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Financial Industry Insights from Advisors Asset Management
On October 16, 2017
AAM Viewpoints – Municipal Bond Supply and Demand
Today’s municipal (muni) bond market has been anything but predictable. Year-to-date (YTD) metrics have mostly contradicted industry forecasts from the beginning of the year. Yields across the muni curve are well below their 2016 year-end levels (the 10-year AAA benchmark yield is 30 basis points lower), returns have been much better than expected (the Bloomberg Barclays Aggregate Municipal Index is returning +4.98% as of Oct 12), and investors are once again compelled to “reach for yield” in order to meet their income targets. What makes the current state of the market so impressive is that the cards were undeniably stacked against the asset class during the fourth quarter of 2016. The potent tag team consisting of a Trump administration determined to promote growth and reform America’s tax code alongside a Federal Reserve on a mission to raise rates and unwind assets were capable of striking fear among even the most bullish of municipal investors. However, it wasn’t long before both parties lost market credibility and those fears of escalating interest rates began to subside. While positive returns across fixed income markets have been a product of GOP policy shortcomings, “mysteriously” low inflation expectations, and the occasional North Korea-driven fear trade, the tried-and-true low supply-high demand imbalance has been a major force responsible for the municipal market’s outperformance versus other asset classes (i.e. U.S. Treasury Index returning +2.30% through Oct 12). Muni issuer supply in 2017 YTD has been consistently below last year’s pace of issuance. Granted last year’s record-breaking volume of $445 billion could be regarded as an outlier, the muni market has been accustomed to seeing supply volume around the $400 billion mark through the last 10 years. Gross issuance at the end of the third quarter stood at $286 billion. The primary reasons for this shortage are as follows:
These three factors have been largely responsible for the decreased supply totals in today’s municipal market and we think there is a high probability that they could carry over into the next year.
On the other side of the equation, there is strong support that the robust demand for municipal bonds seen this year may also persist beyond 2017. For one, there will likely always be an investor base seeking reliable income with reduced volatility versus most other asset classes. As a prestigious member of the “Two Things Certain in Life” club, taxes are inevitable and so are investors who are looking to minimize its effects (via federal and/or state tax-exempt paper) on their income. In addition, the lower volatility and the historically low default rates of municipal bonds has gradually caught the attention of investors beyond the traditional retail household base. Institutional investors such as banks, insurance companies, and foreign investors have piled into municipals over the past few years and taken market share away from the retail crowd, which has been slowly transforming market demand behavior, liquidity, as well as credit spreads. Lastly, the Baby Boomer generation, with thousands turning 65 years old each day, will most likely be readjusting and de-risking their portfolios in the years to come. There is a good chance that at least a portion of those assets will flow into the municipal bond market.
All else equal, we believe municipal bond investors should feel confident that the basic economics of supply and demand are on their side for the long run. Although the asset class is not immune from occasional credit concerns or rising interest rates, we believe careful portfolio management and thorough research has the potential to minimize these ongoing risks.
CRN: 2017-1002-6175R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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