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Muni Midyear Outlook 2019: Three Key Takeaways

We see several areas of opportunity for muni investors in the second half of 2019.

The municipal bond market enjoyed a strong first half, with robust returns and a record $52.9 billion of inflows through the end of July, according to Lipper. Tight supply and increased demand arising from the cap on state and local tax (SALT) deductions have been key drivers of performance and flows, and the upcoming 2020 presidential election has raised prospects for higher taxes given many candidates’ progressive agendas, contributing to demand for tax-efficient investments such as munis.

Here we share three key investor takeaways from our 2019 muni midyear outlook to consider for the second half:

1) Muni valuations remain attractive despite some richening. While yields have fallen in recent months, we remain constructive on munis and think valuations still look attractive on an after-tax basis relative to corporate bonds and other credit markets. Given the broadly accommodative environment since the financial crisis and the Fed’s pivot to a more dovish policy stance, we see the potential for excesses in corporate credit valuations and an environment that could give rise to liquidity concerns if sentiment shifts. Lower rate expectations underpin a broadly supportive macroeconomic backdrop for munis.

2) To tap opportunities in the second half, an informed active approach is key. We’re seeing structural opportunities arising from steep muni yield curves and market mispricing of callable bonds, along with growth in private placements and unrated issues. Active credit selection and avoidance of economically sensitive assets, as well as the potential to exploit market confusion related to “special revenue” bonds, also present opportunities. While investing in these areas may be challenging for individual investors, they can be tapped by managers who meet the qualified investment buyer (QIB) standard (often required for private placements) and with the analytics capabilities to price call options and seek attractive bonds across the curve. A rigorous credit approach is crucial to discern attractive investments from potential pitfalls. 

3) Tight supply is a performance tailwind, but rising unfunded pension liabilities bear watching. Net muni supply remains negative (see Figure 1) as issuance continues to lag bond maturities and calls, and with no major infrastructure plan on the horizon, new issuance will likely remain constrained. Factors including the Tax Cuts and Jobs Act’s elimination of advance refundings, which had represented roughly 20% of annual muni issuance, have contributed to recent tightening. However, budgetary pressure from growth in unfunded pension liabilities has also been a key factor constraining supply. The wide dispersion in pension concerns across the country highlights the need for a thoughtful framework for assessing appropriate credit risk premiums.

Munis continue to offer potential late-cycle benefits

Municipal bonds may offer investors advantages late in this economic expansion, including attractive tax-efficient income, low correlations to riskier asset classes, and default rates that have been low historically. However, credit selection will become more critical as economies cool. PIMCO is positioning out of asset classes, sectors, and credits we view as most susceptible to declines in consumer spending, located in less economically resilient regions, or exhibiting high sensitivity to declining macro fundamentals, including commodity prices. We continue to emphasize credits backed by dedicated revenue streams less subject to politics and pension stress.

Muni Midyear Outlook 2019: Three Key Takeaways

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David Hammer

Portfolio Manager

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Past performance is not a guarantee or a reliable indicator of future results.

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; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Sovereign securities are generally backed by the issuing 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.  Diversification does not ensure against loss. 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 connection with managing the 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. 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 long-term, especially during periods of downturn in the market.  Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and 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. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO.