2Q 2019 — Tax-Free Fixed Income

Jamie Mullen
Senior Portfolio Manager
Neal DeBonte, CFA®
Portfolio Manager

After finishing 2018 as one of the best performing fixed income asset classes, municipal bonds are continuing their blistering pace with a very strong first half 2019 performance. The Bloomberg Barclays Aggregate Municipal Index posted a first half return of 5.10%, while the SMA-focused Bloomberg Barclays 5-Year Municipal Bond Index has returned 3.81%.

The market, which is largely driven by supply/demand economics, continues to feel the additional tailwind from the Tax Cuts and Jobs Act. Put simply, the municipal market issuance has been hampered by the loss of advanced refundings and to a lesser degree, an aversion to debt issuance in some municipalities.

On the flip side, demand has spiked due in part to the $10,000 cap for SALT (state and local taxes), on individual filers returns. These factors, coupled with a persistent rally in rates, has created a perfect storm where municipal valuations have hit the highest levels in recent memory. One way to judge the relative richness of tax-free bonds is through the use of “AAA” municipal bond/US Treasury rate ratio. The higher the ratio is, the “cheaper” municipal bonds appear, with a lower ratio flagging the relative richness of tax-free bonds.

Throughout much of the first half of this year, muni/Treasury ratios fell steadily to some of their lowest levels on record. To put the magnitude of the movement in perspective, the 10-year muni/Treasury ratio declined from a level of 88% to start the year, to a low of 72% in mid-May, the lowest level in over a decade. It is worth noting that there has been some reversal of muni ratios over the past several weeks, which has led to some better entry points for our portfolios. However, we anticipate that the trend of lower ratios should continue as we push further into the summer time.

Municipal bonds are now heading into the time of year that is traditionally known for heavy reinvestments, with large sums of cash returning to investors from both principal and interest payments. The additional cash to be reinvested will continue to absorb any new issue calendar and put further pressure on tax-free rates, especially in the SMA dominated 0-10 year portion of the yield curve. As rates continue to decline, some of the levers available for portfolio managers to pull are those of duration and credit.

Duration has been one of the drivers of additional returns, with the modified duration of the Bloomberg Barclays Municipal Aggregate bonds logging in at a full year longer than its 5-year index counterpart. Credit has also been a driver of additional returns, with the “A” and “BBB” portions of the municipal market outpacing their higher rated peers by well over 100 basis points year-to-date.

Looking ahead, we project that technicals for the tax-free sector will continue to be constructive. Using new issue supply as a measuring stick, the amount of new issue bonds sold in the second quarter was significantly lower than compared to the start of the year. As of March 30, 2019, municipal issuance was up 22% compared to the same time frame in 2018.

New issuance reversed course in the second quarter, and now stands at just over 6% increase year-over-year, further adding to our supply/demand imbalance thesis for the market. Any further rate cuts by the Fed for the remainder of 2019 would provide additional tailwinds for tax-free performance.

Source: Bloomberg, Ned Davis Research

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Bloomberg Barclays U.S. Aggregate Bond Index: The index is unmanaged and measures the performance of the investment grade, U.S. dollar denominated, fixed-rate taxable bond market, including Treasuries and government-related and corporate securities that have a remaining maturity of at least one year.
The Bloomberg Barclays 5-Year Municipal Bond Index is the 5 Year (4-6) component of the Municipal Bond index. It is a rules-based, market-value-weighted index engineered for the tax-exempt bond market. The index tracks general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds rated Baa3/BBB- or higher by at least two of the ratings agencies.
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A S&P “A’ rated obligation is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories. However, the obligor’s capacity to meet ts financial commitments on the obligation is still strong.
A S&P ‘BBB’ rated obligation exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to weaken the obligor’s capacity to meet its financial commitments on the obligation.
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