The run-up to April 15 is a time when many investors reconsider the tax implications of their investments, and many may be facing a different tax backdrop this year following reforms in 2018.1 Tax-exempt municipal bonds may offer investors some key advantages, particularly as the economic expansion enters its later stages, and now may be a good time to consider the potential benefits.

What can investors expect from muni portfolios in 2019? PIMCO is constructive on municipal allocations and believes the asset class will remain resilient even if the economy slows, with support from flat issuance, low relative defaults and continued demand for high quality “safe-haven” tax-efficient income – particularly in high-tax states where state and local tax (SALT) deductions have been curtailed. However, pension dynamics and tight labor markets have given rise to cost pressures for some municipal sectors over the past year. An evolving political climate may also contribute to an uncertain budget outlook late in the cycle. We expect more dispersion across the more than 30 municipal sectors than in recent years, and believe active management and robust credit research will be critical to identify potential winners and losers ahead of the next downturn.

At this point in the cycle, we believe it is prudent to move up in the capital structure and allocate to issuers and sectors expected to be more insulated from an economic downturn. We favor essential service revenue-backed bonds issued by municipal enterprises that maintain monopoly-like pricing power and credits less vulnerable to contractions in consumer spending. We are also more discerning of recent deals issued later in the cycle with weaker bondholder protections and more aggressive growth projections.

Munis have thrived in late-cycle conditions

Despite some “flashing orange” macro signals, PIMCO’s economic outlook for 2019 is broadly supportive of the municipal asset class, which has tended to perform well in late-cycle environments. Past periods of rising rates – including in 2018 – have highlighted the sector’s diversification benefits and outperformance relative to mainstream stocks and bonds.

What has persisted, and what has evolved?

To gauge what investors can expect over the cyclical (six- to 12-month) horizon and how to prepare, we examine attributes of munis at the end of previous economic expansions, while also addressing a key question: What could be different this time around?

Certain muni characteristics have held firm over the past decade and may be attractive to investors contemplating the end of the current expansion:

Low correlations to equities. Over the past 10 years, both investment grade and high yield munis have exhibited negative correlations to the S&P 500 (see Figure 1). This may prove beneficial during periods of equity market volatility that are common late in economic cycles.

Figure 1 is a table that shows the correlation of various asset classes to the S&P 500. Information as of 31 December 2018 is detailed within the table.

Low default rates. Defaults have been rare for investment grade municipal bonds and remain low for high yield munis, especially when compared with their corporate bond peers (see Figure 2).

Figure 2 is a bar chart showing default rates of munis relative to corporate bonds for various rating levels, over the period 1970 to 2017. Default rates for munis are lower than those of global corporates in each rating level, but the gap becomes pronounced in lower-rated asset classes. For high yield, munis have a default rate of about 7%, versus almost 28% for comparable corporates. For the next level up, Baa, munis have a default rate of about 1%, compared with about 3% for corporates. Muni default rates are negligible for Aaa, Aa, and A, versus 0.31%, 0.71% and 1.86% for comparable corporates, respectively.

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Outperformance when rates are rising. While we expect the Federal Reserve to take a cautious approach to monetary policy, interest rate concerns come with the territory in aging expansions. Munis have outperformed core bonds during past periods of rising rates, including in 2018, when munis were up 1.28% for the investment grade index and 4.76% for high yield, while the Bloomberg Barclays Aggregate was unchanged on a total return basis (see Figure 3).

Figure 3 is a table showing how munis have outperformed corporate bonds in past hiking cycles. The table shows various bond asset classes, and how munis and taxable-equivalent munis outperform during five rate-hike periods, from 1988 to year-end 2018. Information as of 31 December 2018 is detailed in the table.

At the same time, we see some key differences between the environment today and that leading up to the last recession, providing both opportunities and reasons for caution:

Stable muni supply provides a technical tailwind. While the amount of fixed income debt has risen substantially over the past decade, tax-exempt muni supply has remained flat, with increases in muni leverage primarily in the form of growing pension liabilities and other post-retirement benefits. The limited growth of municipal debt outstanding supports a favorable supply and demand dynamic.

Aging demographics and the risk of higher taxes boost demand. As markets begin to focus on the 2020 presidential election, Democratic candidates are putting forth proposals that would increase taxes on the wealthiest Americans – a marked shift from policies that reduced taxes in recent years. This trend, along with rising numbers of retirees, could provide a tailwind in demand for federally tax-exempt vehicles such as munis.

A steeper municipal yield curve creates opportunity. The muni yield curve has steepened as U.S. banks and insurance companies buy fewer long-dated muni bonds, given lower corporate tax rates (see Figure 4). Muni investors may benefit from extending duration to reach higher levels of roll down and carry, along with better potential price performance if the environment moves from late-cycle to end-cycle. We think 20-year (noncallable to 10) maturities look attractive, offering close to a 4% tax-free yield, including roll down return. Assuming the highest federal tax rate (40.8%2), this equates to a roughly 6.5% tax-equivalent yield.

Figure 4 shows a line graph of spreads between the two and 30-year yield curves for municipals and Treasuries, from 1990 to 2019. As of 28 February 2019, curve spreads for the munis were 140 basis points, compared with 57 for Treasuries. Over the time period, muni curve spreads are has high as roughly 420 basis points in 2011, and as low as 50 basis points in 2007. Curve spreads of Treasuries roughly track those of munis over the time period, and were typically below those of munis.

Transition to a credit market underscores an active approach. Bond insurance on new muni issuance has declined sharply since the financial crisis, which has in many ways transformed the muni market to a credit market. With over 50,000 unique municipal issues to monitor, the shift has made robust research and active credit selection critical.

Policy continues to move the muni market

Policy developments continue to influence credit trends in the muni market, and we’re monitoring developments in several areas:

New governorships create both upside and downside risks

With many states ushering in new administrations following the 36 gubernatorial elections in 2018, we will be eyeing potential spending increases as these regimes seek to make their mark. Higher discretionary spending could strain budgets late in the economic cycle at a time when non-discretionary costs, such as pension and post-retirement healthcare benefits, continue to rise. Many governors who campaigned on reforms may seek to address state fiscal issues critical to bondholders, such as recurring budget deficits, low fund reserves and underfunding of pensions. There will be greater differentiation in state credit quality as the cycle turns, and PIMCO will demand a higher risk premium from those that perpetuate old bad habits relative to states that achieve meaningful reform and sustainable revenues. We are also watching the degree to which governors may reduce aid to local governments or require them to pick up a greater share of fixed costs.

SALT deduction caps may influence state credit quality

We also are monitoring how the $10,000 cap in SALT deductibility under the Tax Cuts and Jobs Act (TCJA) is affecting states’ fiscal health and residential and business migration. Leaders in high-tax states, such as California, New York and New Jersey, have rallied against the SALT deduction limitation given concerns that the cap, which triggered a tax hike for many top earners and small businesses, could spur outmigration and hurt state budgets. We believe these trends could have a meaningful impact on municipal credit health over the secular (three- to five-year) horizon, particularly among issuers with high income tax rates and wealth concentration (see Figure 5).

Figure 5 is a bar chart showing net migration of various states, superimposed with a plot of the top marginal state tax rates as of 31 December 2018. Florida had the highest migration, about 1.2 million, followed by Texas, with 1 million. Those states had top marginal tax rates of zero. Other states such as North Carolina, Arizona, and Colorado had top marginal rates of around 5%, with net migration of 300,000 or more. States with high top marginal tax rates had outmigration. California, with a top marginal rate of 13%, had an outmigration of 700,000, while New York, at roughly 9%, had an outmigration of 1.2 million. Michigan, New Jersey and Illinois also show outmigration, but at lower levels.

Muni asset allocation views: Focus on quality

At this point in the cycle, we believe that investors will be best compensated on a risk-adjusted basis by focusing on defensive sectors and assets higher in the capital structure. Investment grade and high yield credit spreads are near post-recession lows, and we are wary of loosening covenants and bondholder protections in some recent deals.

We expect greater performance dispersion among sectors in the next economic downturn. While PIMCO has long favored essential service revenue bonds, not all revenue streams will react equally to changing economic tides, and we prefer issues backed by diversified revenue streams with support from inelastic demand.

In high yield munis, selectivity is increasingly important: Spreads for traditional high yield munis relative to the aggregate index tightened to decade lows in 2018 (see Figure 7), and we believe investors are not being fully compensated for the risks associated with many underlying transactions. We have observed a relative dearth of high yield municipal issuance in the past year, in part due to a run-up of deals in 2017 ahead of the Tax Cuts and Jobs Act. Broadly speaking, we would expect deals issued late in the expansion to underperform in an economic contraction. The market has reacted negatively to loosening of covenants in some recent transactions, and weaker bondholder protections combined with overly optimistic growth projections could mean more risk and less reward for high yield investors. We would expect still greater sensitivity and poorer performance of such deals in a less accommodative environment.

Comprehensive bottom-up credit research will be critical to find opportunities in sectors such as senior living and healthcare, which should broadly benefit from aging demographics but may face oversupply in certain regions. Tobacco will also remain a focus of increased regulatory scrutiny and shifting consumer dynamics, which can be exacerbated by an economic downturn.

Figure 6 is a line graph showing the spread of high yield bonds over the muni aggregate index, excluding tobacco and Puerto Rico, from 2006 to 2019. As of 28 February 2019, the spread was around 200 basis points, continuing a downward trend since the last financial crisis in 2008, when they peaked at 650. On the chart, spreads are lowest in 2007, before moving up steeply late that year into 2008.

Sector-level opportunities and risks

Local government obligations (GOs). PIMCO remains constructive on local property-tax-backed credits, including local government obligations (GOs). It helps to recall that property tax assessments tend to lag broader market swings in home price appreciation and thus provide some insulation if home prices decline. Within the local GO sector, we prefer those with diversified revenue streams, avoiding local governments that rely disproportionately on more economically sensitive sales taxes. We also continue to avoid localities with growing fixed-cost profiles and the attendant appropriation risk of non-essential assets, which are vulnerable to being written off or crowded out to prioritize essential services in a downturn.

Housing development deals. We remain constructive on land-secured housing development deals, given our view that home prices will continue appreciate over the cyclical horizon; however, we have become increasingly selective, rotating into deals that demonstrate stronger collateral coverage, less taxpayer concentration risk and greater distance-to-default. We have also reduced our exposure to land-secured housing development deals with less collateral coverage in regions adversely affected by SALT deductibility limitations.

Not-for-profit (NFP) healthcare. Federal tax reform left the NFP healthcare sector unscathed as to its ability to issue tax-exempt debt. However, tax reform did repeal the individual mandate, which may lead to an uptick in bad debt expense across the sector. We still believe NFP healthcare remains susceptible to several policy angles over the cyclical horizon. Potential federal and state policy actions with respect to Medicare, Medicaid and the Children’s Health Insurance Program (CHIP) could negatively affect reimbursement. In addition, rising labor costs from nursing shortages may further compress margins in the sector. Operating pressure will likely lead to more industry consolidation.

Special tax districts and tax increment financings (TIFs). We have trimmed exposure to special tax districts and TIFs supported by tax collections most susceptible to an economic contraction. Retail-backed TIFs, in particular, are susceptible to technology displacement and cyclical consumption declines. We favor fully developed, mixed-used deals located in strong real estate markets where the developments will remain vital to regional economic activity.

Continuing-care retirement centers (CCRCs). While aging demographics and home-price trends support our overall positive view of CCRCs, we began to observe pockets of stress in late 2018 and early 2019. Certain regions appear saturated with supply, contributing to lower-than-expected lease-ups expectations. Moreover, some projects have not met construction timelines due to labor shortages, and additional equity financing has been necessary in some cases. We believe the long-term investment case for this high yield asset class remains very strong, but the need for selectivity has grown in this late stage of the expansion. 

Master Settlement Agreement (MSA) tobacco. We maintain a positive outlook on the MSA tobacco sector. The FDA embraced reduced-risk tobacco products in 2017, which may introduce new product alternatives to traditional cigarettes in the near future. The impact on consumer sentiment is unknown, but the change in FDA policy will likely create headlines. In the meantime, cigarette consumption may decline less than anticipated as tax cuts from the TCJA may contribute higher disposable income, benefiting MSA tobacco cash flows.

Puerto Rico bonds. In February 2019 the Commonwealth of Puerto Rico (PR) reached an important milestone with creditors: COFINA sales tax bondholders and the Commonwealth agreed to restructure all outstanding obligations into a new security structure. Approximately $8 billion in new PR bonds that are not rated by the agencies will become part of the High Yield Muni Index in March, increasing their total index contribution to more than 8%. We see opportunities over the next year as new COFINA bonds and other reorganized PR liabilities transition out of hedge funds and back into the municipal market. These opportunities may come in new PR bonds with improved security features and reduced leverage, monoline-insured PR obligations or in non-PR bonds sold by investors to pay for new PR bond purchases.

All told, we believe muni investors stand to benefit from an active approach that helps seize opportunities and navigate pitfalls that may arise in an aging cycle.

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1 Information provided is current as of the date published and is subject to change without notice. Tax amounts, thresholds and ranges are subject to annual IRS inflation adjustments and PIMCO has no duty or obligation to update the information contained herein.
2 Determined using the top Federal Marginal Tax Rate of 37.0%, in addition to a Medicare Tax of 3.8% for top earners. Together these top tax rates cumulate to a top tax rate of 40.8%.
The Author

David Hammer

Head of Municipal Bond Portfolio Management

Sean McCarthy

Head of Municipal Credit Research

Related Funds

Disclosures

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 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. 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. Sovereignsecurities 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. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. Managementrisk 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.
The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.
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Munis and the Markets, April 2019
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