We believe the federal tax-exempt municipal market may offer attractive benefits to U.S. investors late in this economic expansion, as we expect municipals to outperform taxables on a taxable-equivalent basis as they have in prior tightening cycles.
While the late-cycle performance of municipals has been strong historically, it’s important to consider what might be different this time around. A key shift from past cycles is the sharp reduction in bond insurance on new muni issuance, from over 50% before the crisis to about 4% today. This has, in many ways, transformed the municipal market into a credit market.
We expect credit quality to be a key performance driver when the economic cycle turns, making strong research and active selection critical.
Market Snapshot
Month in Review
The Bloomberg Barclays Municipal Bond Index returned 0.54% in February, bringing YTD returns to 1.30%. The Bloomberg Barclays Municipal High Yield Index performed in-line with the investment grade segment of the market, also returning 0.54% on the month, driven by positive returns in the water & sewer and resource recovery sectors.
Over the month, muni yields rallied across the curve, with yields falling by between 4 and 9 bps. Also, munis outperformed the US Treasury Index over the month. Furthermore, the MMD/UST ratios richened by 4 to 6 percentage points, led by performance on the short end of the curve.
Muni bond mutual fund demand was positive. during the month. Lipper reported $8.42 billion in net inflows in February, bringing year-to-date inflows to $12.41 billion and almost erasing the large outflows that the sector experienced in December of 2018.
February supply was up 1% versus previous the month at $25 billion, and up 39% year-over-year. PIMCO expects 2019 supply to be between $350-370 billion, which is an increase of ~4-10% YoY from the $338 billion in supply in 2018. This supply total remains lower than the trailing five year average, which provides a long term tailwind to the muni sector.
Sector Returns
Munis in Focus – Emphasis on Quality
The run-up to April 15 is a time when many investors reconsider the tax implications of their investments, and many may be facing a different tax backdrop this year following reforms in 2018. This could be the time to look towards investing in municipals. At this point in the cycle, we believe that investors will be best compensated on a risk-adjusted basis by focusing on defensive sectors and assets higher in the capital structure. Investment grade and high yield credit spreads are near post-recession lows, and we are wary of loosening covenants and bondholder protections in some recent deals.
We expect greater performance dispersion among sectors in the next economic downturn. While PIMCO has long favored essential service revenue bonds, not all revenue streams will react equally to changing economic tides, and we prefer issues backed by diversified revenue streams with support from inelastic demand.
In high yield munis, selectivity is increasingly important: Spreads for traditional high yield munis relative to the aggregate index tightened to decade lows in 2018, and we believe investors are not being fully compensated for the risks associated with many credits. We have observed a relative dearth of high yield municipal issuance in the past year, in part due to a run-up of deals in 2017 ahead of the Tax Cuts and Jobs Act in 2018. Broadly speaking, we would expect deals issued late in the expansion to underperform in an economic contraction. The market has reacted negatively to loosening of covenants in some recent transactions, and weaker bondholder protections combined with overly optimistic growth projections could mean more risk and less reward for high yield investors. We would expect still greater sensitivity and poorer performance of such deals in a less accommodative environment.
Municipal/Treasury Yield Ratio
Municipal Market Issuance
DISCLOSURES
Municipal AUM cited herein represents assets of the strategy group in dedicated and non-dedicated portfolios. Past performance is not a guarantee or a reliable indicator of future results.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investors will, at times, incur a tax liability. Income from municipal bondsis exempt from federal tax but may be subject to state and local taxes and at times the alternative minimum tax.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
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