Trump Down-Trade in Muni Market Draws to a Close

 

June 1, 2017 [Municipal Funds, Trump, Tax Reform, Infrastructure Spending]
Charles Roth


Munis sold off in the wake of Trump’s election victory, but have been clawing their way back up as investors glean the difficult paths ahead for tax reform and infrastructure spending.

 

If the Trump reflation trade is proving slower to unwind among U.S. blue chips stocks, it’s become far more apparent in the municipal bond market, which has broadly retraced its steps since the surprise November election outcome. A Trump presidency and Republican control of Capitol Hill had quickly conjured notions of expedited deregulation, tax reform and infrastructure spending, which taken together would presumably catapult annual U.S. economic expansion to a targeted 3% after eight years of anemic 2% yearly growth.

A little more than four months into Trump’s Oval Office tenure, though, things so far aren’t going as planned. Apolitical tech sector earnings growth may be lifting the broader benchmark stock index, but it’s hard not to notice that the more cyclical financials, industrials and materials sectors have been flagging lately after sprinting higher in the wake of Trump’s win.

Conversely, the municipal bond market was hammered last November and December on worries that tax reform might erode, if not rescind, the tax exemption for munis, not to mention eliminate the deduction for state and local taxes. It appears that only the latter, which mostly affects “blue” coastal states, is in the reform plan. Fears that muni issuers would flood the market with new supply to help finance the anticipated surge in infrastructure spending also weighed on sentiment. Investors in the $3.8 trillion muni market yanked a net $28.5 billion out of muni mutual funds last November and December.

Since then, flows have steadily been creeping back into the muni mutual fund market, with nearly $11 billion in estimated net inflows from the beginning of the year through mid-May, according to the Investment Company Institute. Meanwhile, the S&P National AMT-Free Municipal Bond Index has more than recovered from the election surprise, hitting 152.71 points at the end of May after tumbling from 151.68 on the heels of the November vote.

Tax reform, it’s now clear, is much harder than it appeared seven months ago. Of course, it’s still possible that a tax system revamp could lower income tax rates for individuals in the highest tax brackets, undercutting the tax advantages of munis over taxable bonds. Yet given fears of deeper deficits among Congressional fiscal hawks, perhaps muni investors don’t fear tax reform as much as they did previously. Likewise, the specter of a wave of fresh muni issuance to fund infrastructure spending seems unlikely.

Even under Commerce Secretary Wilber Ross’ proposal to offer tax credits to hatch public-private partnerships (PPP), plenty of muni issuance was expected, simply given the trillions of dollars in needed infrastructure upgrades over the next decade. But as Thornburg’s Nicholos Venditti points out in a recent video, PPPs are feasibility-challenged. “Outside of toll roads and some water or sewage systems…very few municipal projects actually generate a revenue stream that would be attractive to most private entities,” he points out. “How many private entities do you know that would be interested in retrofitting the water/sewer system in Flint, Michigan?”

As for municipal finance subsidies via the federal government kicking in additional funding, which would in theory increase muni bond supply and weigh on investor sentiment, recent history of federal stimulus—all those 2009 “shovel-ready” projects—is instructive. “Between the money and the guy with the shovel, you have 15 lawyers and 10 environmentalists and five lobbyists and 80-feet worth of paperwork,” Venditti notes. “These things take time to play out.”

Rather than the supply side, the demand side will be the driving factor in the muni market, he adds. “Huge inflows or huge outflows, at least in my mind, are going to mean more for ongoing total return than cyclical variations in supply,” Venditti adds.

Ahead of last November’s election, munis were quite pricey, given consistently strong demand. Then they fell out of bed as investors fled. That gave muni mutual fund managers a window to pick through the rubble, looking for paper with more reasonable valuations. Since then, the muni market has mostly recovered to rich levels. Still, relative values can always be had with nearly 90,000 muni issuers out there.

It appears muni investors are getting the memo on the difficulty of tax reform and infrastructure spending. Rather than rush in and out of the space on the latest news headlines, though, they would likely do better investing in muni mutual funds that use active, laddered strategies. Staggering maturities and using proceeds from maturing issues to reinvest at the long-end of the ladder in relative bargains among all those issuers helps manage interest-rate risk while taking advantage of credit risks, regardless of the latest twists and turns out of Washington, D.C.

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