All Eyes on Washington
Policy changes, including tax reform and deregulation, create opportunity and uncertainty.
The municipal bond market is likely to garner much attention as the Trump administration brings tax reform to the fore. Details are lacking at this early stage, but we expect that headlines about the potential impact of personal tax reform on the existing tax-exempt and alternative minimum tax (AMT) bonds will be a primary driver of increased volatility. This is because tax reform changes the value of the tax exemption, a feature of most municipal bonds. Potential corporate income tax reform, in addition to personal income taxes, could also have significant impact on institutional investor demand, in particular from insurance companies. Monitoring fund flows will be among our top priorities, as they have historically served as a leading indicator of municipal bond/Treasury ratios. Even with an anticipated increase in the role of the private sector to finance infrastructure projects, we expect municipal supply to surge in the second half of 2017 and into 2018. Concurrently, technical weakness may arise as institutional and retail investors digest the details of tax reform. In addition, rollbacks on regulations imposed following the financial crisis may present an opportunity for new products, driven by increased leverage. As a backdrop, with our expectation that the Fed will raise interest rates three times in 2017, issuers could once again revert to issuing floating-rate debt. Overall, uncertainty about federal programs and policies have the ability to overwhelm the market in the coming months.
Tax Reform Could Create Volatility for Municipals
When the top income tax bracket was 50 percent during the 1980s, 30-year AAA-rated municipal bond yields were roughly 84 percent of 30-year Treasury yields as investors priced the tax advantage. The top income tax bracket has declined over the years, diminishing the tax advantage and causing municipal bonds to trade closer to Treasurys of similar maturities. Details of tax reform are unclear, but we expect headlines about its potential impact to create volatility.
Source: TM3, Guggenheim Investments. Data as of 12.31.2016.
After slightly negative returns in the third quarter of 2016, municipal bonds suffered another negative quarter of performance, with the Bloomberg Barclays Municipal index losing 3.6 percent in the fourth quarter. Year-to-date returns for the index ended 2016 in positive territory, however, at 0.2 percent.
During this period of uncertainty, our focus will be on essential A-rated revenue bonds as well as on general-obligation bond issuers that have demonstrated a willingness to address and implement meaningful pension reforms. With several states experiencing a slower rate of tax revenue growth, credit selection will become even more critical as state and local governments adapt to the Trump administration’s policies. In particular, the potential repeal of the Affordable Care Act could cause state and local governments to experience a significant decline in revenues without an immediate replacement in place.
Institutions Gain Share Among Municipal Bond Holders
Potential corporate income tax reform could have significant impact on institutional investor demand for municipals, in particular from insurance companies, which have gained as a share of the municipal market as the share of individual investors has declined.
Source: SIFMA, Federal Reserve, Guggenheim Investments. Data as of 12.31.2016. Figures may not sum to 100 due to rounding.
—James Pass, Senior Managing Director; Allen Li, CFA, Managing Director
Important Notices and Disclosures
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2017, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.
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