INSIGHTS

On January 22, 2018

AAM Viewpoints – The Future’s So Bright (You Better Wear Shades!)

There is a growing consensus amongst bond market participants that 2018 will shape up to be a good year for municipal bonds. We closed out 2017 with strong December performance, making the year one of the best in recent memory. The BBG Barclays Municipal Aggregate Index finished the month up 1.05% and finished the year with a 5.45% gain. 2017 was the fourth straight year of positive total returns for the index and the highest in the last three years. The strong performance reflected long term expectations for significant supply reductions with the passage of the Tax Cuts & Job Act of 2017 (TCJA) signed into law on December 20, 2017. The new tax law, effective as of December 31, 2017, now prohibits advance refunding which was a mechanism utilized frequently by municipalities to manage interest costs and restructure debt. Estimates peg advanced refundings as constituting approximately 10% to 15% of the outstanding municipal market. All things being equal, one would expect higher prices with 10% to 15% fewer bonds to go around. In addition, the new tax law caps the State and Local Tax deduction which makes municipals in states with high state tax burdens all the more valuable. Investors seem to be taking note as municipal ICI bond fund inflows for the week ending January 10, 2018 came in at over $3 billion which was the largest weekly inflow since 2007. We do see ballast for municipal markets in the form of reduced supply in 2018, but prospects for interest rate volatility, the yield curve environment and tight spread levels has us treading cautiously in the new year. We acknowledge the prospects for a bright future ahead but it might make also sense for municipal investors to make sure they are taking adequate precautions. While reduced supply should be a positive for municipal markets, it does not change the fact that risk still exists.

A decade of quantitative easing, low rates and strong bond markets have made it easy to grow complacent with regard to interest rate volatility. Amid otherwise record low volatility, the fourth quarter of 2017 (Q4 2017) included a reminder that this risk is ever present as the short end of the curve was party to one of the sharpest sell-offs we have seen post-2008. The 2-Year AAA municipal benchmark started Q4 2017 at 0.99% and ended both the quarter and the year 57 basis points (bps) wider at 1.56%. The weakness reflected improving growth and inflation metrics which could give the Federal Reserve support for multiple hikes in 2018. At the last meeting of the year, December 13, the Fed projected three rate hikes in 2018 and increased growth guidance for the year. In addition they confirmed that they will be stepping up the monthly pace of balance sheet reductions from $10 billion a month, instituted in Q3 2017, to $20 billion a month in January 2018. Global central banks, most notably the European Central Bank (ECB), are also now discussing the beginning of the end for their Quantitative Easing (QE) programs. Reduced central bank demand for U.S. Treasuries and a Federal Reserve actively tightening carries the potential to put pressure on rates as we move through 2018. As we return to a more “normalized” environment, it bears remembering that the recent run of low rate volatility may be coming to an end.

The December rally, which capped off a strong year, rewarded duration risk. The strongest performance in the municipal market was on the long-end of the yield curve. Where the short-end sold off, the 30-Year AAA municipal benchmark closed out 2017 at the lowest level of the year (2.55%) and was 30 bps tighter in December alone. The benchmark started the year at 3.04%. The strength on the long-end coupled with the sell-off on the short-end has left municipal markets entering 2018 with the flattest yield curve we have seen in the current expansion. Limited supply could help to support longer dated municipals. Still, a bond is a bond is a bond and higher growth and inflation expectations lead to higher long term rates and there are reasons to believe both could improve in 2018. After a weak start, GDP annualized at more than a 3% pace in both Q2 and Q3 2017. Fiscal stimulus in the form of lower tax rates along with healthy corporate earnings could help to support continued expansion. We do expect rates to remain moderated relative to long-term averages, but we are seeing signs of burgeoning inflation. Inflation expectations picked up toward year-end and the 10 Year U.S. inflation breakeven is now back above 2% for the first time since March 2017. Labor markets are exhibiting strength and unemployment is expected to sustain a 4% level through 2020 based on Federal Reserve projections. This could ultimately lead to wage pressure. Inflation pressures are building here in the United States and abroad and a continued uptick in expectations for future inflation could have large implications for bond markets in 2018. We have already begun to see the municipal yield curve steepen from December lows and with Muni-to-Treasury ratios sitting at or near 10-year lows it is hard to envision a scenario whereby volatility on the long-end of the Treasury curve does not translate to volatility in the municipal markets.

Even with concerns over volatility, we see the potential for outperformance in municipals for 2018. It is important to understand, however, that this outperformance may manifest itself on a relative basis versus other fixed income asset classes. There is, with few exceptions, no such thing as a bond that is immune to higher interest rates. With this in mind, we would suggest reviewing municipal portfolios and taking into consideration several factors. First, we would look to diversify maturities across the yield curve. This can be accomplished by laddering bonds. As evidenced by the short-end sell-off and long-end rally to end 2017, yield curves do not move in a parallel fashion. The 10 Year bond ladder is the most tried-and-true method to reduce sensitivity across the yield curve. We would not structure portfolios today with over allocations to specific points along the yield curve. In addition to laddering bonds, we would look to maintain a defensive duration. The compensation for taking on additional duration (i.e. term premiums) were modest at best before the municipal yield curve flattened to end 2018. With the 10 Year AAA benchmark (2.12%) currently at 80% of the 30 Year level (2.71%) with only a third of the duration risk, we do not see extending duration as an attractive risk-to-reward tradeoff. In the same vein, we would maximize coupons with 5% or better structures as this may also reduce sensitivity to interest rates and allow for faster reinvestment at prevailing rates. We would take note of current credit spread levels and defer to higher quality bonds where there is little to no value in stepping down in credit quality. Credit spreads across all U.S. fixed income asset classes are sitting at or near their lowest levels post credit crisis. While robust credit work can still unearth value in today’s market, when there is little compensation for stepping down in quality from AA to A, we would defer to higher quality. Narrow spread levels between credit qualities tends to be an indication that the higher credit quality may be undervalued relative to the lower rated credit. Furthermore, a slow migration to higher quality is our preferred stance as we approach the end of the current cycle. While we are excited about the prospect for municipals in 2018, we approach the market with cautious optimism and would not stray from a disciplined investment approach. The future certainly looks bright, but we would suggest you wear some shades. 



CRN: 2018-0109-6312 R