Municipal Bonds: Finding Value Amid Volatility

After a strong start to the year and a relatively quiet summer, the municipal market closed the third quarter and entered the fourth with a flurry of activity. Hurricanes Harvey, Irma, and Maria presented meaningful implications for key parts of the market, and the Trump administration released its initial proposal for tax reform. As if those events weren’t enough, President Trump’s comments regarding the “wiping out” of Puerto Rico’s debt set many of the Commonwealth’s bonds on an especially volatile course.

As we have discussed at length in previous pieces, a number of factors contribute to the inefficient nature of the municipal market, increasing the influence that these kinds of headlines can exert on bond prices, particularly in the short term. Following an active and opportunistic approach, we seek to capitalize on such inefficiencies, and this continues to be the case following recent market events.

Puerto Rico: Benefiting from a Focus on Insured Credits

Regarding the full impact of Hurricane Maria, the situation is fluid and highly challenging for Puerto Rico’s residents, and outcomes are uncertain at this stage. There’s no denying that financial and economic conditions in Puerto Rico are bleak, especially in the aftermath of Hurricane Maria. That said, Puerto Rico has faced significant fiscal challenges for several years. Recognizing these challenges early on, we approached the Puerto Rico debt market very carefully, and the vast majority of our holdings in Puerto Rico municipals is wrapped with monoline insurance. As the market has distinguished between enhanced and unenhanced credits, the insured Puerto Rico segment of the municipal market has performed relatively well this fall. As Figure 1 illustrates, this presents a stark contrast with many uninsured bonds, which continue to trade at distressed levels. Over time, our portfolios have benefitted from the emphasis on insured credits, and we continue to feel comfortable with our positions and with the insurers that we have chosen.

Tax Reform: Potential Positives for the Municipal Market1

While it’s too early to definitively sort out the winners from the losers in terms of tax reform, we do see a number of potential positives for the municipal market. To recap, in late September, the Trump administration unveiled the framework for tax reform. While many details will need to be ironed out by Congress in the ensuing months, the proposal reduces federal income tax brackets from seven to three (12%, 25%, and 35%), while also including a provision that would allow for an additional top rate that would apply to the highest earners. What’s more, the proposal calls for repealing the deduction of state and local taxes (SALT) that primarily benefits high earners in states with high income tax rates. This implies that municipal bonds from such states could benefit from increased demand, as their tax-exempt characteristics would become incrementally more valuable to investors. As Figure 2 illustrates, this would be the case in states such as California and New York, two areas of the market where we continue to find attractive investment opportunities.

Another proposal worth mentioning is the recommendation to repeal the Alternative Minimum Tax (AMT), in which case, we believe that the spread on AMT bonds would continue to narrow. While such exposure is fairly limited across our portfolios, we do hold some AMT bonds that could benefit from this theme.

Looking Ahead

While pockets of stress do exist in the municipal market and could continue to influence performance dynamics, we believe that municipal bonds still present an attractive, relatively low-risk investment option for those looking to benefit from tax-exempt income. Despite negative headlines in recent weeks, we would note that many municipalities have improved fiscal positions and are benefiting from increased tax revenues. Additionally, many municipalities have taken positive steps towards addressing their pension liabilities. At MacKay Municipal ManagersTM , we have targeted these municipalities and believe that we remain well-positioned to capitalize on opportunities and navigate risks in today’s market environment.

1 Neither MacKay Municipal Managers™ nor MacKay Shields LLC advise clients on tax matters.

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