Market Insights for 2018 - A Year of Return & Risk

We believe that tax reform and the implementation of new regulatory policies will present investment opportunities for municipal investors who are well-positioned, but will also present risks for those investors who fail to adjust to the new investment environment. The traditional approach of being a passive, intermediate maturity focused investor seeking income only is no longer suitable. We believe that tax reform will result in a structural shift in the municipal market. Historical patterns of issuance will change as will the instruments issued. Some investors will shift away from municipal bonds, while others will take on more prominent roles. Overall demand will likely increase. Concerns over limitations on earning tax-exempt income have been put to rest for likely the next several years. Likewise, we expect retirees, a growing demographic within the population, to continue to increase their exposure to fixed income and, more likely, municipal bonds. Investor demand for liquidity and better price transparency will favor rated bonds and diminish the value of non-rateds. Anticipating all of these changes, we believe an active, relative value approach based on fundamental research will prove to be the prudent approach going forward.

1. Taxable Municipal Issuance Accelerates
We expect taxable municipal issuance could double to ~ $60B annually. We believe that low rates, tight credit spreads and demand for yield should keep taxable municipal yields low. Issuers will likely refinance their higher cost tax-exempt debt with taxable municipal bonds, overcoming the elimination of tax-exempt financed advanced refundings by the 2017 tax reform act. The increased volume of taxable municipal bonds should broaden the investor base, increase liquidity, and provide attractive yield opportunities. Individual investors in high tax states where the top marginal rate is quickly reached may also find in-state taxable municipal bonds, still exempt at the state level, to be attractive.

2. High Yield Municipal Bonds’ Outperformance Continues
We anticipate that favorable technical and improving fundamental conditions will result in tighter high yield municipal credit spreads and outperformance relative to investment grade municipal bonds. Tax reform will likely reduce tax-exempt issuance by 30%, while individual investor and mutual fund manager demand remains strong. We believe ongoing economic expansion and increasing tax revenues, especially excise taxes, should improve coverage ratios for dedicated tax bonds. Stronger credit fundamentals should result in tighter spreads as investor comfort with high yield increases. However, 2018 implementation of the SEC’s rules governing liquidity risk for mutual funds and exchange-traded funds will likely result in the underperformance of non-rated municipal debt as the rule favors frequently traded bonds with published ratings and proven price transparency.

3. Intermediate Municipal Bonds Underperform
Low yields, interest rate sensitivity, correlation to Treasury yields, and curve flattening will, in our opinion, result in underperformance of higher quality intermediate municipal bonds. We believe that investors who reposition away from the high grade portion of the intermediate yield curve to invest in longer, more credit sensitive municipal bonds will experience a higher level of income. This is due to the higher yield on longer maturity bonds, a better return profile due to credit spread tightening and improved liquidity from owning bonds in a more favored portion of the market.

4. Tax-Exempt Municipal/Treasury Ratios Hit 20-Year Lows
We expect that Municipal/Treasury yield ratios will decline due to supply/demand technicals and improving fundamental conditions. As a result, we anticipate that tax-exempt municipal bonds will outperform Treasury bonds and other high-quality taxable bonds. We look to the 2017 tax law changes to increase demand for income exempt at both the federal and state levels and reduce tax-exempt supply. In high tax states, the relative outperformance of tax-exempt bonds will be particularly impactful.

5. Tax-Exempt Market Liquidity Declines
We believe that liquidity will decline and volatility will rise. Lower corporate tax rates will reduce the profitability of trading tax-exempt debt for broker-dealers, leading to a reduction in trading capital committed to the municipal market. As a result, they will likely redeploy capital into the taxable markets to generate trading profits. For capital still committed to the municipal market, we expect broker-dealers to prefer rated, liquid names as the capital cost of positioning non-rated paper will be prohibitive. As a result, non-rated bonds will trade primarily on an agency basis, where the broker will only transact with the seller and buyer simultaneously. We believe this will further reduce their liquidity and, most likely, value.

ACTIVE MANAGEMENT is the use of a human element, such as a single manager, co-managers, or a team of managers, to actively manage a fund’s portfolio. Active management strategies typically have higher fees than passive management.

ADVANCED REFUNDING enables an issuer to “refinance” and obtain the benefit of lower interest rates when their outstanding bonds that offer higher interest rates have not reached their callable date.