities to pre-refund old debt with new debt — but in doing so, permitted two issues for the same project to remain outstanding until the first call date of the original issue, which was viewed as a tax loophole.)
The taxable municipal supply had been largely supported by the Build America Bond program, which lasted from February 2009 to December 2010, and generated approximately $US181 billion in taxable issues. Approximately $US42 billion with standard 10-year optional calls remain outstanding. (Source: Bloomberg.) Analysts estimate that $US5 billion to $US20 billion could be advance refunded with tax-exempt debt in 2019. A smaller market would generally be supportive of spreads.
Without a significant federal program to assist state and local governments with infrastructure needs, we are not anticipating a significant uptick in taxable municipal supply for 2019. We believe the market should see $US35 billion to $US45 billion* in new-issue volume.
Demand has been predominately US-focused in 2018
The demand for taxable municipal debt has been predominantly US domestic in 2018 as escalating currency hedging costs appear to have deterred international flows from the asset class. The most recent US Federal Reserve Z.1 report indicates that foreign ownership of municipal debt for the first two quarters of 2018 was $US101.6 billion, up marginally from year-end 2017 when it stood at $US101.3 billion.
The hedging cost variable is likely to continue to dampen international flows in 2019 if the US dollar maintains its relative strength. From a longer-term perspective, international demand for taxable municipal debt should grow, in our view, as investors have come to understand and appreciate the diversification benefits of this asset class. An increase in supply would be welcomed by investors as the size of the market remains a challenge for some.
Demand for the revenue bond sector from foreign entities should see a noticeable uptick in the next year as insurance regulators in Taiwan have approved several of the sub-sectors for investment by Taiwanese insurers. These investors have been restricted to investing in general obligation bonds prior to the passage of this regulation.
Outlook for taxable municipals
In 2018, we saw taxable municipals outperform on a stronger technical and solid credit fundamental relative to US IG credit. The approximately 10 basis point spread widening in municipals was in sympathy with IG credit, which saw spreads generally widen by more than 50 basis points on rising rate concerns, fears over slowing euro economies, and what a full-blown tariff war with China might mean for credit fundamentals.
Municipal credit fundamentals remain solid, driven by employment gains that have led to higher income tax and sales tax, and a recovery in property taxes as real estate values have generally recovered to pre-recession highs.
Our expectation for 2019 is for taxable municipal spreads to continue to be biased directionally by the US IG credit market. If rates continue to rise, we believe more resilient municipal spreads should generally lead to outperformance and if rates remain in a trading range, municipals should generally perform in line with US IG credit. The one scenario, in our view, where municipals may generally underperform is if the bond market shifts sentiment and rates begin to fall. The relative underperformance of US IG credit in 2018 may potentially lead to significantly more spread tightening rather than municipal credit leading to outperformance.
The backlog of infrastructure need has been well publicized. The American Society of Civil Engineers puts the need at more than $US2 trillion by 2020 to bring US infrastructure up to an “adequate” rating. With the chances of a federal program unlikely, state and local governments must begin to take on this task. The ability to orchestrate this task varies according to their respective financial position. For some state and local governments, waiting to address certain projects may no longer be an option.
* Includes corporate CUSIPs, or identifiers for corporate bond and equity offerings.