INSIGHTS

On May 28, 2019

AAM Viewpoints – Short-Term Gain May Create Long-Term Pain

The importance of proper selection of credits and structure is always important to municipal bond investors. During periods of strong market demand, many investors make the mistake of casually “reaching for yield” by purchasing weaker credits or extending further out the yield curve. We would be remiss if we failed to stress the importance of not falling into this trap and making what we believe is an  investing mistake.

The Trump Tax Plan had a variety of far-reaching affects which impacted the municipal bond market over the past year. Most notably the cap on State and Local Tax (SALT) deductions which individuals could apply on their federal tax returns has notably increased demand for tax-exempt municipal bonds. Individuals in high-tax states were most impacted by the cap, however, they were slow to react in terms of investing behavior. Specifically, though it was widely known at the end of 2017 that the cap would impact 2018 tax returns, investors seemed to wait until early 2019 before significantly changing investing patterns. Once investors began to file their 2018 taxes due at the April 15, 2019 deadline, they noticed the impact upon their tax bill and began to aggressively pursue the tax-haven still available in municipal bonds.

The below chart highlights the changes to the ratio of municipal bonds as a percentage of U.S. Treasury bonds in response to the strong demand for paper. The ratio provides a measure of the relative value of tax-exempt municipal bonds as compared to taxable U.S. Treasury debt. Strong demand (more buying) of municipal bonds causes a decline in the ratio. Presently, ratios across the curve are the lowest they have been since 2001. Aggressive buying of tax-exempt paper, especially by investors in high-tax states (CA, NY, and NJ to name a few) have pushed ratios to these long-term low levels.

The below chart helps show the shape of the AAA MMD (Municipal Market Data) Tax-Exempt Municipal Bond Yield Curves as of May 16 for 2016 through 2019. There are a few points worth noting:

• Currently, the shape of the 2019 yield curve (blue line) is the flattest it has been since 2007. As demonstrated on the chart, one can observe its relative flatness as compared to the shape over the previous three years.


• Yields in today’s market are very similar to the yields available three years ago along much of the curve 10-years and longer (current curve – blue line, 2016 curve – red line).


• Yields are currently below the entire curve from one year ago (yellow line), and lower for much of the curve from two years ago (green line) beginning around the six-year maturity area.

Source: Thomson Reuters

Conclusions:

• Due to the relative strength of the municipal market, investors should be cautious about “reaching for yield.” The strength of the market compresses credit spreads and drives down value for long-dated maturities as compared to historical norms. If/when the market reverses course and weakens, investors in weaker credits or longer maturities will experience added pain from the unwinding of the overbought market conditions.


• Over the past several years, we have cautioned against focusing investments upon the very short-end of the curve. As interest rates have been expected to rise, the total return of such portfolios was at risk of (and did) underperform more neutral portfolios. Presently, the extremely flat front-end of the curve (blue line nearly parallel out to six years), diminishes the relative value in this portion of the curve. We continue to suggest minimizing exposure to five-year and shorter dated paper for investors with longer-term time horizons.


• The longer-end of the yield curve is similarly very flat (blue line 20 years and longer). Along with the added risk to underperformance should interest rates rise, we caution against the risk/reward dynamic of this part of the curve.


• We find the most value in the intermediate portion of the yield curve (yellow oval). Notice this is the steepest slope of the yield curve, indicating investors are reasonably compensated for slightly extending maturities within this range. This portion of the curve also reasonably balances the risk/reward characteristics of underperformance due to the lower yields (short-end of blue line) and underperformance due to rising rates negatively impacting performance for bonds more sensitive to interest rate changes (long-end of blue line).


• Though the present geopolitical climate does not pose an imminent threat of higher rates, if investors wish to remain cautious about higher rates at some point over the next several years, this middle-of-the-road approach should balance the desire for better yields while being mindful of poor performance. Don’t purchase weaker credits or longer maturities in an effort to “gain” higher yields in the present, at the risk of suffering greater portfolio “pain” if there is poor or underperformance of the market.

CRN: 2019-0501-7408R  

Investors may want to consider investing in general market municipal portfolios to achieve diversification, greater choice and greater availability of municipal bond offerings.  Depending on market conditions, the investor may be able to achieve a higher yield on out of state bonds to minimize or offset the additional taxes incurred with the new Federal tax laws.  Regardless, some geographic diversification in a municipal bond portfolio may well be worth the higher taxes that may be paid.  As always please consult your financial advisor before making investment decisions.