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.
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.
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.
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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.
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.