While we think it’s too early to shout “all clear,” investors now have more information about policies likely to affect the municipal bond markets this year, and relative valuations are looking more attractive than they did a few months ago.
PIMCO’s 2017 Municipal Market Outlook called for greater caution this year due to uncertainty on a number of fronts: From a macro perspective, rising inflation, the potential for large fiscal expansion following the U.S. Republican election sweep, and fears of an imminent trade war painted a potentially volatile picture. Municipals underperformed other U.S. credit asset classes following the 2016 election as tax reform, near the top of the new administration’s agenda, loomed over the market.
But so far this year, flows into municipal bond funds have been positive (if only marginally), and recent trends point to further potential upticks as the policy outlook turns more favorable.
A less daunting policy outlook for munis
Looking out over the next six to 12 months, we think the risk of an outright trade war has receded, and we’ve scaled back both our view of the expected size of fiscal stimulus in the U.S. and our assessment of near-term inflation pressures (see PIMCO’s Cyclical Outlook, “Scaling It Back,” for more information).
The last two points are critical to potential muni returns: Muni asset prices have a reasonably strong historical correlation to interest rate volatility, particularly when that volatility arises from sharp interest rate shocks, as we saw after last year’s presidential election and during the “taper tantrum” of 2013. Slower-than-expected policy progress and a Republican majority that lacks a unified vision for healthcare or tax reform make it more likely that an eventual fiscal boost won’t occur until 2018 (and may be smaller than initially expected). Moreover, increases in labor force participation that may damp wage inflation in the coming months, combined with softer oil prices, suggest near-term reflation trade momentum may have peaked.
Taken together, these factors bode well for the municipal asset class.
Tax reform questions persist
That’s not to say the existential threat of broad-based comprehensive tax reform has disappeared. Knowing your tax rate is, of course, key to muni investing, so the potential for lower corporate and individual tax rates is complicating investment decisions for some investors. The possibility of a hard dollar cap on deductions and exclusions or a significant reduction of the tax rate on other sources of non-wage income are further question marks (see Figure 1).
And tax reform is complicated. Unlike straight tax cuts, tax reform involves winners and losers, and Republicans lack a unified vision: The House of Representatives’ plan focuses on a “border adjustment tax” that a number of Republican senators have vocally opposed. The recent White House tax reform proposal reinforces Trump’s campaign messaging, but does not offer much in the way of policy specifics. The failure of healthcare reform was another stumbling block, given that the repeal of the Affordable Care Act would have come with a reduction in the federal budget revenue baseline that might have paved the way for more substantial tax reform.
The setback on Obamacare repeal/replace gives us more confidence in our base case scenario of a less ambitious “tax reform lite.” The upshot is a tax reform backdrop for municipals that, while not without risk, has modestly improved since the beginning of the year and (if realized) would not fundamentally alter the long-term valuation paradigm for tax-efficient investors.
Tax-exempt bond valuations look favorable
In an environment where uncertainty persists, we believe it’s paramount to let valuations be your guide. And given that tax-exempt municipal credit spreads have underperformed the post-election rally in other U.S. credit asset classes, we are a bit more constructive on tax-exempt bonds than on their taxable alternatives.1
High yield municipal spreads look particularly compelling relative to high yield corporate spreads: For the first time since 2014, the spread between AA munis and high yield munis (excluding tobacco settlement bonds and Puerto Rico securities) is wider, at 332 basis points (bps), than the spread between AA and high yield corporate bonds, at 315 bps (see Figure 2).
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Tax-exempt munis across the credit spectrum tend to outperform during Fed hiking cycles as the absolute value of the tax benefit increases. At current tax rates, high yield munis offer more than 200 bps of after-tax yield relative to taxable high yield corporate bonds (see Figure 3). And even assuming a tax rate of 25%, high yield munis offer more than 100 bps of after-tax yield. We expect this tendency to hold true during the current cycle, but the market has yet to adjust.
In addition to the tax benefit, municipals continue to experience lower default rates than corporate bonds (see Figure 4). This trend holds for bonds across all rating categories.
As equities near all-time highs, it’s also worth remembering that municipals tend to have lower correlations to the S&P 500 than other asset classes. At 0.26%, high yield munis’ correlation to equities has been about one-third that of high yield corporates (0.71%) over the last decade (as measured by monthly Bloomberg Barclays High Yield Municipal Index returns over the 10 years from 31 December 2006 through 31 December 2016 versus monthly returns of the S&P 500).
Tobacco bond refundings point to value for investors
PIMCO’s municipal bond fund portfolios have generally long maintained an overweight in bonds backed by Master Settlement Agreement (MSA) revenues securitized by states. The revenue streams for these bonds – paid by tobacco companies to states as a result of the 1998 settlement – are highly dependent on cigarette shipments in the U.S. each year. Smoking declines since the bonds were issued have been stronger than initially forecast, and we believe many of these bonds are likely to default in the future.
So why the overweight? Investors have a claim on settlement revenues post-default, and we believe these post-default claims – which are not well understood by some traditional municipal investors – offer attractive returns relative to other high yield muni securities and tend to be more liquid.
Many bonds in this sector have become callable over the past year, and the State of California and the City of New York executed two large refinancings in first-quarter 2017. As a result, a number of bonds that were trading at discounts were called at par in the first quarter of this year. Additionally, some deeply subordinated zero coupon bonds were tendered in an effort to reduce total leverage. PIMCO’s analysis of tobacco securities aims to identify bonds trading at discounts that will be called at par, which if successful would benefit investors.
Future refinancings should help create positive supply/demand dynamics for the tobacco bond sector over the cyclical horizon, as total speculative-grade tobacco bond supply is now shrinking. More demand and less supply is good for bond prices, and we expect investors will be quicker to buy tobacco bonds trading at discount dollar prices going forward.
Still wary of Puerto Rico primary government debt (including COFINA), but some opportunity in select revenue bonds
In March the federal oversight board approved Puerto Rico’s fiscal plan, which includes a 10-year forecast and allocates an average $780 million of cash resources per year to service approximately $34 billion of contractual debt service. The implied recovery on debt caused Puerto Rico general obligation (GO) prices to drop to all-time lows (see Figure 5).
The municipal market has been debating how the oversight board might determine outcomes across Puerto Rico’s numerous debt issuers. Some observers argue that the board and the Puerto Rican government will work together to seek quick resolutions with creditors that achieve slim and consensual haircuts. Others hold that the impairment of GO debt or COFINA sales tax revenue bonds might irreparably damage the commonwealth’s ability to regain market access.
PIMCO has long espoused an alternative view: that the oversight board will operate on a principle of conservatism and require the Puerto Rican government to adopt realistic fiscal projections that imply deeper concessions from creditors. This could provide a path to achieving debt sustainability, continuing essential services and providing for adequate pension funding. We believe a return of market access for Puerto Rico depends on the creation of a plausible capital structure that simplifies competing claims and achieves both a large reduction in the government’s debt stock and annual debt servicing savings. While PROMESA and the fiscal plan may ultimately result in harsh losses for creditors, it will likely prevent Puerto Rico from succumbing to future rounds of restructuring when performance inevitably deviates from the fiscal plan.
We continue to see downside risk to owning Puerto Rican government debt. Using the current fiscal plan’s projections, we do not believe there are sufficient funds to justify most current valuations, so we maintain no Puerto Rico GO debt or COFINA bonds in PIMCO municipal-focused portfolios. Outcomes are also clouded by the legal proceedings, and determining debt seniority in the capital structure is near impossible given the lack of precedent for U.S. commonwealth restructurings.
That said, we do see pockets of opportunity in select revenue bonds. We have added a small amount of Puerto Rico enterprise debt, which we believe has less downside risk and provides better security through voluntary (and potentially involuntary) restructurings.
Active insights will be key
We are currently more constructive on tax-exempt munis given their more favorable valuations and diminishing policy uncertainty. However, we continue to highlight that credit selection and active portfolio management will remain key drivers of performance.
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