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.
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.