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2018 Mid-Year Municipal Bond Outlook: Headwinds on the Horizon

Key Points
  • Munis are less likely to outperform Treasuries in the second half of the year due to technical factors related to tax reform.

  • We have a favorable view of the muni market, and think credit conditions for most state and local governments are either stable or improving despite some pockets of stress.

  • We suggest muni investors focus on higher-rated munis, and target an average duration between five and eight years.

Munis outperformed both Treasuries and corporate bonds during the first half of 2018, but we think that trend could reverse in the second half of the year. We see some headwinds on the horizon for the muni market. However, we think focusing on higher-rated munis, and keeping average duration within five and eight years, can help investors mitigate the effect of those headwinds on their portfolios.

Despite the headwinds, we have a favorable view of the muni market

Munis are still an attractive investment option for high-net-worth investors, in our view. Although we think we are in the later stages of the economic cycle, and that could strain credit conditions for some municipalities, credit quality for most municipal bonds is already generally high to begin with. In fact, nearly two-thirds of the munis in a broad municipal bond index are rated either AAA or AA1—the two highest rungs possible.

Moreover, municipal bonds continue to yield more than Treasury bonds and corporate bonds, with comparable ratings and maturities, after taxes for higher income earners, reinforcing their position as a relatively attractive option for a bond allocation in taxable accounts. As shown in the chart below, munis yield more than corporate bonds after taxes for investors in the 32% and higher federal tax brackets.

Munis generally yield more than corporate bonds for high-income earners

 

Source: Bloomberg Barclays Municipal Bond Index and Bloomberg Barclays Corporate Bond Index, as of 6/26/18. Corporate bonds assume a 5% state income tax and an additional 2.8% tax for the 32% and above brackets.

Last, the recent rise in short-term yields has enhanced the attractiveness of municipal bond yields on an absolute basis. Today, the yield for a one-year AAA-rated municipal bond index is 1.5%. For comparison, in fall 2017 a seven-year AAA-rated index was yielding 1.5%. Today, investors can get higher yields without having to take on a large amount of interest rate risk.

Focus on higher-rated munis

Although we don’t anticipate a recession any time soon, we believe we are in the later part of the economic cycle, and think muni investors should start preparing for a potential economic slowdown. Lower-rated muni issuers tend to have less financial flexibility to meet debt service, and during an economic slowdown their finances may be further strained, which could result in ratings downgrades. When a bond is downgraded its price generally falls. Moreover, today the additional compensation—called a spread—for investing in lower-rated parts of the investment-grade muni market is the narrowest it has been since the 2008 credit crisis. Today, we think higher-rated munis—AAA and AA—offer a more attractive risk/reward balance.

Spreads have been narrowing since the 2008 credit crisis

Source: Bloomberg Barclays Indices, as of 6/22/18.

Munis have outperformed Treasuries and corporate bonds so far this year

Munis outperformed Treasuries and corporate bonds largely due to tax reform, but that trend could reverse. When the 2017 tax reform was being debated, Congress proposed eliminating issuance of certain types of tax-exempt munis. Due to the potential restrictions, bankers rushed to get deals done that would have otherwise likely been done in the first half of this year. As a result, issuance of munis spiked in the latter part of 2017 and largely dried up at the beginning of 2018. The limited supply of new munis this year helped the municipal bond market outperform both the corporate and Treasury markets. However, due to the rise in yields for long-term Treasuries, investment-grade muni returns are still negative year to date.

Although total returns are negative, investment-grade munis have outperformed Treasuries and corporate bonds year to date

Source: Bloomberg Barclays Indices, as of 6/22/18. Past performance is no guarantee of future results.

The level of new munis coming to the market has since returned to closer to its longer-term average, which will likely make it harder for munis to outperform Treasury and corporate bonds going forward. However, we believe returns will likely be positive for the second half of the year, because we don’t think yields for longer-term Treasuries will increase as much as they have during the first half of the year. Municipal bond yields tend to follow the direction of Treasury bond yields. For more on the outlook for the Treasury market read Kathy Jones’ recent commentary.

The amount of munis coming to market has returned to more normal levels

Source: Bloomberg, as of 6/22/18.

Relative valuations remain stretched

Relative value in the municipal bond market is often measured by the municipals-over-bonds (MOB) spread. The spread compares the yield on an AAA-rated municipal bond to the yield on a Treasury bond of similar maturity before taxes. All else being equal, a higher ratio means munis are more attractive relative to Treasuries.

As shown in the chart below, the MOB spread for all maturities is below their five-year averages. Relative valuations for shorter-term munis are even further below their longer-term averages compared to longer-term munis.

Muni valuations are below their longer-term averages

Source: Bloomberg, as of 6/22/18. Note: Average for 1-year maturity is not to scale.

The lower the MOB spread, generally, the less attractive munis are relative to Treasuries.  Historically, they’ve also been less likely to outperform Treasuries when the MOB spread is lower, as shown in the chart below. For example, when the 10-year MOB spread has been below 90%, munis have underperformed Treasuries by 1.3% on average over the subsequent 12 months. For comparison, when the 10-year MOB spread was above 100%, munis have outperformed Treasuries by 3.1% on average over the following 12 months. The 10-year MOB spread is currently 85.5%.

Munis are less likely to outperform Treasuries at lower relative valuations

Source: Schwab Center for Financial Research as of 5/31/18. Data obtained by Bloomberg. Monthly data from 1/31/01 to 5/31/18. Municipal bonds are represented by the Bloomberg Barclays Municipal Bond Index and Treasury bonds are represented by the Bloomberg Barclays Treasury Bond Index. Past performance is no guarantee of future results.

We believe that coupons and not price appreciation will drive returns for municipal bonds in the latter half of 2018. Longer term, we also believe that we are near the peak of the cycle of rising rates for intermediate- and longer-term bonds. Therefore, we don’t view further increases in interest rates as being a major headwind for munis in the latter half of the year.

What to do now

Review your fixed income portfolio including your allocation to muni bonds. While we believe interest rates for intermediate- and longer-term Treasuries are near peaking in this recovery cycle and into the end of 2018, we suggest that muni investors focus on higher-rated bonds and issuers due to a potential pending economic slowdown and credit risk.

 

1 Source: As represented by the Bloomberg Barclays Municipal Bond Index, as of 6/22/18

 


 

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.
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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.

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.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

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

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.

Bloomberg Barclays Municipal Bond: High Yield (non-Investment Grade) (“High-yield munis”) is composed of non-investment grade U.S. municipal securities with a remaining maturity of one year or more.

Bloomberg Barclays U.S. Aggregate Bond Index (“Diversified fixed income index”) is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.

The Barclays U.S. Treasury Index (“Treasuries”) measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The Bloomberg Barclays U.S. Corporate Bond Index (“Investment grade 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. Corporate High-Yield Bond Index (“High-yield corporates”) 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.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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