Investor demand for municipal bonds has been robust in 2019, despite low absolute yields. Net new cash flows into municipal bond funds totaled $62 billion as of Aug. 21, representing 33 consecutive weeks of inflows and the best start to a year since record-taking began in 1992.1
Municipal fund flows January through July
The bulk of increased demand has come on the heels of the Tax Cuts and Jobs Act (TCJA) of 2017. Under the new law, the $10,000 cap on state and local tax deductions, the so-called “SALT cap,” has resulted in surprisingly larger individual tax bills for people in states with high state income taxes (especially Democratic-leaning states like California, New York, and New Jersey). The Inspector General for Tax Administration Audit of the TCJA estimates that around 11 million taxpayers have been affected by the SALT cap, to the tune of about $323 billion in state and local taxes that are no longer deductible, boosting interest in municipals’ tax-exempt status.2
These record inflows have come during a time of low supply. In 2018, new issuance fell by nearly 25% from the previous year, and that trend has continued in 2019.3 This combination of high demand and low supply has driven price appreciation across the municipal market and generated the longest streak of positive monthly performance in nearly three years.4
The Invesco Fixed Income Municipal Bond team expects positive market technicals to persist through the early fall. Given increased uncertainty about the US and global macroeconomic outlook, we believe municipals may benefit in the short term as the asset class is often viewed as a safe haven and has historically experienced increased demand during flights to quality.
Fundamentals look solid
Fundamentals have also helped support municipal market performance. We view the credit quality of the municipal market as stable, heavily influenced by continued economic recovery and growth across many parts of the US. Growth of state and local property tax collections has been healthy, up 4.6% and 1.6%, respectively, through the end of March.5 The market experienced only one default in 2018, the lowest number since 1997 and the fifth year since 1986 with one or fewer defaults.6 Moody’s reported that credit upgrades outnumbered downgrades in the second quarter of 2019 for the eighth quarter in a row and by the largest margin since the first quarter of 2017 (157 upgrades versus 64 downgrades); the volume of upgraded debt also exceeded downgraded debt by a wide margin ($17.7 billion versus $5.7 billion).7
Further boosting state fundamentals was the US Supreme Court decision in June 2018 to overturn a decades-old ban on state tax collection from online sellers. The 5-4 decision did away with the notion that governments can only collect sales taxes on purchases made from retailers with a physical presence in their state. Since this change, the District of Columbia and 42 of the 45 states with a sales tax have enacted laws or regulations requiring remote sellers to remit a sales tax.8 It was widely estimated that states were collectively missing out on anywhere from $8.5 billion to $13.4 billion a year in potential online sales tax revenue.9 While it is still too early to determine if these are accurate estimates, we expect increased revenue to be net positive for state and local governments in the coming years.
In general, we believe states are better prepared now than they were in the past to face an economic downturn. The median “rainy day fund” balance as a share of “general fund” spending is projected to reach 7.5% in fiscal year 2019, which would be an all-time high according to the National Association of State Budget Officers’ Spring 2019 Fiscal Survey of States.
Valuations appear tight
One of the results of historic inflows into the asset class has been yield and spread compression across the municipal yield curve. So far in 2019, municipal yields have fallen by around 75 to 100 basis points across the curve.10 This lower yield environment has made it more challenging to find value.
Comparing benchmark municipal yields over the past 30 years reveals that 10-year and longer investment grade yields are currently 6 to 32 basis points away from their absolute lows, depending on maturity and rating category.11 The summer of 2016 was the last time yields were around current levels. Relative to taxable debt, however, we believe longer-dated municipals exhibit some value. High-grade 20-year municipals now yield around 110% of 10-year US Treasury benchmark yields.12
By contrast, shorter-dated bonds remain expensive. At the five-year spot, for example, the AAA municipal-to-Treasury yield ratio is 68%, down from 72% on average over the past 12 months.12 Following the Federal Reserve’s recent shift to an easier monetary policy, we believe longer-dated bonds (20 to 25 years) offer better value for new capital investments.
While high yield municipal spreads are tight from a historical perspective, we believe there is still room for further compression given the strength of the technical environment. The high yield municipal market could benefit from a boost in issuance from names outside of the usual issuers and sectors, in our view, since a diversity of issuers and sectors potentially promotes a more balanced market environment.
1 Source: Lipper US fund flows as of Aug. 16, 2019
2 Source: Treasury Inspector General for Tax Administration Review of the Issuance Process for Notice 2018-54, as of Feb. 22, 2019
3 Source: BondBuyer, as of July 31, 2019
4 Source: Bloomberg Barclays, covers period from Nov. 31, 2018, to July 31, 2019, for the Bloomberg Barclay’s Municipal Bond Index, which is an unmanaged index considered representative of the tax-exempt bond market
5 Source: US Census Bureau, as of March 31, 2019
6 Source: Standard & Poor’s Financial Services LLC, as of May 31, 2019
7 Source: Moody’s Investor Services as of June 30, 2019
8 Source: Taxfoundation.org, as of Aug. 19, 2018
9 Source: Taxfoundation.org, as of Aug. 19, 2018
10 Source: Thomson Reuters – The Municipal Market Monitor (TM3) as of Aug. 19, 2019
11 Source: Bloomberg Barclays, covers period from Jan. 31, 1980 to July 31, 2019
12 Source: Bloomberg Barclays, covers period from July 31, 2018 to July 31, 2019
Blog header image: Simon / Stocksy
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.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.
Safe havens are investments that are expected to hold or increase their value in volatile markets.
A basis point is one hundredth of a percentage point.
The opinions referenced above are those of the author as of Sept. 6, 2019. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.