Municipal Bond Market Outlook

Transcription

1 of 9 3/3/204 0:45 AM Municipal Bond Market Outlook Feb. 28, 204 By William Black, CFA, Mark Paris, Robert Wimmel and Stephanie Larosiliere Dislocation creates market opportunity in 204 The Value Proposition Income from municipal bonds has become attractive after a volatile 203 drove yields higher. We believe that demand for municipals in 204 will be driven by higher income taxes and rich valuations in other asset classes. Low supply, driven by the 203 spike in interest rates, should be supportive for municipal bond prices. Rather than watching the market from the sidelines and trying to time the perfect moment to redeploy capital, investors should consider getting invested now, while they can take advantage of current high yields and participate in potential price improvements. As US GDP improves, so do the fundamentals of municipal issuers. Through the third quarter of 203, states have posted a record 5 consecutive quarters of year-over-year revenue increases. Attractive total returns, low historical default rates, high historical recovery rates and attractive valuations are reasons to consider an investment in the municipal bonds now. Municipal Bond Market: 203 sell-off creates yield advantage relative to other fixed income investments The past five years have been touch-and-go for municipal bond investors. The 2008 financial crisis fundamentally altered the market, which saw a dramatic decline in the number of AAA-rated municipal bond insurers. The reduced amount of insurers helped lower the share of AAA-rated bonds in the municipal bond market from 75% in 2007 to 3% today. In 200, a noted Wall Street analyst predicted that the market would suffer from widespread defaults. The unfounded doomsday prediction helped trigger an indiscriminate sell-off in municipal bonds. Amid such volatility, institutional and crossover buyers, who had the resources to conduct in-depth fundamental credit analysis, identified compelling investment opportunities and increased their municipal bond allocations. As fear of mass defaults abated, market technicals turned positive, with increased investor demand and lower supply. These factors contributed to double-digit municipal bond total returns for calendar years 20 and 202. A volatile 203 has again created dislocation in the municipal bond market. Investment grade municipal bonds finished the year down -2.55%, and high yield municipals ended the year down -5.5%. These returns were particularly disappointing in a year when investment grade and high yield corporate bonds generated returns of -.53% and %, respectively, and the S&P 500 returned in excess of 3%. Since 98 the municipal bond market has not experienced two consecutive years of

2 2 of 9 3/3/204 0:45 AM Invesco - Insights negative annual total returns. While 203 was a challenging year for investors, it has created potential opportunities for 204 and, if history repeats itself, this year could be a standout year for the tax-exempt market. We believe municipal bonds are currently oversold and their yields appear attractive on both an absolute and relative basis. The high yield municipal bond yields of 6.76% seen at year-end were a record 20% of high yield corporate bond yields, which stood at 5.64% (Figure ). At the end of 202, the ratio of high yield municipal to high yield corporate yields was 92.3%, and over the past decade this ratio has averaged just 80% (a higher ratio indicates relative cheapness of municipals versus corporates). This yield differential is even more significant when factoring in the impact of income taxes on investment income. For example, using year end 203 yields, on a tax-adjusted basis households in the top federal tax bracket of 43.4% can earn yield of.94% by investing in high yield municipals. 3 Source: Barclays, as of Dec. 3, 203. Tax-Equivalent Yield is the required pretax yield on a taxable bond that equates to the after-tax yield on a tax-exempt municipal bond. High Yield Corporate Bonds are represented by the Barclays U.S. Corporate High Yield Index; High Yield Municipal Bonds represented by the Barclays High Yield Municipal Bond Index; Senior Loans by the S&P/ LSTA Leveraged Loan Index; Investment Grade Municipal Bonds by the Barclays Municipal Bond Index; Investment Grade Corporate Bonds by the Barclays U.S. Corporate Investment Grade Index; and Broad Fixed Income by the Barclays U.S. Aggregate Bond Index. Past performance is not a guarantee of future results. An investment cannot be made directly in an index. Municipal bonds are issued by state and local government agencies to finance public projects and services. They typically pay interest that is not subject to federal regular income tax or state and local income taxes in their state of issuance. Because of their tax benefits, municipal bonds usually offer lower pre-tax yields than similar taxable bonds. Unlike bonds, senior secured loans are secured by collateral, but are typically made to below investment-grade companies. The risk of default may be higher when compared to loans or bonds issued for investment-grade companies, but senior secured loans typically have a lower risk when compared to noninvestment-grade or high-yield bonds. High Yield bonds investment in noninvestment-grade bonds and are therefore subject to greater volatility than investment grade bonds. Investment grade municipal bonds finished the year cheap relative to Treasuries and also enter the year as an attractive relative value opportunity. The 30-year municipalto-treasury yield ratio was 06% compared to its long-term average near 00%. The top federal tax-equivalent yield on the Barclays Municipal Bond Index was 5.57% compared to the Barclays U.S. Corporate Investment Grade Index yield of 3.26%, and a 0-year US Treasury yield of 3.03%. 3 While yields on municipal bonds are attractive, there are several other determinants of total return to consider in 204, including supply and demand, municipal market

3 fundamentals and monetary policy. Demand: Positive returns, higher income tax rates and attractive valuations are potential catalysts for inflows Demand affects all financial markets but its impact can be particularly pronounced in the retail- dominated municipal bond market. Nearly three-fourths of municipal bonds are held either directly by individuals or in mutual fund accounts. As a result, market direction is often driven by mutual fund flows. In previous cycles, retail investors sold municipal bond funds en masse, either because they feared rising interest rates or, as was the case in 20, because of idiosyncratic events. Last year, there was a perfect storm of challenges for the municipal bond market. Concerns over rising rates initiated outflows in the spring. The outflows rapidly accelerated in June after the Fed's comments on the timing for tapering its bond-buying program were misinterpreted by the market. Compounding the situation was Detroit's bankruptcy filing in July. Pension issues resulted in downgrades for the state of Illinois, and credit woes in Puerto Rico also made headlines throughout the summer. While these issues were not indicative of the general condition of municipal credits, they further spooked already skittish retail investors. In December, tax-loss selling contributed to additional outflows as investors realized losses on municipal bonds to offset large gains from equities and other investments. As a result of this behavior, the market experienced outflows in 4 of 44 consecutive weeks, with an unprecedented $67.6 billion leaving the asset class from March through December 203. That amount far exceeded the previous record of $48 billion in outflows that occurred during the last municipal sell-off from November 200 to August 20. While outflows continued through the end of the year, there is compelling evidence suggesting that the trend could reverse in 204. For example, the pace of outflows has slowed significantly since August, excluding December's seasonal tax-loss selling, which makes outflows for the month difficult to assess. This trend is also supported by early results in 204 that showed net inflows in the second, third and fourth weeks of January the first weeks of net positive flows since May 203. As flows normalize, market liquidity and price discovery should improve as well. In turn, we would expect municipal bond pricing dislocations to moderate, potentially leading to positive returns. As is often the case in the asset class, positive returns drive inflows, which can create a virtuous cycle of upward pricing pressure and additional inflows. Another catalyst for improving demand may be changes in income tax laws made in 203. Increased taxes may prompt many investors to reconsider the tax benefits offered by municipal bonds. As it stands now, it is apparent that the retail investing community as a whole has yet to fully realize the impact that higher tax rates will have on their 204 tax bills. Those higher taxes are the result of 3 substantial income tax changes made in 203, including the raising of the top federal income tax rate to 39.6% from 35% and the addition of the 3.8% Medicare surtax on net investment income. 5 4 The 203 tax code also includes the expiration of numerous Bush-era tax cuts that were enacted in 200 and These now-expired tax cuts lowered tax rates on both income and long-term capital gains. According to the Tax Policy Center, on average, 3 of 9 3/3/204 0:45 AM

4 4 of 9 3/3/204 0:45 AM Invesco - Insights taxpayers earning more than $ million will see their tax bills increase by $70,000 6 as a result of the income tax changes implemented in 203. Wealthy investors facing higher taxes in the 204 tax season will likely seek tax-advantaged investments, potentially resulting in increased demand for municipal bonds. While high-tax-bracket investors benefit most from the tax- advantaged status of municipal bonds, all investors may benefit from potential price appreciation driven by higher demand as well as current yields, which are attractive even on a pre-tax basis. A final driver of improving demand may be the relative attractiveness of municipal bonds compared to other asset classes (Figure ). US equities now appear fully valued, trading in the upper range of historical price-to-earnings (P/E) ratios. With moderate growth expectations for corporate earnings and the US economy, another banner year for equities in 204 is unlikely, particularly as tapering of quantitative easing reduces pressure on investors to move into risk assets. From June through December 203, there was a strong negative correlation between municipal bond fund flows and US equity fund flows (Figure 3). If this relationship holds in 204 and equities lose their luster, we believe fixed income could be a beneficiary. The relative attractiveness of municipal yields compared to other fixed income products should help steer flows toward the tax-exempt market. Source: Lipper as of Dec. 3, 203. Supply: Higher interest rates and conservative spending should keep issuance low in 204 The size of the municipal market remained relatively unchanged in 203 at $3.7 trillion, however, the level of issuance has dwindled. New money issuance in 203 increased about 0% from 202, driven by strong issuance during the earlier part of the year. However, this was more than offset by a 27% fall in refunding issuance, as higher interest rates made refinancing transactions uneconomic for many issuers. The total municipal issuance of $33 billion was 3% less than 202's total. Sell-side projections for 204 issuance are at $285 billion, 4% lower than 203, which would make 204 the lowest total issuance year in the municipal bond market since 2000 (Figure 4). The downward pressure of higher interest rates is expected to persist in 204. As such, we expect a meaningful decline in refunding volume. New money issuance is expected to remain flat year-over- year as state and local governments balance fiscal restraint against pent up demand for capital expenditures that have been delayed since the financial crisis. 7

5 5 of 9 3/3/204 0:45 AM Sources: 204 estimate source: Morgan Stanley. Historical issuance source: BondBuyer. As of Dec. 3, 203. The lower supply that is expected in 204, combined with higher demand, should result in a strong technical environment for municipal bonds, similar to what we observed following the 20 sell-off. Supply in 20 was the lowest recorded since 200, with municipal bond funds recording $48 billion in outflows between November 200 and August 20. Following this wave of redemptions, municipal bond funds recorded positive inflows in each of the next 5 months, ultimately totaling about $72 billion. This strong demand, coupled with issuance that came in far below the 0-year average, resulted in 5-month cumulative returns of.55% and 20.64% for investment grade and high yield municipal bonds, respectively. It is important to note that there are differences between 20 and today; as such, investors should not expect the same outcome. However, we do believe supply and demand dynamics should be positive for the municipal bond market in 204. Fundamentals: Positive revenue and spending trends filter through to public sector balance sheets Municipal issuer fundamentals generally improve as US gross domestic product (GDP) grows. While US GDP growth has been below its long-term trend since the financial crisis, growth was positive in 203 and is expected to accelerate in 204. State and local governments have improved fiscal health through the collection of higher tax receipts, and by curtailing spending. Historically, improvements in public sector credit tend to lag the private sector, which has also been true in this cycle. As such, municipal bonds may benefit from credit spread tightening and ratings upgrades as the economic cycle progresses. Through the third quarter of 203, states have posted a record 5 consecutive quarters of year- over-year revenue increases. Personal income taxes, which account for the largest share of state tax revenue about 40% have improved since 2008, driven by higher asset values and improvements in employment. As we expect growth in asset values will slow in 204, we also forecast that state revenues will continue to grow, but at a more moderate pace. Most local governments rely heavily on property taxes, which tend to be relatively stable and less responsive to property value declines than income, sales and corporate taxes are to declines in the overall economy. Over the last two decades, property taxes have consistently constituted more than 65% of total local tax collections. 9 Home prices have improved since June 202 as a result of low mortgage rates, tight supply and institutional buying. The S&P Case-Schiller 20-City Composite Index, which tracks home prices, was up 3.7% year-over-year at the end of November 203. November was the 8th consecutive month of year-over-year increases for the index. In 204, higher mortgage rates could have a negative impact on home prices. However, given that property taxes tend to lag home prices by as much as two years, we expect continued improvement in local tax revenues for some time following any slowdown in 8 0

6 6 of 9 3/3/204 0:45 AM Invesco - Insights home price appreciation. Concerning expenditures, state and local governments continue to cut costs. Rigid cost structures relative to the private sector limited opportunities for deleveraging during the economic downturn. As a result, the public sector is in the earlier innings of balance sheet repair than corporate America. The private sector cut a large number of jobs rapidly in In contrast, state and local governments initiated more gradual cutbacks later in the cycle. Private sector employment has also recovered quicker than in the public sector. As of December 203, the absolute employment level in the private sector was only 0.6% below its peak level in January 2008, while state and local employment was 3.4% below its August 2008 peak (Figure 5). Source: Bureau of Labor Statistics, data released Jan State and local governments have also demonstrated budgetary discipline and lowered their borrowing costs by refinancing higher interest rate debt. This is evidenced by the lower amounts of new money issuance and higher levels of refunding issuance in recent years. The results of higher revenues and fiscal discipline can be seen in improving state budget metrics. For example, improved revenue collections and spending controls have significantly reduced the number of states with budget gaps in fiscal year 204. Sixteen states reported closing a total of $6.4 billion in budget gaps prior to the start of fiscal 204, and five states have a combined $572 million in remaining budget gaps. By comparison, during this same period in fiscal 203 and fiscal 202, states reported closing $37 billion and $7.7 billion in budget gaps, respectively. Since 200, state balances as a percent of expenditures (a measure of the cushion states have to meet budgetary shortfalls) climbed from 5.2% to 9.6%. While state fundamentals have broadly improved, conditions have not yet recovered to pre-crisis levels. If improvements in fundamentals continue on trend, municipal bonds could experience credit spread tightening and lower credit risk premiums in 204. Interest Rates: Monetary policy moves are expected to be measured and reasonably well telegraphed In December 203, the Fed surprised the market by announcing that it will begin to moderate the pace of its large-scale asset purchase program. The Fed indicated that it plans to taper asset purchases by $0 billion per month, to $75 billion per month, beginning in January 204. At the January meeting the Fed communicated that it would further reduce purchases by $0 billion per month, to $65 billion, beginning in February 204. We believe that clarity on the Fed policy should help to stabilize municipal fund flows, a key driver of 203 municipal performance. While municipal bonds have been an improving credit story, the asset class and its investor base have been particularly responsive to changes in interest rates. Fear of 2 2

7 rising rates triggered the municipal bond sell-off of 203, which created a self-fulfilling negative feedback loop in which investors sold bonds and pushed rates higher, even as the Fed reaffirmed its commitment to accommodative monetary policy. In 203, the 0-year US Treasury rate sold off 27 basis points to end the year at a yield of 3.03%. Municipal bond investors responded by redeeming $58 billion from municipal bond funds. In turn, the 0-year AAA-rated general obligation municipal yield sold off 05 basis points to 2.77%. The impact on longer maturities was even more pronounced as investors moved into shorter duration bonds to limit exposure to rising rates. While we expect rates to notch higher in 204, we believe the Fed has provided a measure of clarity on its course of action and the market has priced in much of these expected changes. Outgoing Fed Chairman Ben Bernanke indicated that measured reductions of asset purchases, could be announced at each upcoming Fed meeting. Reductions similar in size to that announced in December and January would imply an end to the Fed's quantitative easing program in the fourth quarter. At the same meeting, the Fed stated it anticipated keeping its policy rate target in the current range well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the 2% goal. This statement helped provide clarity on the Fed's future actions, as unemployment had declined to 6.7% in December from 7.9% a year earlier. (Much of the reduction in the unemployment metric is a result of people leaving the workforce, rather the economy adding jobs, as the labor force participation rate of 62.8% is the lowest since 978.) December's disappointing jobs report, which said the economy added only 74,000 jobs during the month the lowest since January 20, and well below the nearly 200,000 expected by Wall Street would argue for a slower end to accommodative policy than the headline unemployment number would imply. Inflation which depends ultimately on broad money and credit growth, not on the size of the Fed's balance sheet also appears subdued, in part due to a slowdown in bank lending. The Fed's own economic projections released at the time of the December meeting do not have inflation reaching its 2% target level until 205. If inflation remains benign in 204 and employment continues to grow slowly, we expect the Fed Funds target rate to likely remain unchanged in 204. The appointment of Janet Yellen as Ben Bernanke's successor further bolstered the markets' expectations of accommodative and measured monetary policy. If interest rates rise gradually as the economy improves, credit fundamentals of municipal issues are also likely to improve as well. As such, credit spread tightening and credit rating upgrades of municipal bonds may help offset the negative impact of higher interest rates. In addition, current relatively high yields provide a better cushion against negative returns compared to many other fixed income asset classes. Putting it all together The municipal bond market has seemed like a roller coaster ride for investors in recent years. However, it is important to separate perception from reality. Over the past ten years municipal bonds have generated tax adjusted returns in line or better than comparably rated fixed income products, and US equities, and with significantly lower volatility. Before adjusting for taxes, investment grade and high yield municipals returned an annualized rate of 4.29% and 5.6%, respectively over the past decade. Virtually all of those returns have come from tax-exempt income rather than price appreciation. Using the current top federal income tax rate the tax-adjusted returns are 7.58% and 9.2%, respectively. Over the same period investment grade and high yield corporates ten-year annualized returns were 5.33% and 8.62%, respectively, and the S&P 500's ten-year return was 7.4%. The annualized standard deviation of high yield municipal returns was 7.8% compared to 0.4% and 4.6% for high yield corporate bonds and US equities, respectively. Investment grade municipal standard deviation of 4.4% was comparable to US Treasuries and well below the 6% volatility of investment grade 3 corporates. 7 of 9 3/3/204 0:45 AM 2

8 8 of 9 3/3/204 0:45 AM Invesco - Insights In addition to lower volatility, Municipal bonds have lower default rates than comparably rated corporates bonds. The long term default rate for high yield municipal bonds is 7.9%, far below the 33.7% rate for high yield corporate bonds. The investment grade municipal default rate of 0.% is far below the 2.6% rate for investment grade corporate bonds. When bonds do default, the average recovery rate for municipals is 65% compared to only 49% for corporate bonds. 4 The gap between perception and reality created in 203 represents an opportunity for long term investors with a focus on after tax income. While valuations are attractive, the market is not without risks. At times, the fragmented nature of the municipal market, along with a high degree of retail ownership, results in reduced liquidity and increased volatility. A professional municipal bond manager with the resources to construct and monitor a well-diversified portfolio can help you navigate the increasingly complex, but potentially rewarding, municipal bond market. Rather than watching the market from the sidelines and trying to time the perfect moment to redeploy capital, we believe investors may want to consider getting invested now, while they can take advantage of current high yields and participate in potential price improvements. Diversification does not guarantee a profit or eliminate the risk of loss. Source: Barclays as of Dec Source: Standard & Poor's 3203 top marginal tax rate of 39.6% for single taxpayers with more than $400,000 in taxable income or couples with $450,000 or more combined with the 3.8% medicare tax on net investment income. 4Source: Morningstar 5 Source: Internal Revenue Service. The American Affordable Care Act includes a 3.8% surtax on net investment income (NIIT) for households making $250,000 and above and individuals making $200,000 and above. 203 top marginal tax rate for single taxpayers with more than $400,000 in taxable income or couples with $450,000 or more. Distributions from municipal bonds are primarily exempt from regular federal income tax. A portion of these distributions, however, may be subject to the federal alternative minimum tax and state and local taxes. Income from municipal bonds is exempt from this tax. 6 Tax Policy Center as of October 203. Based on 203 federal tax rates. The average 203 income tax impact utilizes the median increase of each 203 tax policy change. For illustrative purposes only estimate source: Morgan Stanley. Historical issuance source: BondBuyer 8 Source: Barclays, cumulative returns from Sept., 20 to Nov. 30, Source: The Nelson A. Rockefeller Institute of Government. Third Quarter 203 is the latest state revenue data available. 0 Source: S&P / Case-Shiller as of January 204 Source: Bureau of Labor Statistics 2 Source: National Association of State Budget Officers, The Fiscal Survey of States, Fall Source: Barclays and S&P 4 Source: Moody's Investor Services. Long term reflects 970 to 20. About Risk Municipal bonds are issued by state and local government agencies to finance public projects and services. They typically pay interest that is not subject to federal regular income tax or state and local income taxes in their state of issuance. Because of their tax benefits, municipal bonds usually offer lower pre-tax yields than similar taxable bonds. Lower-rated municipal bonds involve a greater risk of default or price changes due to changes in the credit quality of the issuer. The values of such bonds fluctuate more than those of high-quality bonds in response to company, political, regulatory or economic developments. Values of these bonds can decline significantly over short periods of time. Junk bonds involve a greater risk of default or price changes due to changes in the credit quality of the issuer. The values of junk bonds fluctuate more than those of high-quality bonds in response to company, political, regulatory or economic developments. Values of junk bonds can decline significantly over short periods of time. Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower's payments may be received earlier or later than expected due to

9 9 of 9 3/3/204 0:45 AM changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value. Economic and regulatory factors may affect a municipal security's value, interest payments, repayment of principal and one's ability to sell it. An issuer's failure to comply with tax requirements may make income paid thereon taxable, thus reducing the security's value. In addition, there could be changes in applicable tax laws or tax treatments that reduce or eliminate the current federal income tax exemption on municipal securities or otherwise adversely affect the current federal or state tax status of municipal securities. Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating. Market prices of municipal securities with intermediate lives generally fluctuate more in response to changes in interest rates than those with shorter lives but generally fluctuate less than market prices of municipal securities with longer lives. NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE This information is intended for US residents. Invesco Distributors, Inc., is the US distributor for Invesco Ltd. s Retail Products and Collective Trust Funds. Institutional Separate Accounts and Separately Managed Accounts are offered by affiliated investment advisers, which provide investment advisory services and do not sell securities. These firms, like Invesco Distributors, Inc., are indirect, wholly owned subsidiaries of Invesco Ltd.