When foggy weather obscures the path forward, it is prudent to get your bearings more frequently. Similarly, uncertainty clouds our visibility going into 2019. Whether the economy is in late cycle or taking a pause, municipal investors will be balancing their concerns about risk against their need for income. When the path is unclear, it is wise to watch your footing and we think that a similar sentiment will weigh on market participants’ investment decisions as 2019 progresses. However, being overly cautious can cause a misstep; we believe that a tactical approach in 2019 will best ensure progress for our clients’ investment objectives.

1. Dedicated Tax and General Obligation Debt Outperforms as Tax Revenue Streams Grow

The recent expansion in overall economic activity has fueled growth in individual and corporate income taxes as well as sales taxes. State government revenues have exhibited strong year over year growth, with 2018 revenues up almost 6% through the third quarter of 2018 (source: U.S. Census Bureau 3Q 2018). We anticipate investors will place a premium on higher quality, tax-backed debt. However, security selection is essential as the recovery in credit fundamentals among state and local governments has been uneven.

2. Municipal Issuance Exceeds Market Expectations

Cumulative issuance of both tax-exempt and taxable municipal bonds, in our opinion, will exceed expectations as issuers increase funding for capital investment. We anticipate ongoing revenue growth will spur governors to reinvest incremental cash flows back into their state economies. We expect the growing supply of taxable municipal debt to be readily absorbed as demand increases from pensions and endowments that are seeking to diversify away from their exposure to the BBB-heavy corporate bond asset class.

3. Restructuring of Puerto Rico Debt Provides Opportunity to Increase Allocation to High Yield Municipal Bonds

The market will, we believe, demand higher yields and wider spreads on the massive volume of restructured Puerto Rico debt. We anticipate the spillover effect from this transition to accrued bonds offers investors the opportunity to increase their allocation to high yield debt at very attractive levels. We expect the opportunity for outperformance in the high yield municipal market to occur in the second half of the year.

4. Municipal Financing with Embedded Real Estate Risk Underperforms

We anticipate the market will penalize sectors and credit structures exposed to real estate market values. Financings tied to selected commercial real estate, raw land housing development and continuing care retirement centers, in our opinion, will come under pressure as peaking market values recede. These same sectors also historically experience higher default rates (source: Municipal Market Analytics Inc.). By contrast, we believe that financings dependent on assessed valuations of existing developed real estate (e.g. general obligation debt) will find favor in the market as debt coverage remains strong.

5. Tactical Portfolio Positioning Drives Performance

In contrast to the last number of years when strategic portfolio structure proved beneficial, we believe a tactical approach going forward to be more prudent. Given the uncertainty of the overall markets, tactically adjusting portfolio exposures as market direction becomes evident should, in our opinion, provide more flexibility. As a result, we believe that this approach provides better total return opportunities than strategies anchored to more traditionally passive investment approaches.