Municipals: Watching Election-Season Tax Debates
Talk of tax reform will likely create uncertainty in the otherwise-robust municipal bond market.
While we agree with the old adage that “all politics is local,” we are paying even greater attention to the national and global political process. Notable events of the second quarter include the establishment of the Puerto Rico fiscal control board, the approval of Illinois’ six-month stop-gap budget that temporarily ended a 12-month budget impasse, and the Brexit referendum. With the presidential and local elections less than three months away, we expect the municipal market will face headwinds as each party begins to float trial balloons with regards to tax reform. In California, if Prop 55—a referendum on extending to 2030 certain temporary incremental increases in both income and sales taxes—does not pass, it would create a significant funding gap starting next year in the most populous U.S. state and largest issuer in the municipal market. Although the uncertain outcome of the vote will likely cast a shadow over the market, we expect to continue to see strong market demand from both traditional investors and new participants, such as international investors looking for positive absolute yields. With the drop in new supply in July, this demand will likely provide strong support to the market.
Muni Issuance Plummets in July Despite Record Low Yields
Municipal bond issuance fell by around 45 percent from June to July, the largest monthly dip since January 2011 when the Build America Bonds program expired, despite record low rates in the market. Issuers’ reticence is most likely a result of uncertainty over the election outcome, as well as a general aversion to further indebtedness.
Source: The Bond Buyer, Thomson Reuters, Bloomberg, Guggenheim Investments. Data as of 8.9.2016.
In the second quarter of 2016, the Barclays Municipal Bond index recorded a gain of 2.6 percent, with the Barclays Revenue Bond index outperforming the General Obligation Bond index by 50 basis points. As 30-year Treasury yields set record lows, bonds with greater than 22-year maturities returned 6.8 percent for the quarter compared to quarterly returns of only 2.3 percent for bonds with four to six years remaining. Mirroring the rally in risk assets, BBB-rated municipal bonds were also the best-performing rating group in the municipal market, with a total return of 3.2 percent compared to quarterly returns of 2.2 percent, 2.4 percent, and 3.1 percent for AAA, AA, and A-rated municipal bonds.
The reach for yield by going out in duration is evidenced in every rating category in the municipal bond market. For example, 30-year BBB general obligation bonds offer only 1.4 percent additional yield over five-year BBB general obligation bonds, a decline from 2.1 percent premiums in February. At this point, given the significant flattening of the curve on the long end, there is little reward for allocating to longer durations.
Declining Value at the Long End for All Ratings
The reach for yield by going out in duration is evidenced in every rating category in the municipal bond market. For example, 30-year BBB general obligation bonds offer only 1.4 percent additional yield over five-year BBB general obligation bonds, a decline from 2.1 percent premiums in February.
Source: Municipal Market Monitor (TM3), Guggenheim Investments. Data as of 7.22.2016.
—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.
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