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2019 Municipal Bond Market Outlook: A Cautious Approach

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

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.

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 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

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

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The S&P/LSTA U.S. Leveraged Loan 100 Index (“Bank Loans”) is a market value-weighted index designed to measure the performance of the largest 100 issues in the U.S. leveraged loan market.

The ICE BofA Merrill Lynch Fixed Rate Preferred Securities Index (“Preferreds”) tracks the performance of fixed-rate USD-denominated preferred securities issued in the U.S. domestic market.

The Bloomberg Barclays U.S. Corporate Bond Index (“IG Corporates”) covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index (Agg).

The Bloomberg Barclays U.S. Treasury Index (“Treasuries”) includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have $250 million minimum par amount outstanding and at least one year until final maturity.

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index (“High-Yield”) covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays U.S. Municipal Bond Index (“Investment grade municipals”) is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The Bloomberg Barclays U.S. Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.

The Bloomberg Barclays Emerging Markets USD Aggregate Bond Index  (“Emerging Market Bonds”) includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.

The Bloomberg Barclays Securitized Bond Total Return Index (“Securitized”) represents the securitized section of the Barclays US Aggregate.

The Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index (“TIPs”) is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

The Bloomberg Barclays International Developed Bond Total Return Index (“International developed”) provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. Bloomberg Barclays International Developed Bond Total Return Index ex US excludes the U.S. Aggregate component.

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