Municipal investors are in a much different place than they were a year
ago, with 2017 likely to be a year of change for the market. Uncertainties
about tax reform and fiscal spending have created muni-specific policy risk
that could result in higher price volatility than in recent history. We
believe this could create opportunities for nimble managers who incorporate
top-down macro analysis with bottom-up credit selection in their municipal
As we discussed in PIMCO’s latest Cyclical Outlook,
Into the Unknown, Donald Trump’s victory in the U.S. presidential election has increased
both right-tail (positive) and left-tail (negative) risks to economic
growth over the next several years, with outcomes hinging on which policies
are implemented and the global policy response.
A similar fattening of tails is occurring in the municipal market. Over the
next year, we expect to see greater interest rate volatility, driven by
global macro uncertainty and additional Fed rate hikes against a backdrop
of uncertain U.S. tax policy. While we believe our New Neutral secular
thesis will largely hold, the possibility of a continued “reflation trade”
and higher rates has increased. On the flipside, some tax policy changes
(or lack thereof) could be beneficial to valuations, and even less
favorable policy shifts may have positive near-term effects. In any of
these tail scenarios, the resulting market volatility could give rise to
opportunities for active investors in the muni market looking to increase
their tax-efficient income streams.
Tax reform implications
With a Republican sweep of the executive and legislative branches of the
U.S. government, tax reform – particularly corporate tax reform – will
likely take center stage in 2017. Banks and insurance companies have
increased holdings of municipal assets in recent years and now own over 25%
of outstanding municipal debt (see Figure 1). Banks and insurers have
served as a primary liquidity provider to the municipal market since the
financial crisis, filling some of the void left by declining broker-dealer
balance sheets. During periods of sharp retail outflows, banks and
insurance companies have stepped in to buy munis when they became
attractive on an after-tax basis relative to investment-grade corporates.
A proposed decline in the corporate tax rate to 20% would change the lens
through which many banks and insurance companies view investing in munis.
While they might still be buyers in times of stress, they are likely to
require higher relative yields before stepping in. This could introduce
additional price volatility going forward.
Individual tax reform is more complicated and potentially more costly than
corporate tax reform (and thus perhaps less likely to be enacted), but it
is certainly something a Republican majority will pursue. If history is a
guide, changes in the top marginal tax rate have been poor predictors of
municipal asset performance, so we believe cutting this rate to 33% from
43.4% (the most likely option on the table) is unlikely to have a long-term
We think muni valuations face more significant left-tail policy risks from
potential limits on high-income individuals’ ability to shield municipal
income from taxes. Trump’s campaign plan included a $200,000 cap on
deductions for married couples, although it was silent on the muni
exclusion, and Former House Ways and Means Committee Chairman Dave Camp’s
2014 tax reform proposal suggested imposing a 10% surtax on municipal bond
interest at higher income thresholds.
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While we don’t expect either outcome in our base case, these proposals
could become part of the conversation if the Trump administration widens
the scope of individual tax reform and emphasizes deficit neutrality. Under
each proposal, we would still expect the municipal federal tax exemption,
and in some cases state and local exemptions, to be valuable for much of
the traditional investor base. But even their inclusion in the conversation
could be enough to trigger additional market volatility and potential price
dislocations (and in turn opportunities for active management).
We also see several potential right-tail policy outcomes for the municipal
market. Changes in tax policy affecting munis could come in tandem with a
grandfathering of existing bonds, creating scarcity value and potentially
leading to a market rally. And elimination of the alternative minimum tax
(AMT), which previous versions of the House tax reform bill proposed, would
improve the value of many outstanding
private activity bonds. Alternatively, Congress may get bogged down with other priorities, such
as Supreme Court nominations or repealing the Affordable Care Act (ACA),
that push individual tax reform to next year or beyond.
Position for the long term and let valuations be your guide
Prospects for higher interest rate volatility, lower corporate tax rates
and hard-to-predict policy outcomes all point to a more volatile muni
market in 2017. We believe investors should remain defensively positioned
within muni allocations to begin the year, which would allow scope to be
more aggressive when valuations overshoot fundamentals, as they often do in
the tax-exempt muni market. As recently as early December, AA-rated
tax-exempt municipals were trading at valuations that more than compensated
investors for any future tax policy outcome (see Figure 2). In the absence
of policy certainty, let valuations be your guide and use volatility to add
long term portfolio value over the cyclical horizon.
Spotlight on Municipal Credit
Even as PIMCO forecasts policy volatility and fatter-tailed outcomes in the
year ahead, we maintain a constructive view of U.S. municipal credit
against a broadly supportive backdrop. PIMCO expects U.S. GDP growth of
2%-2.5% in 2017 as business investment recovers and consumer spending
remains strong. Markets have seen a reflation trade in equities since the
election, and homebuilder sentiment reached a post-recessionary high of 70
in December (as measured by the NAHB Housing Market Index). A continuation
of these trends would support municipal credit health in 2017.
We would also note that high profile U.S. municipal bankruptcies have
largely proven idiosyncratic: Neither Puerto Rico’s placement in federal
oversight nor the City of Detroit’s bankruptcy filing have had broader
implications for municipal credit. But given the “aging” of the U.S.
economic expansion – in March, the current recovery would become the
third-longest in postwar history – we’re on the lookout for signs of
late-cycle conditions and early credit fatigue. We continue to place a
heightened emphasis on top-down sector allocation and bottom-up security
State governments: Neutral outlook
Our neutral outlook on state governments reflects the push and pull of
several factors. State and local government contributions to annual U.S.
real GDP have slowed (see Figure 3), which can be an indication of fiscal
restraint and overall credit health. The slowdown may be attributable in
part to the steep drop in energy prices since mid-2014, with states heavy
in energy production experiencing a lagged effect.
The transmission of weaker energy prices to state finances can come from several channels, including lower regional economic activity, severance taxes (on extraction of minerals from the ground), personal income taxes and corporate taxes, among other things. States exhibited a noticeable softening of revenues in the second quarter of 2016, with a 3.3% decline (see Figure 4). Although corporate taxes generally make up a relatively small proportion of total state tax collections, they can be volatile and had fallen for four consecutive quarters through second-quarter 2016. Growth in personal income taxes, a large driver for most state coffers, also contracted in the second quarter of last year.
In 2017 and beyond, however, PIMCO expects modestly higher state tax
collections, driven by a recovery in corporate profit margins and stronger
equities. Higher equity prices mean higher capital gains and thus higher
personal tax collections.
At the same time, federal policy uncertainty may have unforeseen
consequences on state credit quality. For example, an aggressive trade
agenda and corporate tax reform each have implications for the dollar that
might hurt corporate profits and manufacturing. Efforts to repeal and
replace the ACA could also harm state budgets in 2017 and beyond. Finally,
despite a record number of bond authorizations in November 2016 state
ballots, state governors may choose to defer plans for spending on physical
assets in anticipation of a larger federal infrastructure program.
One possible silver lining? Repatriation. If Congress pursues a
repatriation of income held abroad by U.S. corporations, states rich in
certain industries (for example, New Jersey with pharmaceuticals and
California with technology) may benefit, as profits remain subject to state
Local governments and land-backed deals: Positive outlook
The outlook for local governments is more optimistic than for state
governments. Local governments in the U.S. are funded primarily by property
taxes, which lag home price appreciation (HPA) due to the infrequency of
assessments. HPA in October was positive for the 54th consecutive month,
and PIMCO does not expect rising interest rates or higher
inflation expectations to set back the U.S. housing recovery. These
conditions support local government credit, and property tax collections
continue to exhibit positive year-over-year growth (see Figure 5).
PIMCO municipal portfolio managers have added overweight positions to “dirt
deals” and other land-secured deals to our municipal portfolios. We expect
these sectors will continue to demonstrate positive credit fundamentals
with support from U.S. housing conditions.
Not-for-profit (NFP) healthcare: Neutral outlook – Maintain high
The NFP healthcare sector is acutely susceptible to a repeal or
modification of the ACA. The act fundamentally changed the delivery and
reimbursement system for NFP healthcare in the U.S., leading to improved
operating profitability across the sector as bad debt expenses shrank.
Thirty-two states, including Washington, D.C., expanded Medicaid
participation under the ACA, adding roughly 16 million people to the
program, and about 62% of Medicaid spending in 2015 was funded by the
Congress has discussed converting Medicaid to a block grant program, which
provides states greater flexibility but would also make them responsible
for more of the costs. (Accordingly, put risk related to Medicaid for
states under an ACA repeal is a factor in our neutral outlook for state
credit quality, since states that expanded Medicaid will ultimately need to
offset the loss of federal funding with higher taxes or cuts to benefits
PIMCO has always viewed a disruption in federal reimbursement as a key risk
to the NFP healthcare sector, and our portfolios maintain a high quality
bias to healthcare systems with strong balance sheets. To the extent that
the sector faces a reimbursement cycle disruption, we believe high quality
credits would outperform lower quality systems, and there may be additional
opportunities for active managers to add risk-adjusted value to their
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