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
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
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…
Source: S&P as of 10/30/2018.
…that they haven’t been adequately addressing.
Sources: S&P as of 10/30/2018 and Moody’s as of 8/27/2018.
Note: States with either low contributions or a low funded ratio may have recently enacted plan changes, greater contributions, or other changes. Consult with a fixed income specialist prior to making any investment decisions. “Tread water” is defined by Moody’s as making sufficient payments to pension systems to prevent reported unfunded liabilities from growing even when investment targets are met.
Issuers in areas with limited or no economic diversity
General Motors' recently announced plant closures highlight the importance of economic diversity. In late November, GM announced it was closing four different plants, including one in Lordstown, Ohio, a village of roughly 3,200 residents located about 40 miles outside Akron. The Lordstown plant accounts for 9.4% of total county wages and the closure will have a “pronounced negative effect on Trumbull County’s employment base,” in Moody’s opinion. The closures of other GM plants in Detroit; White Marsh, Md.; and Warren, Mich., are all credit negatives for issuers in those areas, as well, but their impact will be less pronounced due to greater economic diversity in those areas, according to Moody’s.
As the economic cycle potentially peaks and turns, we suggest that investors focus on issuers with greater economic diversity, because if there is an economic slowdown, issuers that are not reliant on one industry or company generally have greater economic and financial flexibility. Muni investors can find the issuer’s largest employers in the bond offering documents available on Schwab.com. Please be aware that this information may not be current.
Issuers with poor demographic trends
At their most basic level, issuers in areas with growing populations and a younger educated workforce generally have greater financial flexibility. We suggest caution on areas with aging manufacturing industries, most of which are in the Rust Belt.
Major risks to our view:
- Higher Treasury yields: Stronger global growth or higher inflation expectations could each push Treasury yields higher. Higher Treasury yields could lead to negative total returns for munis.
- A major infrastructure spending package that results in increased muni supply: We expect gridlock with a split Congress, but one area that could garner compromise is an infrastructure spending package. If it results in an increase in issuance of municipal bonds it could produce a tailwind for performance.
- Tax Reform 2.0: Although we’re not anticipating any significant tax law changes in the upcoming year, if there were new laws that lowered tax rates or eliminated the attractiveness of the municipal bond tax exemption, it could reduce demand for tax-advantaged income. Lower demand could cause muni yields to increase more than Treasuries.
- Increased issuance: Increased issuance without offsetting demand should result in higher yields relative to Treasuries and corporates. Higher yields could weigh on total returns since yields and prices move in opposite directions.
¹ Source: SIFMA, as of 12/3/18. Assumes issuance for December 2018 is equal to the average for the 11 prior months.
² Source: S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, percentage change from 2/29/12 to 9/30/18
3 Source: Tax Foundation, as of 6/20/17
4 Source: Center for Retirement Research at Boston College
What You Can Do Next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.