We are here to simplify the municipal bond market. Read on for an update on interest rates, the House’s tax legislation, and municipal bond portfolio positioning recommendations.
Yield Curve Inversion? A major issue today is the flattening of the treasury yield curve. Short term interest rates have been moving higher for the past year, particularly T-bills to 10 year rates. Conditions for this yield rally were ripe given the Fed raising the Federal fund rate three times since December 2016, pending tax
legislation, strong 3rd quarter GDP, Fed balance sheet unwinding, and a perception that inflation will rise given strong employment figures. The 10 year treasury rate rose from 2.05% on September 7th of this year to 2.46% on October 26th. Today we are at 2.32% on the 10 year, lower than when we started 2017 despite two 25 bps rate hikes by the Fed this calendar year. The old adage held true again: longer paper typically is a safer place when the Fed hikes rates. The 2-10 year treasury spread (the 10 year treasury yield minus the 2 year treasury yield) is as low as it has been since the Great Recession of 2007-2009: the spread is now 0.70% (see chart below – Fed Reserve Bank of St. Louis). To our eye, this is indicative of the bond market’s belief that we are not in a period of sustained economic strength. An excellent leading indicator of an economic slowdown is an inverted yield curve and today we are 70 bps away from a flat 2-10 yr spread). Add in the possibility of three more 25 bps rate hikes between December 2017 and the end of 2018 and we could see the 2 year treasury higher than today’s 10 year treasury. This is an indicator that bond investors must continue to follow.
Tax Legislation and Municipal Bonds: The House’s tax legislation does not touch the municipal bond tax exemption which is great news. It did surprise investors and issuers as the proposed legislation indicated elimination of new tax-exempt financings for Private Activity Bonds (a broad category encompassing airports, ports, housing entities, some colleges, certain hospitals, and other non-profit issuers) as well as advanced refundings (when issuers refinance their debt early to reduce borrowing costs). It is difficult to measure how much this could shrink the new issue calendar in 2018 and beyond, with some indicating new issuance could fall by as much as 40% (The Bond Buyer). This seems a drastic reduction in new supply and is inconsistent with long-standing goals to improve the nation’s infrastructure, education quality, and access to quality healthcare.
About 70% of municipal investors are individuals and the updates to the tax-code do not appear to create a drastic reduction in marginal tax brackets. Reducing state and local tax deductions, limiting property tax and mortgage interest deductions, and adjusting child tax credits seem to provide a slight tax break for investors. In our opinion, investors will continue to seek out and enjoy the tax-exemptions even if marginal rates fall by a few points. Decreasing the top corporate tax rate to 20% is a large decline and that roughly 30% segment of the municipal market’s investor base may choose to own fewer municipal bonds, yet still seek to own some tax-exempt bonds for diversification and to minimize taxes as needed. In total as currently outlined we think the impact of the legislation could potentially be a net positive to bond returns, given decreased supply, even if the majority is placed in lower brackets.
Portfolio Positioning: Let us cut through the noise and fear: a diversified exempt municipal bond portfolio is a safe investment for assets with a 3+ year investment horizon, even if 2, 5, 10, 20, and 30 year treasury rates rise. Nobody is economically rewarded by sitting in bonds and cash that yield 0.30% – 1.50%. After inflation which is running now in the high 1% range, an investor is losing purchasing power (i.e. inflation is eroding your wealth). We do not foresee a large rate rise materializing anywhere on the yield curve except at the short-end where the Fed appears committed to rate increases. It appears we are in an environment where technology is a deflationary force, we are well into a long economic expansion which will inevitably become a recession at some point, and a sustained GDP figure of 3% or more seems unlikely without significant investment in productivity and infrastructure (see above comments on potential private activity bond limitations).
Today, municipal bonds exhibit attractive relative value compared to other investment grade fixed income. The bulk of the municipal bond market’s yield can be earned in the first 15 years of the curve. We prefer portfolios with coupons averaging 4%-plus, AA credit quality, and duration of 4 years. We suggest callable bonds with call years in 2019-2025 and final maturities in 2026-2037. Bonds in this range provide 2.00%-3.30% exempt yields to call, and yields to maturity of 3.00%-4.30%, combined with a 4.00%-5.00% annual tax-exempt coupon payments. Should we see a rise in intermediate interest rates (a portfolio like this would be most impacted by intermediate rates), we believe it would be modest and portfolio income could quickly recoup that sized drawdown. If you are an investor that does not need all of your fixed income allocation to generate current income, we recommend considering some callable zero coupon bonds with similar call and maturity years as they provide more yield than coupon bonds. Regarding sector, we recommend a diversified blend weighted more toward larger GO’s with stronger local economies, essential service revenue bonds, education issuers, and transportation systems with smaller weights toward healthcare and housing.
We will leave you with this thought, timing interest rates is impossible. Some of the smartest investors have been wrong, some on 1 year projections, some continually for a decade. If you have a 3+ year investment horizon, a portfolio of municipal bonds is a simple and effective solution to generating tax exempt income and preserving principal, net of inflation.
As asset managers and bond traders, we position our clients uniquely close to the municipal bond market. Please contact us to learn how we can help you build individual bond portfolios.
Greg Lavine, CFA, CFP®
Past performance is not indicative of future results. The opinions expressed are my own and do not necessarily reflect the opinions of Moors & Cabot. Member NYSE, FINRA, & SIPC
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