Municipal bonds are at their richest levels versus US Treasurys in the last 5 years. Several factors are at work. The 2017 Tax Cut and Jobs Act (TCJA) had many provisions, but one in particular significantly affected States’ incentive to issue debt. Until TCJA, any state treasurer could issue tax-exempt debt, set aside some or all funds to cover future refinancing costs of previously issued debt, and effectively lower the state’s cost of funds. Of course, the US Treasury, through its federal tax exemption, was essentially subsidizing such state activity and lenders. Note, funds raised in such a manner are not used for schools or roads or other infrastructure improvements; it’s merely financial engineering. TCJA eliminated the loophole. Now, states that wish to issue such “refunding” debt will do so without the Federal tax-exemption, effectively eliminating the incentive. The result has been a net reduction in municipal supply since 2017.
What’s happened to the demand side? The TCJA corporate tax reduction clearly served to reduce corporation demand for municipal debt. However, individual investors have significantly increased their demand for tax sheltered income in response to the Act’s reduced SALT (Sate and Local Tax) deductions.
The resulting supply/demand relationship have caused municipals to be one of the best performing bond asset classes over the last 6 months. They currently are trading at their largest spreads through US Treasury yield seen in the last 5 years.
Does it follow that municipal bonds are over-valued relative to other bond asset classes? Not necessarily. Corporate bonds are fully taxable and, as such, need to offer enough nominal spread to remain attractive versus Municipals and US Treasurys. In high tax states like California, wealthy investors will still earn more adjusted yield investing in municipals, but spreads aren’t as wide as they used to be. A well constructed bond portfolio should be diversified across asset risk and term. In today’s market: Shorter term, favor Treasurys. Intermediate term, favor Corporates. Longer term, favor Municipals.
Legend: Yields are annualized. Taxable Equivalent Yield (TEY) assumes 37% Federal tax rate, 3.8% Medicare tax, 13.3% CA tax rate. CA Municipals are exempt from both Federal and State taxation, US Treasury securities are Federally taxable but exempt from State taxation. Corporate Bonds are fully taxable. Breakeven yields are the inflation rates over the term period in which investors are indifferent between owning US Treasurys and Treasury Inflation Protected Securities (TIPS)
US interest rates have fallen since their mid-November 2018 highs as markets finally started discounting the myriad of investment risks we’ve mentioned in past commentaries. Normal volatility has returned as markets exhibit more rational behavior patterns. Currently, Fed Funds rate stands at 2.5%. Expectations for short rates, as shown in the last column in the below futures market graphic, indicate markets are completely discounting that the Federal Reserve is done raising. Yes, the futures forward market has a notorious reputation of overstating the directional magnitude of rate changes, but YoY inflation has been under 2% the last four months, TIPS breakevens are under 2% (see above), and the yield curve is relatively flat; it’s tough to argue the market’s perception is incorrect…