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Municipal market enters 2018 with certainty and strength
Growth continues without inflation
After years of waiting, the municipal bond market finally gained certainty regarding the status of tax reform. The Tax Cuts and Jobs Act largely spared municipal bonds, but the legislation will likely affect certain market dynamics. The U.S. economy continues to improve, while inflation remains muted. We believe this environment provides a positive backdrop for municipal bond performance in 2018.
After a sluggish first quarter, the U.S. economy generally surprised on the upside for the balance of 2017. The U.S. economy averaged just 1.9% annual growth from the financial crisis of 2008 through the end of 2016. Growth looks to have broken through the 2% barrier to reach 2.4% or greater in 2017. Growth appears well balanced between consumption, investment spending, home construction and auto sales.
The consumer seems to be improving, as retail sales accelerated in the fourth quarter and exceeded 3% growth for the year. Total vehicle sales strengthened in the fourth quarter to reach 17.13 million for the year, near the 2016 record of 17.46 million. Solid household formation, combined with low interest rates, have kept the housing market strong. Housing starts were 1.3 million units in 2017, up slightly from 1.2 million in 2016. Importantly, home construction is not outstripping demand, as median home prices increased 5.8% for the year.
The job market tightened marginally. Average nonfarm payrolls exceeded 200,000 in the fourth quarter, with an average of 175,000 net new jobs added each month. The participation rate held steady at 62.7%, pushing the unemployment rate to a post-recession low of 4.1%. Despite gradual strengthening of labor market conditions, wage growth has not accelerated into problematic territory. The last two payroll releases in 2017 showed an average hourly earnings (AHE) growth of 2.5% year over year, less than at the beginning of 2017.
The link between GDP growth and inflation is not nearly as strong or consistent as economists have assumed. The Phillips Curve explains the theory that low unemployment creates higher inflation. Developed in the 1960s, it may need some modernization. 2017 economic data challenged the general view that higher growth rates always translate into higher inflation.
While GDP growth increased during the final three quarters of 2017, the core consumer price index (CPI) and the core personal consumption expenditure index (PCE) declined during the year to end below 2%. Core CPI (excludes food and energy) had been running at a 2.2% annual rate on a trailing 12-month basis in January 2017. It measured 1.8% in December.
The core PCE deflator, the Federal Reserve’s preferred inflation measure, started 2017 at 1.7% and dropped to 1.5% year over year by December. Investment spending, technological innovation, global competition and aging demographics may all play some role in the economy’s ability to generate above 2% growth with below 2% core inflation. This would be positive for financial markets if it continues. Because the Fed is succeeding on its dual mandate of low inflation and low unemployment, there is less pressure to accelerate the rate hike trajectory.
The Federal Reserve continues to tighten
The Federal Reserve (Fed) increased interest rates three times in 2017, by 25 basis points (bps) each. The fed funds rate sits in a range of 1.25% to 1.50%. Based on the Fed’s median forecast, the long-term neutral fed funds rate forecast is reaffirmed at 2.75%. Longer-term bonds outperformed in 2017, driven by higher income and capital appreciation. The U.S. Treasury yield curve flattened, with the 30-year yield declining by 31 bps while short yields rose by 75 bps. As the Fed increases short-term rates, tightening monetary policy actually reduces long-run inflation expectations because it is pre-emptive in nature. This dynamic is contributing to yield curve flattening.
Global growth remains synchronized
Demand from Europe and Japan for long-term, high quality fixed income assets contributed to municipal yield curve flattening and outperformance on the long end. U.S. Treasury yields remain the highest in the global sovereign market. The 10-year U.S. Treasury yield ended 2017 at 2.41%, versus Germany at 0.56% and Japan at 0.07%. European and Japanese interest rates have been suppressed in recent years by European Central Bank (ECB) and Bank of Japan (BOJ) bond buying policies. These quantitative easing (QE) policies are not permanent. Adjustments from the ECB and BOJ could impact U.S. Treasuries, which could affect municipal bond yields.
European area growth rates have averaged 2.8% over the trailing 12 months, although inflation rates remain below the central bank’s objectives. The ECB plans to gradually wind down its QE program by September 2018. Similarly, the BOJ plans to slightly reduce purchases of longer-dated government bonds (from 200 billion yen to 190 billion yen monthly) in response to improved growth statistics. Inflation in Japan remains well below its 2% target, and the long-term bond purchase program is expected to continue at least throughout 2018.
Global growth forecasts have risen from 3.3% to 3.9%, which may put upward pressure on interest rates. No major economies are in recession, nor forecasting a recession for 2018. However, as in the United States, this synchronized growth recovery has had very little effect on inflation. Any changes to central banking policies should emerge only gradually.
Global growth forecasts have risen from 3.3% to 3.9%
Municipals outperform Treasuries
Municipal bonds generally outperformed Treasuries in the fourth quarter and for 2017 due to higher income levels and falling municipal-to-Treasury ratios. The 10-year AAA municipal yield dropped slightly from 2.00% to 1.98% for the quarter. The 10-year Treasury yield increased from 2.34% to 2.41%. The 30-year AAA municipal yield fell from 2.84% to 2.54%. The 30-year Treasury yield fell less, from 2.87% to 2.74%.
As a result, the 10-year municipal-to-Treasury ratio declined from 85% to 82% and the 30-year ratio fell from 99% to 93%. The 10-year ratio declined slightly below the long-term historical average and the 30-year ratio is approaching the average. Nevertheless, we believe both will decline further.
Recent tax reform legislation argues for lower ratios, as the changes will likely increase the value of municipal bonds and decrease supply. The passing of tax reform settles the risk of retroactive changes for the municipal tax exemption. More certain tax benefits, combined with stable credit conditions and decreasing supply, mean municipal-to-Treasury ratios are very likely to fall further.
Municipal outperformance is more impressive considering accelerated year-end supply.
Municipal outperformance is more impressive considering accelerated year-end supply. Fourth quarter 2017 issuance totaled $144.6 billion, 33% higher than the same time period in 2016. As tax reform became increasingly likely, and certain types of issuances appeared restricted, borrowers rushed bond offerings to market ahead of year-end deadlines. This resulted in record high December issuance of $62.5 billion. The bonds were readily absorbed, as it became clear that tax law changes would not be retroactive and municipal bond scarcity may be a greater concern in 2018. Average credit spreads moved just slightly, from 270 bps to 271 bps. Credit conditions remained stable (excluding Puerto Rico) and demand for excess yield continued.
Municipals (mostly) breathe a sigh of relief
Early in the tax policy debate, there were serious concerns that legislative changes would negatively affect municipal bond supply. Fortunately, municipal bonds were largely spared and all tax law changes apply only to newly issued bonds.
Private activity bonds were spared
Private activity bonds (PABs) are used to fund hospitals, nursing homes, charter schools and university facilities. The House version of the legislation would have eliminated the tax exemption of PABs, but the final bill retains the tax-exempt status. This is probably the best tax news from a municipal bond perspective, given these bonds make up 20% to 30% of the municipal market.
New issuance of advance refunding bonds is no longer tax exempt
The advance refunding structure allowed issuers to refinance higher interest rate debt before a bond’s scheduled call date. It was a common way for issuers to reduce interest expense, so issuers will now likely lose some funding flexibility. For investors, supply and demand will be affected, as new issue supply has been dominated by refunding activity over the last five years. The lack of these types of bonds will reduce new municipal bond supply going forward, which could result in positive market technical conditions for existing bonds.
State and local tax deductibility may make municipals more attractive
The legislation caps the deductibility of state and local taxes (SALT) at $10,000 for those that itemize taxes. The $10,000 cap can be comprised of any combination of property taxes and income or sales taxes paid to state and local governments. This provision expires on 1 Jan 2026 and will revert back to prior law barring any subsequent legislation maintaining the cap on SALT deductibility.
This legislation could increase the combined federal, state and local tax burden on certain individuals, but state and local governments are most directly affected. Future efforts to raise property and income taxes could become more politically challenging. Previously, any additional income and property taxes paid due to tax increases were at least partially federally tax deductible for most taxpayers who itemize. These taxes are no longer fully deductible.
Because future state and local tax increases will be felt more acutely, there could be more organized resistance to proposed tax increases, particularly in high-tax states. Some state and local credit profiles could come under additional pressure over time if these political challenges delay or prevent needed tax increases for priorities such as pension contributions, capital investment and other governmental needs. The changes to the deductibility of state and local taxes will likely increase the demand for tax-exempt municipal bonds, particularly in states with high income and/or property taxes. Of course, nearly every state with a personal income tax could be considered a “high tax state” within the context of capping SALT at $10,000
Technicals Remain Positive
Municipal issuance totaled $438.8 billion in 2017, just 2% lower than the 2016 record high. We expect supply to decline sharply in 2018. Advance refundings, representing 25% of supply in recent years, are no longer tax exempt under the new tax legislation. In addition, much of the $62.5 billion of December 2017 new issuance was effectively pulled forward from 2018.
To forecast 2018 supply, one may assume the 2017 new money issuance of $203.5 billion grows by 5% to $214 billion. All additional issuance must be current refundings, since advance refundings are no longer feasible. $135 billion of municipal bonds become callable and therefore eligible for current refunding in 2018. Assuming a high percentage of those bonds are refunded, total 2018 supply may total between $300 billion and $330 billion. If issuers brought $330 billion of gross supply to the marketplace in 2018, the net new issuance would be negative -$121 billion. These figures illustrate the possible scarcity value of municipal bonds in 2018.
Net municipal bond fund flows were steady and positive in 2017. Investors added to municipal bond funds every month through November, before pulling back slightly in December. Total inflows were a solid $26.2 billion in 2017, and we expect this trend to continue. The economy is improving, which typically means lower defaults and stronger fundamentals. Demand may have been lower than its potential over the last several years due to periodic risks around the tax-exempt status. With the passage of tax reform, we finally have long-term certainty. In addition, the reduction or capping of other popular deductions makes the tax exemption more valuable for many upper tax bracket individuals, especially in states with an income tax.
Investors enter 2018 with heightened uncertainty surrounding high yield municipal supply, while economic growth accelerates from enthusiasm over tax reform. A large credit spread contraction beyond historical averages appears increasingly likely, especially if the yield curve flattens and the search for yield intensifies.
We expect the municipal yield curve to flatten in 2018, given the Fed’s continued expected path for short-term rates and a major reduction in high grade municipal supply that will put downward pressure on long-term ratios. The high yield municipal asset class should counteract any negative effects from rising Treasury yields, with credit spreads wider than average and a strong case for contraction. We expect high yield municipals to outperform taxable fixed income, including high yield corporates where credit spreads are tighter than average.
Spreads should fall below the long-term average spread of 271 bps. Even a 220 bps spread remains attractive. Much of this contraction is normalization following the Great Recession. Spreads have been significantly above average for the past 10 years, increasing the long-term average spread by 80 bps versus the pre-2008 average.
Spreads should fall below the long-term average spread of 271 bps.
There were no significant defaults in the fourth quarter (excluding Puerto Rico). The par value of municipal bonds entering a first-time payment default was just $828 million (excluding Puerto Rico). This is the first time since 2008 that payment defaults have been less than $1 billion. This represents a drop from 2016, where first-time payment defaults affected $1.84 billion in face value. Most municipal bonds will never likely come close to an actual default, but credit trends will still affect performance based on spread widening or tightening.
Overall revenues are still growing at a pace similar to or slightly higher than the economy. For states as a whole, general fund revenues grew by 2.3% during fiscal year 2017. Similarly, expenditures have averaged 2.3% growth. Local government credits are more sensitive to property tax revenues, which have grown by 4.1% over the 12 months ending 30 Sept. And rating agency upgrades continued to exceed downgrades within public finance over the past year.
For states as a whole, general fund revenues grew by 2.3% during fiscal year 2017.
Tax reform may affect credit standing
Changes in SALT deductions are a negative for higher earners who itemize their deductions and live in high-tax areas. We stop short of suggesting that this new development would be sufficient for individuals to relocate from a high tax state. Inter-state migration patterns are often over-predicted. States like Florida and Texas have seen an increase in population for a variety of reasons over the last several years, and tax law changes could accelerate this trend. The topic certainly bears watching over time, but we believe it is premature to be overly concerned.
The loss of tax-exempt advance refunding bonds (issuers could theoretically use taxable bonds) shouldn’t reduce infrastructure investment, but could have longer-run effects. Investors would likely see reduced tax-exempt supply and therefore some increase in value to existing tax-exempt municipals. The precise increase is difficult to predict, as advance refunding supply varies greatly with interest rate changes.
For issuers, the loss of advance refunding bonds means one less tool to manage interest costs. And, at the margin, financing costs will be slightly higher over time as issuers wait for call dates to trigger traditional refunding transactions. Some issuers may also opt for synthetic refundings of higher-cost debt through derivative contracts to recreate the financial effects of advance refunding. This could result in new credit risks related to counterparty risk, interest rate risk and termination payment risk, among other concerns.
The lack of advance refunding may precipitate efforts by borrowers to shorten call protection on new issues. It is too early to say whether this effort will be successful, but this potential trend would mean many new issuances could come with higher yields and lower durations.
Municipals appear attractive in 2018
Global macroeconomic conditions appear favorable as we begin 2018. U.S. GDP growth has risen above 2% and no major country is flirting with a near-term recession. Even with stronger global growth, inflation remains low in the major economic zones. This means changes to central banking policies may occur only gradually, reducing the risk of an interest rate shock. Low inflation, combined with tightening monetary policy, is contributing to yield curve flattening. We expect this trend to continue in 2018. We believe municipal bonds are in a strong position to outperform taxable fixed income due to our outlook for fewer total bonds outstanding, stable credit conditions and the finalization of tax reform. In addition, high yield municipals could potentially enhance investor performance, as an improving economy and lower defaults mean credit spreads for lower-rated bonds should contract closer to pre-2008 norms.
Gross Domestic Product: U.S. Department of Commerce
Treasury Yields and Ratios: Bloomberg (subscription required)
Municipal Bond Yields: Municipal Market Data
ICI Fund Flows: http://www.ici.org/research/stats
Municipal Issuance: Seibert Research
Defaults: Municipals Weekly, Bank of America/Merrill Lynch Research, July 7, 2017.
State Revenues: The Nelson A. Rockefeller Institute of Government, State Revenue Report, June 2017.
State Budget Reserves: Pew Charitable Trust.
Global Growth: International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD)
Standard & Poor’s and Investortools: http://www.invtools.com/
Flow of Funds, The Federal Reserve Board: http://www.federalreserve.gov/releases/Z1/Current/z1.pdf
Payroll Data: Bureau of Labor Statistics
Bond Ratings: Standard & Poor’s, Moody’s, Fitch
New Money Project Financing: The Bond Buyer
Consumer Price Index: http://www.bls.gov/cpi/ http://research.stlouisfed.org/fred2/series/CPIAUCNS
The Municipal Market Data AAA scales are compilations of the previous day’s actual trades for AAA-rated insured bonds.
The personal consumption expenditures (PCE) deflator indicates the average increase in prices for all domestic personal consumption.
One basis point equals .01%, or 100 basis points equal 1%.
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
Risks and other important considerations
This report provides general information only. The analysis contained herein is based on the data available at the time of publication. This information represents the opinion of Nuveen Asset Management, LLC and is not intended to be a forecast of future events and this is no guarantee of any future result. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. Information is current or relevant as of the date indicated and such information may become outdated or otherwise superseded at any time without notice. This analysis is based on numerous assumptions. Different assumptions could result in materially different outcomes. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment.
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.
This information should not replace an investor’s consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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