Municipal Market Update: Short-Term Headwinds and Long-Term Value
Despite favorable supply and demand dynamics, the municipal bond market has underperformed Treasurys thus far in 2018, due to a combination of factors. We believe this should be short term in nature and remain confident in our longer-term outlook for the municipal market and the value it presents for active investors.
At the end of 2017, the impact of the U.S. Tax Cuts and Job Act quickly became obvious with regard to municipal supply, as issuers rushed to market before year end. Based on this technical factor, the market observed heavy issuance in December 2017, as debt was front-loaded from the first quarter of 2018. Despite record-setting issuance and the expectation this would lead to negative returns, strong demand absorbed this increase in supply, leading to positive municipal market returns in late 2017.
In early 2018, the unexpected happened once again. With modest seasonal issuance, acceleration of deal flow late last year, and higher volume of coupons and maturities seeking reinvestment, many believed this would lead to strong municipal performance in early 2018. Municipal performance, however, has belied these trends thus far, as the positive dynamic of declining supply this year has been offset by other factors. Perhaps most significantly, the rate sell off we have seen in the Treasury market has carried over to municipals to an even greater extent, driving the market’s rates higher. So far in 2018, municipals have underperformed Treasurys, more notably on the long end of the yield curve. We would attribute this to the high volume of reinvestment proceeds funneling back to the intermediate segment of the market while, simultaneously, we believe investors focused on the long end of the curve have stayed on the sidelines, due to long-term inflation concerns. We believe this is temporary in nature and that the long end of the yield curve is even more compelling today. We also still believe that municipals will outperform Treasurys in 2018.
Figure 1: Valuations are Increasingly Attractive on the Long End of the Municipal Curve
Source: Barclays Research and the U.S. Treasury Department, as of 3/19/18. The municipal yield is a baseline curve for high-quality, tax-exempt municipal bonds. The Treasury yield is based on the U.S. Treasury yield curve.
Where Do We Go from Here?
We entered 2018 with a longer-term view that the municipal yield curve would flatten and municipal-to-treasury ratios would decline, as tax-exempt bonds outperformed. While the market has not behaved this way so far, our thesis remains intact. Contributing to this view is consistent demand from retail investors and more modest supply of bonds with longer-dated maturities going forward.
At the same time, we expect that life insurance companies will begin to play a more active role in the municipal market, as tax reform has increased the amount of tax-exempt income life insurers can recognize to 70% of interest earned. Life insurance companies are more likely to focus on the long end of the yield curve, as they look to manage liabilities that are longer term in nature. At the same time, the long end of the municipal yield curve has become more compelling recently.
Meanwhile, we expect that banks and property & casualty (P&C) investors will shift their investment of new dollars away from the intermediate portion of the municipal market. The reduction in the corporate tax rate to 21% increases the after-tax yields these investors can capture in corporate bonds, relative to municipals. In our opinion, this theme could potentially be exacerbated due to the relative richness illustrated by valuations on the tax-exempt side.
In our opinion, the recent weakness in the municipal market has been overdone, particularly on the long end of the curve, and we have taken advantage of opportunities that market headwinds have helped to create. While we recognize that increased volatility may be a consistent theme going forward, we remain confident in our positioning due to a long-term investment outlook that remains solidly intact.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
New York Life, MainStay Investments, and its affiliates do not provide legal, accounting, or tax advice. You should obtain advice specific to your circumstances from your own legal, accounting, and tax advisors.
Before you invest
Mutual funds are subject to market risk and will fluctuate in value.
A portion of a municipal fund’s income may be subject to state and local taxes or the Alternative Minimum Tax. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
High-yield securities (commonly referred to as “junk bonds”) are generally considered speculative because they present a greater risk of loss than higher-quality debt securities and may be subject to greater price volatility.
High-yield municipal bonds may be subject to increased liquidity risk, as compared to other high-yield debt securities.
Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.
Active management is the use of a human element, such as a single manager, co-managers, or a team of managers, to actively manage a fund’s portfolio. Active management strategies typically have higher fees than passive management.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities. Such uncertainties could cause increased volatility in the municipal securities market and could negatively impact the Fund’s net asset value and/or the distributions paid by the Fund. Securities purchased by the Fund that are liquid at the time of purchase may subsequently become illiquid, due to events relating to the issuer of the securities, market events, economic conditions, or investor perceptions.
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New York Life Investments engages the services of MacKay Shields LLC, an affiliated, federally registered advisor, to subadvise several Funds. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.