Less-attractive valuations and the potential for tax reform could mean lower returns for muni bonds in the second half of 2017 compared with the first half of the year.
However, in our view, credit conditions for most municipalities appear stable and muni bond yields are attractive relative to fixed income options for high income earners after accounting for taxes
We believe munis still make sense as a core bond position for investors in higher tax brackets, and suggest investors target an average maturity between five to 10 years for the best balance of risk and reward.
It has been an eventful year for muni bonds, with the market delivering surprisingly strong returns. Most muni market participants entered the year expecting yields on municipal bonds to increase more than yields on Treasuries or corporate bonds with comparable maturities, largely due to the potential for lower tax rates and increased infrastructure spending. However, the yield on a benchmark 10-year AAA-rated muni bond fell by 0.51%, compared with just 0.28% for a 10-year Treasury bond. Because of the decline in yields, municipal bonds returned more than 4% for the first half of the year, outperforming both Treasuries and the broad fixed income market.1
Munis have outperformed both Treasuries and the broad fixed income market in 2017
Source: Bloomberg Barclays, as of 6/21/17. See disclosures for index definitions. Past performance is no guarantee of future results.
In the second half of 2017, we do not expect munis to perform as well as they did during the first half of the year primarily due to less attractive valuations relative to Treasuries and other comparable fixed income investments. We don’t believe rates on municipal bonds will increase significantly in the near term and expect they likely will follow the direction of Treasury rates—which we think will trade in a range between 2.0% and 2.5% during the second half of the year. Performance during the second half of the year will likely come from the return from coupon payments and not further price gains. The potential for tax reform could also negatively affect the short-term performance of municipal bonds, as various proposed changes have the potential to reduce the tax benefits that munis offer relative to other investments. However, municipal bonds are still an attractive option for more conservative investors in higher tax brackets.
The drop in yields made munis less attractive
To analyze the relative attractiveness of municipal bonds, we often look at the municipals over bonds (MOB) spread. It is a ratio of the yield on a municipal bond compared to the yield on a Treasury bond of similar maturity—not accounting for taxes. Since the beginning of the year, the 10-year MOB spread has fallen from 96.2% to 85.5%. The lower the ratio, all else being equal, the less attractive munis are relative to Treasuries, before taking into account tax advantages. As the chart below shows, the MOB spreads for all maturities are well below their averages since the end of 2010. For example, at a ratio of 85.5%, the 10-year MOB spread is well below the average since December 2010 of 99.3%.
Relative valuations are below their longer-term averages across the yield curve
Source: Bloomberg, as of 6/21/17.
Note: Average using weekly data from 12/30/10 to 6/16/17.
When valuations are less attractive, the near-term prospects for outperformance are lower. Using data going back to the beginning of 2001, we found that when the 10-year MOB spread was below 90%, municipal bonds underperformed Treasuries by an average of 0.30% over the next six months and 1.35% over the next 12 months. As shown in the chart below, when valuations were worse—85% for example—munis underperformed Treasuries to an even greater degree.
At less attractive valuations, munis have historically underperformed Treasuries
Source Schwab Center for Financial Research, monthly data from 1/31/01 to 5/31/17. Munis are represented by the Bloomberg Barclays Municipal Bond Index. Treasuries are represented by the Bloomberg Barclays US Treasury Bond Index. Past performance is no guarantee of future results.
Tax reform could have a negative impact on muni performance
We think the potential for broad tax reform this year is less likely today than it was at the start of the year. However, it could still occur this year and, if it does, the goal will likely be similar to the proposal that the White House released and commented on in April. As it relates to munis, the administration proposed the following:
- Lower tax rates for investment income. The administration proposed lower federal income tax rates as well as eliminating the 3.8% tax on investment income for wealthier investors that was enacted as part of the Affordable Care Act. If both of these proposals were passed, it would reduce the tax savings benefits that munis offer relative to other forms of investment income and could negatively affect the relative short-term performance of munis. Since 1982, in the year before the top marginal tax rate was lowered, munis underperformed Treasuries by an average of 49 basis points2 (one basis point is equal to 0.01%). When the top federal income tax rate dropped from 69.1% in 1981 to 50% in 1982, munis underperformed Treasuries by 19.5% in 1981.
- Elimination of state and local tax deductions. The ability to deduct state or local taxes from federal income taxes is especially beneficial for individuals in high tax states like California and New York. Eliminating the state and local tax deduction is equivalent to a tax hike on people in these and other high-income-tax states. A tax hike could increase their effective tax rate. At higher effective tax rates, municipal bonds are generally more attractive relative to taxable bonds. Therefore, if the state and local tax deduction is eliminated, and that results in higher effective tax rates for people in high income tax states, it may increase demand for muni bonds in those states. Increased demand would likely result in higher prices and lower yields.
- Elimination of the Alternative Minimum Tax (AMT). Income from some municipal bonds is subject to the AMT. If you have to pay AMT and hold such a bond, your interest income would generally be taxed at the applicable AMT rate, which could be 26% or more. The proposal calls for eliminating AMT. According to Bloomberg, $140 billion, or about 4%, of outstanding munis are covered by AMT, and they yield about a half percentage point more than non-AMT munis. If the AMT is eliminated, you could see yields on munis that were previously subject to AMT fall.
Congress, not the president, sets tax policy, and the final outcome may be different from what President Donald Trump’s administration initially proposed. We do not advocate trading based on potential policies coming out of Washington.
Credit quality is generally stable despite pockets of risk
We are generally positive about credit conditions for tax-exempt issuers and think that trend should continue. For example, state government employment has increased for 28 of the past 30 months on a year-over-year basis, while local government employment has increased for 39 straight months on a year-over-year basis. State and local governments, unlike the federal government, must balance their budgets annually. One way to do this is to reduce expenses, such as employment, if there isn’t enough revenue to meet current expenses. We believe the continued growth in state and local government is a signal that state and local revenues, as a whole, appear stable.
Where are the risks?
The $3.5 trillion muni market defies broad generalizations and not all municipalities are financially healthy. Four situations to watch in the second half of the year:
- Illinois. The state of Illinois recently passed a budget for the first time in more than two years. Operating without a budget for so long left the state’s financial situation in a difficult place. According to Moody’s Investors Service, the state’s inability to pass a budget hurt efforts to address its pension problems and resulted in a backlog of unpaid bills that now account for roughly 40% of the state’s operating budget. We believe Illinois, unlike other states, has unique legislative challenges. In our view, investors shouldn’t avoid other state muni bonds because of the situation in Illinois. However, investors holding Illinois bonds should be prepared for the possibility of further downgrades and heightened volatility during the second half of the year, including potential price declines.
- Puerto Rico. In early May, Puerto Rico filed a petition to put the island’s central government into bankruptcy-like protection largely due to stalled negotiations to restructure the island’s massive debt load. The debt restructuring will likely be a long and complicated process and the outcome is unknown. We don’t think investors should let the situation in Puerto Rico scare them away from investing in other muni bonds. Puerto Rico’s financial debts, unfunded pensions, and demographics are much worse than any other U.S. state, in our view.
- Weak demographics. Municipal bonds are largely about the demographics of the area. We are cautious about areas with negative demographic trends, such as a declining population or a workforce that relies on few industries. These areas often have less financial flexibility to meet their debt payments if the local economy falters.
- Pensions. We believe under-funded pension obligations pose a greater burden on some issuers than others. However, the burden—and the ability to address underfunded pensions—varies widely. During the second half of the year, we expect to hear more stories about pension trouble, but overall, most municipalities have taken steps to address the problems and fund their pension obligations. For more on the issue, please read our recent commentary.
Tax benefits and generally high credit quality still make municipal bonds attractive in our view
Despite the relatively less attractive valuations and potential for tax reform, we still like municipal bonds for high income earners in the second half of the year. Interest on municipal bonds is generally exempt from federal income taxes, and may be exempt from state income taxes as well. For investors in higher tax brackets, even at these less attractive valuations, yields for munis are often greater than after-tax yields for corporates and Treasuries of similar credit quality and maturity.
Munis generally look better at higher tax rates
Source: Bloomberg Barclays, as of 6/21/17.
Note: After-tax corporates assume an additional 5% state income tax and a 3.8% tax for the 33%, 35%, and 39.6% brackets.
What to do now
Although returns during the second half of the year likely won’t be as strong as during the first half, we think that munis still make sense as a core bond position for investors in higher tax brackets. We suggest investors target an average maturity between five to 10 years for the best balance of risk and reward in the muni market. This is slightly longer than our maturity target we suggest today for other areas of the fixed income market. Munis tend to have less volatile credit characteristics. Therefore, we’re more comfortable with investing in munis with longer maturities. Investors using individual bonds should diversify among at least 10 different issuers with different credit characteristics. Another option would be to use a professional solution like a mutual fund or managed account.
1 As represented by the Bloomberg Barclays Municipal Bond Index, Bloomberg Barclays U.S. Treasury Bond Index, and Bloomberg Barclays U.S. Aggregate Bond Index as of 6/21/17
2 Source: Schwab Center for Financial Research calculations using data from the Tax Policy Center and Bloomberg Barclays, data from 1983 to 2015. Municipal bonds are represented by the Bloomberg Barclays Municipal Bond Index and Treasuries are represented by the Bloomberg Barclays Treasury Index.