Municipal Bond Outlook: What Investors May See in 2017

Key Points

  • We expect continued volatility in the municipal bond market in early 2017, driven by investors' post-election expectations for lower tax rates and ramped-up bond issuance to support infrastructure spending.
  • However, investors should be cautious: Tax policy hasn’t changed yet, nor have we seen state or local politicians express eagerness to boost borrowing.
  • Tax-exempt income remains attractive for many investors. Munis still offer higher after-tax yields than other comparable bonds, and may continue to do so even if tax rates decline. Periods during which muni yields rise above yields on comparable Treasury securities could provide attractive entry points for investors in 2017.

What is the outlook for municipal bonds for 2017? Since early July, rates for municipal bonds have risen. They especially shot up following the election, primarily due to rising U.S. Treasury bond yields, but also, in part, to concerns about the potential for increased infrastructure spending and possible tax cuts.

The sharp rise in yields has been tough to stomach for existing bondholders, but it's not unprecedented. We expect the volatility to continue as the market navigates the potentially changing landscape, but the devil is in the details and there have been no major policy changes for the municipal market yet. We would caution investors against making hasty decisions. We think rising interest rates could present an opportunity for long-term investors looking for higher after-tax yields.

The rise in rates has been swift, but not unprecedented

There has been much attention to the recent rise in interest rates, with many investors believing munis have been harder-hit than other sectors of the bond market—Treasuries, in particular—due to the results of the 2016 U.S. elections. Since November 8, yields on most fixed income sectors have risen, resulting in negative total returns. Nevertheless, munis have actually outperformed Treasuries since the election, posting a return of -3.1% compared with -3.3% for Treasuries.

Although negative, returns for municipal bonds have fared better than Treasuries

 

Source: Bloomberg, as of 12/27/16. See disclosures for index descriptions. Past performance is no guarantee of future results.

A tax-rate cut would not be as damaging as a threat to munis' tax exemption

With a Republican-controlled Congress and White House, the likelihood of lower federal tax rates has increased, in our view. Both President-elect Donald Trump and congressional Republicans have proposed changes that would lower income taxes as well as reduce taxes on investment income. One of the primary benefits of municipal bonds is that they pay interest income that is often exempt from federal income taxes, which make them an attractive option for investors in high income tax brackets. We believe that a cut in top tax rates would be less damaging than a threat to the municipal bond tax exemption. Lowering federal tax rates but not eliminating the tax exemption would reduce the attractiveness of munis for their tax advantages. However, eliminating the tax exemption would wipe out munis' tax advantages, likely causing yields to rise (and prices to drop) to account for the lack of tax benefits.

But a threat to the exemption appears unlikely to us. The incoming administration supports infrastructure spending, and tax incentives to do it. Cutting the muni exemption would work against this. Trump team members also have said they supported lower tax rates, not higher. A cut in the exemption would be equivalent to a tax increase for high-income investors. Trump also reportedly said that he supports keeping the municipal tax exemption, according to a group from the U.S. Conference of Mayors following a meeting with the president-elect in December. 

Tax rates would have to drop substantially for munis to lose their tax appeal

Although federal tax rates may decline, thereby reducing the tax benefits that munis offer, we believe muni yields remain attractive relative to those on corporate or Treasury bonds. For example, a 10-year AA-rated municipal bond currently yields 2.73% and a 10-year AA-rated corporate bond yields 3.42%. If the investor pays federal tax of 15% plus an additional estimated state tax of 5%, the after-tax yield on both the corporate and municipal bonds are nearly equal. Even though tax rates may drop, they would have to drop to below 15% to make after-tax yields on munis less attractive than those of their taxable counterparts. As the chart below shows, federal tax rates would have to drop more than 15% to make munis less attractive at different credit ratings.

At federal tax rates above 15%, after-tax yields for municipal bonds are greater than their taxable counterparts

Source: Bloomberg, as of 12/27/16.

Note: The "after-tax" yield for corporate and Treasury bonds is found by calculating the yield on corporate or Treasury bonds times (1 – the tax rates). Corporate bonds assume an additional 5% state tax rate.

The benefit to municipal bonds isn’t limited to taxes

Although a primary feature of municipal bonds is their tax benefits, their generally strong ability to pay timely interest and principal payments is also a big benefit. For example, Moody’s Investors Service found that the probability that a lower-rated investment-grade municipal bond will miss a timely principal or interest payment in the next year is only 0.4%, compared with 4.0% for a corporate bond of similar credit quality.1 Going forward, we believe munis will continue to exhibit the strong credit quality that they have shown historically. However, the muni market is nearly $3.5 trillion in size and defies broad generalizations. Although we think the historical strength of the muni market will continue, it’s worth noting that some municipalities may face financial difficulties going forward.

Increased infrastructure spending may not mean traditional muni bond issuance

It appears that the incoming Trump administration’s infrastructure proposals may focus on federal spending combined with tax incentives and programs to encourage private, for-profit projects to improve the nation’s infrastructure. The feasibility of this, given prior efforts to encourage such partnerships, is less of an issue than the potential impact on muni markets. We do not view a federal policy shift toward increased fiscal stimulus or support for infrastructure as a factor driving increased or decreased supply of tax-exempt muni bonds. However, without more detail, it is very difficult to estimate the impact of the various proposals.

We think the recent rise in interest rates provides a better entry point for longer-term investors

Although rising interest rates result in falling prices and often negative total returns in the short term, higher interest rates are actually beneficial for longer-term investors, because they provide greater income. Over time, we found that most of the total return for a bond portfolio is due to the return from coupon payments, not changes in prices.

Yields for munis have moved closely with Treasuries

Source: Municipal Market Advisors. AAA-rated Municipal General Obligation Consensus 10-year yield and Generic U.S. 10-year Government Note yield, weekly data as of 12/27/16. Past performance is no guarantee of future results.

Should investors be buying now?

Relative value has improved, but muni markets may not have yet fully absorbed all the news or potential for future tax cuts, meaning relative valuations may have room to increase more. To analyze the attractiveness of munis relative to Treasuries, we watch the municipal-over-bond spread closely. It compares the yield for a AAA- rated municipal bond before taxes relative to the yield on a Treasury bond with a comparable maturity date. We think levels between 100% and 120% of Treasuries provide good entry points. We may not see those levels, but if we do, it is a good time for long-term investors to look for opportunities.

We believe muni-over-bond yield ratios above 100% provide attractive entry points

Source: Bloomberg, weekly data as of 12/27/16.

What to do now

For investors in taxable accounts, 2017 may present attractive entry points to buy municipal bonds from a relative-value perspective—after taxes—even taking into consideration the possibility of tax cuts, in our view. The landscape for municipals has yet to change, and although there have been different proposals, nothing major has changed yet. We caution investors against overreacting, and believe that munis still have a place in the portfolios of investors looking for tax-advantaged income.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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Important Disclosures