Munis, Circa 2016
Reminiscent of the summer of 2016, the municipal bond market continues to benefit as U.S. Treasury yields fall to multiyear lows and investors scoop up securities with positive yields in a negative interest rate world. (Negative-yielding bonds represent approximately $13 trillion in assets.) Year-to-date positive inflows entering the municipal market total approximately $46 billion, a modern-day record.1 We believe the $10,000 cap (per household) on the state and local tax (SALT) deduction, along with a dovish Fed, continue to be catalysts for the record-breaking positive inflows entering the municipal market.
Municipal Fund Flows Have Been Sharply Positive
Net Fund Flows, $ Billions
Source: Bloomberg. Data through June 2019.
Global Supply of Bonds Yielding Below Zero Hits $13 Trillion
“Kilometers are shorter than miles. Save gas, take your next trip in kilometers.”
— George Carlin
The FOMC seems to be telegraphing that it will lower rates this summer in the face of a slowing global economy and uncertainty related to the U.S.-China trade war. This “insurance cut,” should it help sustain the current recovery, would transpire with stocks near record highs and longer-maturity U.S. Treasury yields near historical lows. Short-term rates, which are most sensitive to FOMC policy, will likely fall, but reducing them could stoke inflation and potentially lead to higher longer-term rates, resulting in a steeper yield curve.
The Liquidity Premium
The market once again is witnessing 5% coupon bonds priced comfortably above $120 at longer maturities. Since the premium coupon is coveted for its above-market income stream and defensive qualities, high-coupon bonds tend to be much more liquid and less volatile than par bonds of similar maturities in a rising rate environment. Throughout the spike in rates witnessed in early 2018, the volatility of par bonds increased as some issues became subject to de minimis tax treatment—a negative tax consequence. This makes par coupon bonds less desirable in the marketplace and can cause them more price erosion than premium bonds with like maturities.
The municipal asset class remains one of the few places where investors can earn tax-free income. As individuals continue to feel the full impact of tax reform and the loss of deductions, municipals remain the beneficiary of supportive fund flows. Peak reinvestment season is well underway and should continue to support municipal outperformance versus U.S. Treasuries, given a large projected summertime net negative supply (more maturing bonds by value than new bonds being created). Looking past summer, we believe an increase in supply would actually prove favorable for the market, as sometimes this can generate demand and enhance price discovery. Additionally, while relative valuations versus 10-year Treasuries look “fair” (currently 80%), we believe the impact of tax reform has repriced municipal-to-Treasury ratios to lower levels, creating a compelling entry point for investors.