Top 5 Municipal Market Insights for 2019
Tactical Moves Guide Investors Through Market Uncertainty
When foggy weather obscures the path forward, it is prudent to get your bearings more frequently. Similarly, uncertainty clouds our visibility going into 2019. Whether the economy is in late cycle or taking a pause, municipal investors will be balancing their concerns about risk against their need for income. When the path is unclear, it is wise to watch your footing and we think that a similar sentiment will weigh on market participants’ investment decisions as 2019 progresses. However, being overly cautious can cause a misstep; we believe that a tactical approach in 2019 will best ensure progress for our clients’ investment objectives.
1. Dedicated tax and general obligation debt outperforms as tax revenue streams grow
The recent expansion in overall economic activity has fueled growth in individual and corporate income taxes as well as sales taxes. State government revenues have exhibited strong year over year growth, with 2018 revenues up almost 6% through the third quarter of 2018.1 We anticipate investors will place a premium on higher quality, tax-backed debt. However, security selection is essential as the recovery in credit fundamentals among state and local governments has been uneven.
2. Municipal issuance exceeds market expectations
Cumulative issuance of both tax-exempt and taxable municipal bonds, in our opinion, will exceed expectations as issuers increase funding for capital investment. We anticipate ongoing revenue growth will spur governors to reinvest incremental cash flows back into their state economies. We expect the growing supply of taxable municipal debt to be readily absorbed as demand increases from pensions and endowments that are seeking to diversify away from their exposure to the BBB-heavy corporate bond asset class.
3. Restructuring of Puerto Rico debt provides opportunity to increase allocation to high yield municipal bonds
The market will, we believe, demand higher yields and wider spreads on the massive volume of restructured Puerto Rico debt. We anticipate the spillover effect from this transition to accrued bonds offers investors the opportunity to increase their allocation to high yield debt at very attractive levels. We expect the opportunity for outperformance in the high yield municipal market to occur in the second half of the year.
4. Municipal financing with embedded real estate risk underperforms
We anticipate the market will penalize sectors and credit structures exposed to real estate market values. Financings tied to selected commercial real estate, raw land housing development and continuing care retirement centers, in our opinion, will come under pressure as peaking market values recede. These same sectors also historically experience higher default rates.2 By contrast, we believe that financings dependent on assessed valuations of existing developed real estate (e.g. general obligation debt) will find favor in the market as debt coverage remains strong.
5. Tactical portfolio positioning drives performance
In contrast to the last number of years when strategic portfolio structure proved beneficial, we believe a tactical approach going forward to be more prudent. Given the uncertainty of the overall markets, tactically adjusting portfolio exposures as market direction becomes evident should, in our opinion, provide more flexibility. As a result, we believe that this approach provides better total return opportunities than strategies anchored to more traditionally passive investment approaches.
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1. Source: U.S. Census Bureau 3Q 2018
2. Source: U.S. Census Bureau 3Q 2018
All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market.
Credit Ratings: AAA credit ratings apply to the underlying debt securities and are rated by an independent rating agency, such as Standard & Poor’s (S&P), Moody’s, and/or Fitch. S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade. Moody’s rates borrowers on a scale from Aaa through C. Aaa through Baa3 represent investment grade, while Ba1 through C represent non-investment grade. Fitch rates borrowers on a scale from AAA through D. AAA through BBB represent investment grade, while BB through D represent non-investment grade.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
This material contains the opinions of the MacKay Municipal Managers™ team of MacKay Shields LLC but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2019, MacKay Shields LLC.
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