Head - Fixed Income Strategy
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After US municipal bonds’ impressive year in 2018, we see further potential for robust performance over the coming year.
2018 was an impressive year for US municipal bonds. Sweeping tax legislation and higher yields, combined with declining net supply, created a supportive environment for “muni” investors. With the recent rally in long-term US rates providing a late-season push, the Bloomberg Barclays Municipal Bond Index has generated 60bp of positive return this year. This not only exceeds returns in the US Treasury market by 100bp, but also tops US taxable investment-grade corporate bonds by 400bp
A key driver of munis’ returns in 2018 was the Tax Cut & Jobs Act (TCJA.) The TCJA’s elimination of advanced refundings – which had allowed issuers to refinance debt earlier to take advantage of lower interest rates – prompted a flood of new issuance to come to market before the act was officially passed. While this cheapened valuations in late 2017, it also front-loaded the level of new supply that was expected for 2018. As a result, 2018 gross supply has fallen 20%. Based on Citi Research’s projections, it is estimated that we will see the US municipal bond market shrink by $50 billion in 2018.
The TCJA also limited the amount of state and local taxes that taxpayers could deduct from their federal tax liability. Essentially, this raised many high-income individuals’ effective tax rates, particularly in highly taxed states like New Jersey, New York, and California – figure 1. As muni interest income can be state-tax free for local investors, demand for in-state munis increased substantially.
Figure 1. Taxable-equivalent yields offers value for locals
Source: Bloomberg, The Yield Book,Citi Private Bank Investment Strategy as of December 12, 2018. Past performance is no guarantee of future results. Real results may vary. For illustrative purposes only. This should not be construed as a recommendation of a specific investment.
Looking ahead to 2019, we believe that conditions remain supportive for munis. As US Treasury rates have moved higher over the last fifteen months, benchmark muni yields have risen by some 70bp. The rise has been striking in shorter-dated yields. Muni yields on one- to three-year maturities have reached a decade high – figure 2.
Figure 2. Short-term muni yields’ 10-year high in 2018
Source: Bloomberg Barclays Indices as of December 12, 2018. Past performance is no guarantee of future results. Real results may vary.
However, compelling value is not confined to shorter-dated maturities. While the TCJA has strengthened muni demand from individual high-income earners, it is doing quite the opposite for other larger holders of muni bonds, or more specifically, for US banks and property & casualty insurance companies, which hold nearly 25% of the outstanding muni market.
Lower corporate tax rates have lessened munis’ attractiveness for these holders, as the attractiveness to own tax-exempt munis declines. As a result, investors have already reduced their exposure to munis, and we expect a further reduction in 2019. Considering these holders tend to focus on longer term maturities, the selling pressure has cheapened the long-end of the muni curve, while keeping the muni yield curve relatively steep – figure 3.
Figure 3. The US municipal yield curve is steeper than the Treasury market
Source: CPB Investment Strategy as of December 12, 2018. Past performance is no guarantee of future results. Real results may vary. For illustrative purposes only. This should not be construed as a recommendation of a specific investment.
We should also not forget that the turn of the New Year also coincides with one of the potentially strongest technical periods for the US municipal bond calendar. Otherwise known as the “January effect”, this is when muni investors typically receive significant cash flow, either in the form of matured bonds or coupon payments. This is also why January tends to be a seasonally strong period for muni performance.
In this environment, Citi Private Bank’s Global Investment Committee has an overweight tactical recommendation on US municipal fixed income. We recommend constructing ‘barbell’ portfolios of both shorter- and longer-dated munis. In our view, combining attractive short-end yields with better values in longer-term securities in this way could help dampen overall portfolio volatility if interest rates rise further. We feel this is the best portfolio strategy for 2019, as higher US yields remains a decent risk to fixed income performance.
Please see also our Make your cash work much harder theme in Outlook 2019.
Citi Private Bank clients can read our thoughts in full in December 2018’s Global Fixed Income Strategy.
In 2019, we will also be launching Muni Watch, a new publication that includes our latest views on the US municipal bond market, incorporating insights into the economic outlook, politics, and muni sectors.
This material does not constitute an offer to sell or the solicitation of an offer to buy these securities. Views, opinions and estimates expressed herein may differ from the opinions expressed by other Citi businesses or affiliates, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice, and are subject to change without notice based on market and other conditions.
Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. Depending on your state of residency, some bond interest may be exempt from state and local taxes; however, interest may be subject to the federal alternative minimum tax
An Investment in Municipal Bonds may be subject to state and local taxes and you may also be subject to Alternative Minimum Tax (AMT). Official offerings may be made only by the final Official Statement. If sold prior to maturity you may receive more or less than your original investment. Past performance is not a guarantee of future results.
Depending on your state of residency, some bond interest may be exempt from state and local taxes; however, interest may be subject to the federal alternative minimum tax.
Fixed-income securities, such as municipals, present issuer default risk. Municipal securities will be affected by tax, legislative, regulatory, demographic or political changes, as well as changes impacting a state's financial, economic, or other conditions. Municipal investments may be highly impacted by events tied to the overall municipal securities markets, which can be very volatile.
Certain sectors of the municipal bond market have special risks that can impact such sectors more significantly than the market as a whole. For example: Investing significantly in municipal obligations backed by revenues of similar types of industries or projects may make them more susceptible to developments affecting those industries and projects. Because they invest primarily in securities issued by municipalities, they can be more vulnerable to state specific issues."
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can
be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.