When Is a Muni Fund Like a Growth Fund?
Chasing the muni market may come back to bite you.
Performance chasers in the municipal bond market are driving prices higher and may be creating a bubble. Some investors appear to have forgotten that muni bonds are intended to provide stable, tax-exempt income for a portfolio. The BoAML Muni Bond Index’s yield to worst has dropped while the price return has appreciated over the past year as investor demand continued.
Off to the Races
What sparked this cycle of hot demand? The U.S. tax law passed in 2017 reduced state and local tax deductions for many citizens, creating large demand for municipal bond investment opportunities to shelter income beginning in tax year 2018. Data show about 10.9 million taxpayers were unable to write off $323 billion in state and local taxes on their federal returns filed in 2019.1
Demand for municipal bonds has again led to heavy issuance in 2019, with more in the first nine months than in the same period of 2018. There has also been an uptick in high yield issuance, as demand has pushed investors from investment grade into riskier territory.
Through October of 2019, fervent demand had spurred about $75 billion in new flows into municipal bond mutual funds.2 About 20% of the muni market is held by retail investors through mutual funds.3 That makes muni bond fund due diligence so much more important.
Get Back to Basics
Let’s remember the function of municipal bonds. For the issuing municipalities and state governments, revenue raised from the sale of muni bonds was intended to help build bridges, highways, hospitals and schools, through relatively inexpensive financing. For investors, muni bonds could provide dependable tax-exempt interest income and relatively safe exposure, backed by revenue from a project, or a state or municipal taxing authority.
However, given the sharp muni bond rally and low yields, a muni’s tax-exempt income in many cases is less than what a U.S. Treasury of the same maturity would produce after tax. Keep in mind, that’s after the tax advantage muni income has over U.S.Treasuries.
Another concern is that many muni bonds do not carry the investor protections of years before, because a risk-on market and feverish demand mean they can get away with it. Again, the losers could very well be holders of mutual funds, led by portfolio managers who have embraced risk.
Or You May Be Left Holding the Bag
Investors also may be forgetting that most muni bond issues are less liquid. About $11.6 billion in muni bonds changes hands each day, representing less than 0.5% of the outstanding issuance. Some bonds don’t trade for weeks or months.
So, if your muni bond fund took on too much risk, and the bubble bursts, it may be hard for the portfolio manager to sell and mitigate losses. You could be left holding the bag.
Muni Bonds Always Have a Portfolio Role
Muni bonds always have a role to play in a portfolio. Given the risk taking by some portfolio managers, and supply and demand dynamics of the current municipal bond market, disciplined risk management has become even more important.
1. U.S. Treasury Inspector General for Tax Administration
2. Investment Company Institute
3. U.S. Federal Reserve Statement of Accounts, Q2 2019