By John Bonnell, CFA, Senior Portfolio Manager of Equity Investments
Strengthening demand, so-so supply – this is the municipal bond market in a nutshell.
The result of this imbalance is rising muni prices, as more cash in the market chases fewer securities available for purchase. This has been good for muni investors on the whole – total return for the asset class was just under 4% through the first five months of the year; this compares to a 0.2% total return for all of 2016.
Total return on a muni bond investment has two components: capital appreciation and current income. Most of the return so far in 2017 has been due to short-term capital appreciation as bond prices rise due to high demand and short supply.
We’re happy to get the price appreciation, but as long-term investors, we focus more on the income component. Over time, income will generate the lion’s share of a bond’s total return. The supply-demand mismatch, however, is driving down yields – yields fall as prices rise – even as the Federal Reserve continues to raise interest rates.
Much of the new demand for munis is actually old demand – a return of investors who had fled the market after the November election.
Bond investors worried in late 2016 that stronger economic growth would lead to higher interest rates. Municipal bond investors also perceived tax cuts by the new administration would diminish the value of tax-exempt interest, and an ambitious infrastructure program might flood the muni market with new supply. Now it seems that tax-rate changes may take longer than originally thought, and how the infrastructure program will be funded is still unknown. As a result, those nervous investors who ran for the post-election exits now feel safe coming back.
The stiff competition for munis is driving many yield-starved investors to put money into lower-rated corners of the municipal bond market. We think many of these bonds carry substantial risk, which highlights the importance of fundamental, bottom-up credit research.
Other sources of muni demand include investors seeking to reinvest the proceeds of tens of billions of dollars in redeemed bonds, and investors concerned that the U.S. economy may be weakening. GDP growth in the first quarter of 2017 was a paltry 1.2%. This same trend is affecting Treasuries – the Fed has raised short-term interest rates three times since December, but worries about a slowdown keep pushing down yields for longer-dated securities.
On the supply side, long gone is last year’s upswing in issuance – according to a report from Barclays, the total value of muni bonds issued through May is down 13% from the same period in 2016. Refundings, which involve refinancing existing muni debt at a lower interest rate, still represent most of the available stock.
State and local government revenues in the first quarter were up 4% over the same period in 2016. Still, issuers are reluctant to issue new debt for expanded infrastructure or to catch up on deferred maintenance work on existing public assets – this is contributing to the muni supply shortage. These same governments are trying to deal with the huge gap between their current pension funding and their future pension liabilities – this is a long-term issue that may continue to affect muni bond supply (and prices) in the years ahead.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are suited for you based upon your individual goals, objectives, risk tolerance and time horizon.
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