Munis in Focus

Munis in Focus: 2020 Municipal Market Outlook

After a year of strong performance and record-setting flows, we expect continued robust demand for munis in 2020.

After a year of strong performance for municipal bond portfolios and record-setting flows into muni assets (see Figure 1), we expect continued robust demand for munis in 2020. As detailed in our recent Cyclical Outlook, while recession risks have diminished this year, so has the potential loss given recession – and full valuations on risk assets leave little margin for error if macro expectations deteriorate or market volatility spikes. Against this backdrop, we remain constructive on munis given their low default rates historically and low correlations to risk assets, such as equities, along with attractive after-tax yields versus comparably rated corporate bonds.

That said, we expect shifts in supply factors – including a decline in tax exempt supply, related growth in taxable munis, changing call structures, and a rise in unrated and private high yield debt – to result in an evolving opportunity to unlock potential in muni allocations this year. But a disciplined investment approach and robust credit and quantitative research will be key.

Figure 1 is a bar chart that shows a record high of average monthly flows of $48 million into municipal assets in the second half of 2019. Flows averaged $46 million in first half of 2019. Those levels are more than double than any other half-year period dating back to 2010.

Constrained tax-exempt supply supports tax-exempt muni valuations

Despite continued robust investor appetite for municipal bonds, the size of the market has remained roughly static since the financial crisis. We attribute this reality primarily to supply-side dynamics. Rising pension costs and other post-employment benefit (OPEB) liabilities continue to crowd out infrastructure investments, and new federal funds for infrastructure remain scarce – a situation that is unlikely to change in an election year, in our view. We’re also seeing signs that tax revenue growth is slowing and that financial managers have grown more concerned about a recession, making a new wave of spending unlikely. And critically, tax reform – specifically, the Tax Cuts and Jobs Act’s elimination of advance refundings – has led issuers to increasingly refund debt in the taxable market.

Taken together, these trends have reduced supply and supported valuations on tax-exempt bonds (see Figure 2), while also presenting opportunities in taxable munis.

Figure 2 shows a line graph comparing issuances of municipal, Treasury and corporate bonds from 2008 through the end of 2019. Muni issuance over that time period was relatively flat, around $4 trillion a year. Corporate issuance rose steadily to about $9.5 billion in 2019, up from about $5.5 billion in 2008, while Treasury issuance climbed faster, to about $16 billion, up from roughly $6 billion in 2008.

Relative value opportunities in a growing taxable muni market

With tight credit spreads and absolute yields near all-time lows, the taxable markets (Figure 3) may appeal to issuers drawn to the historically low cost of capital and looking to diversify their investor bases, while being able to use taxable bond proceeds for non-tax-exempt purposes – including advance refunding. Taxable refunding issuance in 2019 totaled $56 billion, according to Citi Research, and we expect the growth in this market to continue absent a sharp increase in interest rates or a change in tax policy that permits tax-exempt advance refundings.

Taxable munis have cheapened with recent 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. Mispriced taxable munis may also present select opportunities for U.S. investors that are subject to federal income taxes, on an after-tax basis. We anticipate continued strong investor demand for long-dated, high-quality taxable muni assets in 2020.

Figure 3 shows a timeline of annual municipal issuance from 2009 through 2019. Year-over-year taxable bond issuance rose to more than $400 billion in 2019, up from $350 billion in 2018. Taxable refunding issuance was $56 billion in 2019, up 100% from 2018, and representing the highest growth rate during the 11-year span.

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Sophisticated investors can seek to leverage mispricing of an increasing supply of nonstandard call structures

In addition to having led issuers to increasingly refund debt in the taxable market, tax reform has also led to the issuance of more nonstandard call structures. For instance, issuers are increasingly using five- to seven-year rather than 10-year call periods due to the elimination of advanced refundings on tax-exempt munis. The rise in issuance of such nonstandard call structures, which traditional muni investors may have a difficult time pricing, present an opportunity for muni investors able to accurately value them. We see a benefit to overweighting what we view as underpriced high-coupon callable muni bond structures in portfolios and an opportunity to leverage quantitative research to potentially increase returns without taking on more interest rate or credit risk late in the cycle.

Pockets of high yield markets look compelling for qualified investors

With a rise in unrated and private high yield debt, we see several areas of opportunity in high yield municipal markets in 2020 for muni investors who can leverage strong credit research capabilities:

Puerto Rico’s reentrance to muni markets as the commonwealth emerges from bankruptcy. In the wake of COFINA sales tax bondholders and the commonwealth having agreed to restructure all outstanding obligations into a new security structure, approximately $8 billion in new, unrated Commonwealth of Puerto Rico (PR) bonds became part of the High Yield Muni Index in March, increasing their total index contribution to more than 8%. We see continued opportunities – potentially in the form of new PR bonds with improved security features and reduced leverage, monoline-insured PR obligations, or non-PR bonds sold by investors to pay for new PR bond purchases – as new COFINA bonds and other reorganized PR liabilities transition out of hedge funds and back into the municipal market. Further, the trend of the more liquid portion of the master settlement agreement (MSA) tobacco bond market shrinking as issuers refinance high yield bonds into investment grade debt should support PR assets as investors look to redeploy cash. To be sure, one area of investor concern related to Puerto Rico has been speculation that holders of “special revenue” bonds would lose some degree of claims on dedicated revenue because of the legal precedent set in PR’s bankruptcy. However, we have a more limited view of the ramifications of the U.S. Supreme Court’s recent decision not to review lower courts’ rulings on the matter – as we discuss in a recent post on the PIMCO Blog.

Rising unrated and QIB-only issuance. We have also observed a sharp increase in unrated munis, private placements, and other securities that can be purchased only by qualified institutional buyers (QIBs, as defined in SEC Rule 144A under the Securities Act of 1933), which is creating distinct opportunities for qualified investors (see Figure 4). The ‘QIB-only’ distinction has often signified higher yield potential, given the restricted base of investors who can access these deals in either the primary or secondary markets. Despite extracting higher yields from issuers, QIB-only and unrated bonds have continued to rise as a percentage of the high yield muni index, to 22% and 48%, respectively at year-end.

Figure 4 is a bar chart showing rising issuance of unrated and 144A municipals, private placements and other securities over a 15-year period through 2019. Volume in 2019 of these instruments for qualified institutional investors represented more than 80% of annual issuance, the highest level during the time span. Overall issuance of these securities represented roughly only 12% of annual issuance in 2005.

We believe investors who are able to both access these bonds and appropriately evaluate their credit risks, particularly their legal structures and revenue streams, will be best positioned to tap their potential benefits. This requires broad and deep global credit analysis capabilities that go beyond the expertise needed to analyze state and local municipal debt.

Signs point to another strong year in 2020

We think both technical factors and the macro outlook bode well for municipal assets in 2020. However, with risk assets priced for perfection and muni credit spreads near the tightest levels of the past 10 years, we view a bias toward higher quality in muni allocations as warranted. In our view, shifting supply dynamics associated with growth in taxable munis, mispriced callable structures, and select credit exposures offer ample opportunity for active managers to enhance return potential over the next year.

To learn more about how PIMCO expects to take advantage of opportunities created by these shifting supply dynamics in 2020, watch our exclusive webinar: Navigating Uncertainty to Unlock Muni Potential in 2020.

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The Author

David Hammer

Head of Municipal Bond Portfolio Management

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

A word about risk: 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 low interest rate environments increase this risk. 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 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. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO or Gurtin will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO or Gurtin in connection with managing the strategy. Private Placements are offered by Private Placement Memorandums for sophisticated investors, have a high degree of risk, and offer limited liquidity.

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This material contains the current 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. PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Gurtin Fixed Income Management, LLC dba Gurtin Municipal Bond Management (“Gurtin”) is a SEC independent registered investment adviser. As of January 2, 2019, Gurtin became a PIMCO company. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2020, PIMCO

CMR2020-0212-438660

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