Key Points
  • Heading into 2019, we see the most favorable risk-to-reward opportunities in higher-rated (AA/Aa and AAA/Aaa) municipal bonds, and in the five- to eight-year part of the yield curve.

  • Although credit quality is generally strong, tight credit spreads don’t justify taking on added credit risk, in our view.

  • In 2019, we expect total returns to be positive, driven by low supply and limited upside to intermediate- and longer-term Treasury yields.

We believe municipal bond investors should take a cautious approach in 2019, amid rising economic uncertainty, concerns about trade friction and worries about the impact of higher interest rates. We favor the five- to eight-year part of the yield curve and suggest focusing on higher-rated (AA/Aa and AAA/Aaa) issuers for an attractive balance of risk and reward due to tight credit spreads and limited upside to intermediate- and longer-term Treasury yields.

Although there are risks in the broader markets, we expect muni returns to be positive in 2019, due to a combination of limited new supply and strong demand for tax-advantaged income. Credit conditions are strong for most muni issuers, although some regions are struggling. Munis should continue to yield more than comparable corporate and Treasury bonds after taxes for high-income earners, making them a relatively attractive option in 2019.

Here are a few things to keep in mind in 2019:

1. The muni market will continue to feel the effects of the 2017 tax law changes.

The 2017 Tax Cuts and Jobs Act limited some types of bonds permitted by issuers. It also limited or eliminated a number of expenses eligible for federal tax deductions. Partly as a result, 2018 muni bond issuance is on pace to be the lowest since 20141. Limited supply supported prices this year and helped munis to deliver higher total returns than most other major fixed income sectors. We expect issuance of munis to remain low in 2019, which should provide a tailwind for performance in 2019.

Returns for munis have bested most other fixed income categories

Year to date returns for municipal bonds were 0.8% as of Dec. 10, below bank loans (2.3%), but higher than agency bonds (0.4%), Treasury bonds (0.1%), securitized bonds (-0.2%), high yield corporate bonds (-0.6%), core bonds (-1.1%), TIPS (-1.3%) and other fixed income classes.

Source: Bloomberg, as of 12/10/2018. See index disclosures for a list of indexes used.

2.  Higher-rated issuers may fare better if the economy peaks and then slows.

We expect economic growth in this cycle to peak and anticipate a potential slowdown in 2019. As a result, muni investors should consider higher-rated issuers (AA/Aa and AAA/Aaa). We prefer higher-rated issuers, not primarily due to credit concerns but because spreads—that is, the additional yield for investing in lower-rated issuers—are historically low. In other words, investors aren’t getting adequately rewarded for taking on additional credit risk, in our view.

Narrow spreads don’t justify taking on added credit risk, in our view

The spread between the AAA index and the AA index is 11 basis points. The spread between the AAA index and the A index is 47 basis points. The spread between the AAA index and the BAA index is 109 basis points.

Source: Bloomberg Barclays AAA, AA, A, and BAA Indices, as of 12/6/2018.

Lower-rated issuers typically have less financial flexibility to pay debt service. During an economic downturn, their finances could be further strained. Although municipal credit quality generally lags that of the general economy, we believe that now is a good time for muni investors to begin preparing for a slowdown.

3.  Focusing on an average duration of five to eight years may offer the most attractive risk-reward balance.

Munis yields tend to move in the same direction as Treasury yields, and we think the rise in Treasury yields is likely near the peak for this cycle. In our 2019 Bond Market Outlook we discuss our view that the 10-year Treasury bond yield may have peaked around the 3.25% level and isn’t likely to move much higher.

We think investors can take advantage of higher longer-term rates while incorporating our view that intermediate and longer-term interest rates may have already peaked by targeting an average duration between five and eight years. Also, yields relative to Treasury yields are more attractive for intermediate to longer-term munis.

Keep in mind that an average duration between five and eight years means that you will have some bonds that are shorter and longer than that range. By targeting an average duration between five and eight years, you can take advantage of the more attractive valuations on the longer end of the muni yield curve, while still not investing in munis with maturities that are too long. Bonds with longer maturities are more sensitive to rising interest rates.

Mutual fund and ETF investors can find the average duration of their funds on the “Research” section on Schwab.com.

4. Muni credit quality remains positive despite some pockets of risk.

Credit quality for municipal issuers historically tends to lag that of the general economy, thus we expect that credit conditions for most muni issuers should continue to remain strong this year.

For example, national home values have increased over 50% since their lows in early 20122 and are above their highs just prior to the 2008 credit crisis. Although property taxes are based on the assessed value, which can be different from the market value, this is a positive for many cities, counties, and school districts, as property taxes are a large source of revenue.

Moreover, the improving financial health of the average consumer—evidenced by the strong labor market, improving household net worth, and moderately increasing wage growth—supports retail activity, and resulting sales and income taxes. Sales and income taxes account for almost half of all tax collections for state and local governments, with variations by state and government3.

Although we believe that credit conditions for most municipal issuers should remain favorable in 2019, we suggest caution in a few areas:

Issuers with large unfunded pension obligations that they haven’t been adequately addressing

The severity of unfunded pension liabilities varies by issuer and we don’t think that investors should avoid the muni market as a whole due to fears of unfunded pensions. We do suggest caution with issuers with large unfunded pension liabilities that they have not been addressing or that are legally difficult to address.

A positive is that most issuers have been taking steps to address their pension liability. Overall, 74% of state plans and 57% of local government plans have made changes—such as reducing benefits or increasing contributions—to their pension systems since the 2008-2009 financial crisis4.

Most states also have diverse revenue streams and the financial flexibility to meet pensions, debt service, and other essentials. Payments toward pensions, other post-employment benefits (OPEBs), and debt service combined average 31.3% of state general fund expenditures. However, as illustrated in the chart below, there’s variability among states. States with a lower percentage have greater financial flexibility.

Source: S&P, as of 9/17/2018

The finances of issuers with large unfunded pension liabilities may be further strained if there is a prolonged equity market decline in 2019 because it would likely result in a deterioration of a plan’s funded ratio. Issuers would either have to increase contributions or reduce benefits—which can be legally challenging—to increase the plan’s funded ratio.

We’re cautious on issuers with large underfunded pensions…

States with a pension funded ratio of below 50% include Colorado, Illinois, Kentucky, Delaware, and Connecticut. States with a pension funded ratio of 80% or greater include Washington, Oregon, Utah, and Florida.

Source: S&P as of 10/30/2018.

…that they haven’t been adequately addressing.

States with pension contributions as a percent of “tread water” that are below 70% include Colorado, Texas, Minnesota, Kentucky, New Jersey and Massachusetts.