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 portfolios.

Fatter tails

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.

Figure 1 is a line graph showing the allocation to municipal assets by banks and insurance companies, over the time period 1991 through September 2016. The chart shows a big increase over the time span, to about $1.1 billion by 30 September 2016, up from about $225 million in 1991. The slope of the allocation amount over time steepens around 2001, when it was about $325 million, and climbs fairly consistently through September 2016.

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 impact.

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.

Figure 2 is a line graph showing the breakeven tax rate of AA rated municipals versus AA rated corporates over the time period 2006 through 2016. As of year-end 2016, the breakeven tax rate is around 10%, down sharply from about 30% six months earlier, and much lower than a peak on the chart of 40% in early 2015. Over the time span of the graph, the rate fluctuates between about negative 20%, seen in years 2010 and 2013, and the 40% peak in 2015. From 2008 to 2010, the rate trended downward to its low of negative 20%, from a high of about 35%. The rate trended upward from 2012 to 2015, peaking at 40%, up from its lows around negative 20% in late 2012 and early 2013.

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 selection.

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.

Figure 3 is a line graph showing the state and local government contribution to U.S. gross domestic product over the time period 2012 through third quarter 2016. As of 30 September, the seasonally adjusted annual rate was round 0% of GDP, down from a high of about 0.4% a year earlier. From 2012 to the third quarter of 2015, the rate trended upward, from lows of around negative 0.2% in 2012 to zero in 2014 to its peak in 2015. After that it started moving downward to 0% in September 2016.

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.

Figure 4 shows the inflation-adjusted state tax receipts for the period 2007 through mid-year 2016, scaled by quarter. Since around the third quarter of 2015, the four-quarter average year-over-year change fell for sales tax, personal income tax, and corporate income tax. The change in corporate tax receipts fell to lower than negative 5%, down from about positive 5% over that period. The rate of change of the personal income tax fell just above zero, down from its recent high in 2015 of about 7.5%, while the sales tax rate change fell to the same level, sown from about 5%. All three metrics showed mostly positive growth from late 2010 onwards until 2015. All three had negative growth during the years of 2008 to 2010.

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 taxes.

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).

Figure 5 is a line graph showing the rate of growth of local government property tax collections from March 2012 through September 2016. The four-quarter average year-over-year change was at its highest level in September 2016, at around 5%, up from 2% a year earlier, and 0% in March 2012. The rate also peaked in mid-2014 at around 3%, before falling to 2% in 2015. From September 2015 onward, the metric rose steeply, then leveled off in mid-2016 at around 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 quality bias

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 federal government.

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 and appropriations.)

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 portfolios.

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The Author

David Hammer

Portfolio Manager

Sean McCarthy

High Yield Credit Research Analyst, Municipals



All investments contain risk and may lose value. 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 the current low interest rate environment increases this risk. Current 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. Income from municipal bonds 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. 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. 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.

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