Muni Bond Sales Surge as Issuers Ride Demand Wave
Caveat emptor: current technical supply and demand flows favor issuers more than buyers. But diligent, disciplined investors can always find attractively priced, fundamentally sound bonds.
Why would so many investors pour into relatively pricey shorter-term munis when the U.S. Federal Reserve recently signaled “patience” in continued monetary tightening? The late 2017 tax reform and the structure of the $3.8 trillion muni market investor base may have something to do with it.
According to the Fed’s Flow of Funds data, households represent 42% of muni market investors, though retail investors no doubt also comprise a number of the 7% in the “Other” category, which groups ETFs, closed-end funds, and public sector entities, among others. Banks and insurers make up around 28% of the investor base, while mutual funds account for 18% and muni money market funds the remaining 3%.
Perhaps some households are chasing the outperformance of shorter-term munis in 2018, when the Fed was still steadily raising rates. Maybe others don’t want to lock their money up in longer-maturity bonds. Certainly tax reform has spurred demand for munis of various maturities among wealthier taxpayers, particularly in states with high personal income tax rates. While the reform reduced the incentive for banks and insurers to invest in munis by cutting the corporate tax rate to 21% from 35%—hence the decline in muni demand from banks—it also capped the deduction individuals could take on their state and local taxes at $10,000. That raised the attractiveness of munis, especially in “blue” coastal states, as munis are exempt from federal taxes, and in many cases from city and state taxes, too.
Yet investors would be well advised to be highly selective in taking on more duration and credit risk, particularly in high-yield munis. To be sure, the recent rise in yields is pushing relative value metrics farther out the curve. But credit spreads remain near all-time lows, which doesn’t inspire confidence when the economy, while still quite solid, is nonetheless slowing, with drags in housing, auto-financing, student loan and credit card segments.
Meanwhile, the Bloomberg Barclays Muni High Yield Index’s yield to worst has compressed to around 4.9%, which might make those rushing into high-yield munis a little more circumspect. Investor flows in the segment can also be exceedingly volatile and tend to heavily influence returns.
Fundamental, bottom-up credit research matters, particularly when technical supply and demand flows favor issuers more than investors. To be sure, there are always pockets of value to be found for those willing to look.