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Investors May Benefit as Muni Issuers Turn to Taxable Markets

Muni issuers are increasingly refinancing tax-exempt munis in the taxable market, but both areas offer potential benefits.

Despite strong (and growing) investor appetite for municipal bonds, the size of this market has remained static at roughly $3.8 trillion since the financial crisis – in marked contrast with the more rapid expansion of the U.S. Treasury and corporate bond markets (see chart). Supply-side dynamics are the main culprit in the limited growth: Since 2009, issuers have faced a backdrop of 1) rising pension costs and other post-employment benefits (OPEB) liabilities, which have crowded out municipal discretionary spending; 2) limited direct federal investment in U.S. infrastructure, which has restricted new-money issuance; and 3) an inability to advance-refund debt in the tax-exempt market after the Tax Cuts and Jobs Act of 2017.

As a result, issuers are increasingly refinancing tax-exempt munis in the taxable market, leading to less tax-exempt supply. But we see advantages to actively investing in both tax-exempt and taxable munis.

This figure shows the level of municipal debt had remained relatively constant from 2008 to 2019, at around $3.8 trillion since the credit crisis. By contrast, Treasury debt rose to $16 trillion by 2019, up from about $6 trillion in 2008, and corporate debt increased to almost $10 trillion, also up from about $6 trillion.  

Why are issuers drawn to taxable debt?

With tight credit spreads and absolute yields near all-time lows, the taxable markets are appealing to issuers for a number of reasons, including the historically low cost of capital, investor base diversification, and the ability to use taxable bond proceeds for non-tax-exempt purposes – including advance refunding. In an advance refunding, an issuer calls a bond that has a call date 90 days or more in the future, often with the goal of lowering the cost of capital by defeasing (exchanging) higher-cost debt with lower-cost issuance. Given current absolute yields, issuers have been able to call tax-exempt debt issued five to 10 years ago, when U.S. Treasury yields were 100 or more basis points higher than they are today, with taxable debt. Taxable refunding issuance this year totals more than $30 billion to date (through November) and is on pace to exceed $45 billion by year-end.

Absent a sharp increase in interest rates or a change in tax policy that once again allows for tax-exempt advance refundings, we expect issuers to continue to defease tax-exempt issues with taxable debt.

Investment implications: Opportunities in taxable and tax-exempt markets

With record flows into tax-exempt muni bonds to date, investor appetite remains robust, and we expect demand for high quality tax-efficient income-producing assets to keep growing as the population ages. Absent major boosts to municipal discretionary spending or federal infrastructure plans, the contraction in tax-exempt issuance should provide an ongoing tailwind for municipal valuations.

Additionally, as more municipal issuers explore taxable issuance, we expect to see continued strong demand for long-dated high-quality taxable muni assets. Taxable munis have cheapened with the growth in supply, and we believe they provide attractive relative value versus corporates and an appealing entry point for investors who may not benefit from munis’ tax exemption. Further potential benefits include low return correlations with risk asset classes and low default rates historically.  

Despite the technical tailwind provided by limited supply, an active approach to identifying opportunities and avoiding risks late in the cycle remains critical in both the tax-exempt and taxable municipal markets.

Visit Municipal Bonds at PIMCO for more on how we help investors unlock the potential of munis.

David Hammer is PIMCO’s head of municipal bond portfolio management, and Kyle Christine is a municipal bond portfolio manager.

The Author

David Hammer

Head of Municipal Bond Portfolio Management

Kyle Christine

Portfolio Manager, Municipal Bonds

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Disclosures

All investments contain risk and may lose value. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in managing a strategy.

PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

Munis in Focus: 2020 Municipal Market Update
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