KEY TAKEAWAYS

  • Municipal bonds have outperformed broad high-quality fixed income since early 2017.
  • Credit quality trends remain positive and defaults remain low as the market adjusts to lower supply post-tax plan.
  • Valuations relative to Treasuries are quite elevated as a result.

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Municipal bonds have held up well year to date, given the significant rise in interest rates across the yield curve, leading to expensive valuations by some measures. The Bloomberg Barclays Municipal Index has notched a total return of -0.9% year to date through May 24, 2018. The Bloomberg Barclays U.S. Aggregate Index, a broad proxy for high-quality bonds, returned -2.2% over that same period. Since early 2017, municipals have outperformed by even more, at 4.5% vs. 1.2%. This has richened municipals relative to Treasuries, as evidenced by quite low municipal to-Treasury yield ratios [Figure 1] (the 10-year ratio has been below current levels just 5.6% of the time over the last 10 years). So while the outperformance over the last 18 months has been notable, it has left municipals on the expensive side relative to Treasuries.

SINKING SUPPLY

One tailwind for the municipal market year to date has been supply—specifically the lack thereof. Changes to rules around what types of municipal issues qualify for tax-free treatment are partially responsible. While only advance refunding bonds were denied tax-free treatment in the 2017 Tax Cuts and Jobs Act, markets were concerned that private activity bonds would similarly be denied tax-free treatment. As a result of this uncertainty, the fourth quarter of 2017 saw very heavy municipal supply ahead of the bill’s likely passage, which weighed on the market. However, we’ve seen lower-thanaverage supply year to date as a result; and that, coupled with consistent demand, has helped municipals outperform the broad high-quality bond market so far this year.

LEGISLATIVE CROSSWINDS

One factor driving optimism within the investmentgrade municipal market is their new designation as high-quality liquid assets (HQLA) to satisfy capital requirements on banks’ balance sheets. Postfinancial crisis regulations have mandated that banks hold certain amounts of cash and/or other securities on their balance sheets, relative to the size of the bank and its lending practices. This is to ensure they have sufficient cash, or securities that can easily be converted to cash, on hand in case of an economic crisis. Various types of securities, such as Treasuries, had previously been acceptable as HQLA. Now that investment-grade municipal securities have been designated as HQLA, demand from banks could increase, all else equal, providing a tailwind for the municipal market overall.

Other legislation may be counteracting that effect, however. Because of the cut in overall corporate tax rates to 21%, municipal bonds are not as attractive as they previously were, relative to other investment options such as similar-quality corporate bonds. Lower individual tax rates may also lessen demand from top income earners. Having said that, the HQLA designation is a small positive for municipal demand, all else equal.

POSITIONING PREFERENCES

With approximately 1 million individual issues outstanding, the municipal market is very complex. Active management may add value in the municipal space by overweighting certain segments of the market and underweighting areas that could pose risks for investors. Our preferences for managing interest rate risk in municipal investments mirror our views in other segments of fixed income. We think appropriate investors should consider portfolios with intermediate, slightly below benchmark duration (interest rate sensitivity). By doing so, investors may be able to limit the impact of rising interest rates on their portfolios while simultaneously retaining the potential diversification benefits of high-quality fixed income, because the diversification benefit may not be as pronounced with very short-term municipal debt.

CONCLUSION

Municipal defaults remain historically low and credit conditions for municipalities are stable, but issues remain in states with budget concerns and underfunded pension liabilities. Investors should remain vigilant against these and other risks by considering active management or, at the very least, employing a meticulous security selection process.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax free but other state and local taxes may apply.

Active management involves risk as it attempts to outperform a benchmark index by predicting market activity, and assumes considerable risk should managers incorrectly anticipate changing conditions.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

INDEX DEFINITIONS

The Bloomberg Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year.

The Bloomberg Barclays U.S. Aggregate Credit Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate, taxable corporate bond market.

The Bloomberg Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investmentgrade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

This research material has been prepared by LPL Financial LLC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by Any Government Agency | Not a Bank/Credit Union Deposit.

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