The opportunity in municipal bonds The opportunity in municipal bonds\images\insights\video\video-small-gallo.jpg March 22 2019 July 9 2018

The opportunity in municipal bonds

Senior Portfolio Manager R.J. Gallo explains why municipal bonds have largely outperformed their taxable investment-grade counterparts in 2018.
Published July 9 2018
My Content
R.J. Gallo, CFA
Senior Vice President
Senior Portfolio Manager
Head of Municipal Bond Investment Group
Head of Duration Committee
Video Transcript
How much of a headwind do 3% treasuries pose to munis?
The total return on munis on a year to date basis is right around zero. Not bad when you compare it to about 2% losses of taxable fixed income indices of investment grade taxable fixed income, for example. The reason munis have outperformed even though interest rates have risen muni issuance has fallen pretty sharply on a year to date basis. This is the flip side to the effect of the tax bill last year. Last year there was a rush to issue ahead of the tax bill. December of last year was a record in terms of gross muni issuance ever, ahead of the tax bill. This year we're giving that back, and issuance has been pretty light. Demands been okay, and on net munis have incrementally outperformed. They have enriched in fixed income space with muni ratios generally heading lower for intermediate and shorter term bonds. So year to date returns are muted, but they're a little better than taxables. In a world where rates are still rising we'll count that as a small victory.
Do you expect municipal credit to remain stable given constrained state budgets, and pension costs?
The U.S. economy is doing very well. When the economy is expanding you see state and local governments benefiting from higher income tax revenues, higher sales tax revenues, as well as higher property tax revenues. All of those factors have helped to repair municipal budgets sharply from where they were a number of years ago as we came out of the very deep recession and had a long grinding recovery. So, the municipal credit picture actually looks pretty good in general. There are pockets of concern however, so some states like in New Jersey, or in Illinois where pension funding is very weak, 40% funded ratios give or take. No rainy day fund for the next slowdown. You have to be concerned there. Maybe not now because the wind at the back of all states is helping New Jersey and Illinois as well, but they have structural imbalances they haven't really fixed. They have pension problems that they have to address. They have no rainy day fund for when the economy eventually rolls back into recession. Near term the story's generally good. The timing of the next down turn is a question and then we'll have varying implications across the credit spectrum. There are some states that are not well positioned for that ultimate day.
What about impacts to munis as a result of tax reform?
Tax reform reduced the corporate tax rate sharply. It was 35% at the federal level. It's now 21, so one of the most salient impacts in this calendar year has been selling from banks. Banks and insurance companies which pay corporate income tax and saw a 14% point reduction in their tax rate have less interest in tax exempt income, so they've lightened up their muni allocations. They've been generally pretty strong sellers of municipal bonds. Individual investors however, the highest tax bracket went from 39.6 to 37, a pretty modest adjustment. The brackets moved, so some people who might have made $250,000 in a year they might have moved down a bracket as well, but on net we have not seen individual investors react to the tax cut nearly as strongly as the corporate investors have. Munis are still in demand when it comes the individual investor both in the form of mutual fund flows as well as, direct bonds. Demand's held up reasonably well from that party. The key thing to consider is that issuance on a year to day basis is down about 25% compared to where we were at this time over the last three years. That's a big drop, so with demand being okay on net, and issuance dropping sharply, supply and demand matter everywhere and they matter in munis too, and that has supported relative performance thus far on the year. As interest rates have backed up, munis have actually outperformed a little bit.
Views are as of June 25, 2018 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices. Interest income from municipal securities may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes. Federated Investment Management Company 18-74999 (6/18)
Tags Fixed Income . Taxes . United States . Active Management . Tax Aware . Income .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Federated Equity Management Company of Pennsylvania