Short-Term Headwinds and Long-Term Value

Despite favorable supply and demand dynamics, the municipal bond market has underperformed Treasurys thus far in 2018, due to a combination of factors. We believe this should be short term in nature and remain confident in our longer-term outlook for the municipal market and the value it presents for active investors.

What Happened

At the end of 2017, the impact of the U.S. Tax Cuts and Job Act quickly became obvious with regard to municipal supply, as issuers rushed to market before year end. Based on this technical factor, the market observed heavy issuance in December 2017, as debt was front-loaded from the first quarter of 2018. Despite record-setting issuance and the expectation this would lead to negative returns, strong demand absorbed this increase in supply, leading to positive municipal market returns in late 2017.

In early 2018, the unexpected happened once again. With modest seasonal issuance, acceleration of deal flow late last year, and higher volume of coupons and maturities seeking reinvestment, many believed this would lead to strong municipal performance in early 2018. Municipal performance, however, has belied these trends thus far, as the positive dynamic of declining supply this year has been offset by other factors. Perhaps most significantly, the rate sell-off we have seen in the Treasury market has carried over to municipals to an even greater extent, driving the market’s rates higher. So far in 2018, municipals have underperformed Treasurys, more notably on the long end of the yield curve. We would attribute this to the high volume of reinvestment proceeds funneling back to the intermediate segment of the market while, simultaneously, we believe investors focused on the long end of the curve have stayed on the sidelines, due to long-term inflation concerns. We believe this is temporary in nature and that the long end of the yield curve is even more compelling today. We also still believe that municipals will outperform Treasurys in 2018.

Figure 1:Valuations are Increasingly Attractive on the Long End of the Municipal Curve

Source: Barclays Research and the U.S. Treasury Department, as of 3/19/18. The municipal yield is a baseline curve for high-quality, tax-exempt municipal bonds in the Bloomberg Barclays Municipal Bond Index. The Treasury yield is based on the U.S. Treasury yield curve.

Where Do We Go from Here?

We entered 2018 with a longer-term view that the municipal yield curve would flatten and municipal-to-treasury ratios would decline, as tax-exempt bonds outperformed. While the market has not behaved this way so far, our thesis remains intact. Contributing to this view is consistent demand from retail investors and more modest supply of bonds with longer-dated maturities going forward.

At the same time, we expect that life insurance companies will begin to play a more active role in the municipal market, as tax reform has increased the amount of tax-exempt income life insurers can recognize to 70% of interest earned. Life insurance companies are more likely to focus on the long end of the yield curve, as they look to manage liabilities that are longer term in nature. At the same time, the long end of the municipal yield curve has become more compelling recently.

Meanwhile, we expect that banks and property & casualty (P&C) investors will shift their investment of new dollars away from the intermediate portion of the municipal market. The reduction in the corporate tax rate to 21% increases the after-tax yields these investors can capture in corporate bonds, relative to municipals. In our opinion, this theme could potentially be exacerbated due to the relative richness illustrated by valuations on the tax-exempt side.

Conclusion

In our opinion, the recent weakness in the municipal market has been overdone, particularly on the long end of the curve, and we have taken advantage of opportunities that market headwinds have helped to create. While we recognize that increased volatility may be a consistent theme going forward, we remain confident in our positioning due to a long-term investment outlook that remains solidly intact.



This material contains the opinions of the MacKay Municipal Managers™ team of MacKay Shields LLC but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2018, MacKay Shields LLC.