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Munis May Offer Some Late-Cycle Relief

With the recession already a decade past, now may be a good time to turn to municipal bonds. David Hammer, head of municipal bond portfolio management, explores the reasons why.
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David Hammer, Head of Municipal Bond Portfolio Management: We’re more than ten years since the last recession. We see munis for investors as a late-cycle haven, and as we contemplate all of our portfolio construction, individual investments through that late-cycle lens, munis screen as attractive, for a few reasons: 

Shot from New York Stock Exchange trading floor and screen with stock information on it.

The first one is low correlations to other risky asset classes, in particular equities.  If you compare investment-grade munis or high-yield munis for that matter to the S&P 500 over the last decade, correlations are negative in both cases.

The second reason is a potential change in future tax policy. 

Shots of White House and U.S. Capitol Building.

As investors look towards the next US presidential election, there’s increasing concern that the next tax rate change might be higher instead of lower, which would increase the value of tax-exempt municipals.

Shots of U.S. Federal Reserve Building.

The third reason is out-performance when rates are rising.  If it turns out the fed is not done and they continue to raise rates, munis historically outperform some other fixed-income credit asset classes when rates are rising.

Shot of people walking on crowded sidewalk and shot of New York Stock Exchange building.

And then the last reason is favorable supply and demand dynamics. Over the last decade, there have been about $11 trillion in newly created fixed-income assets. 

Chart: A three-line graph shows the debt outstanding from 2008 to 2019 for Treasuries (increasing), corporates (slightly increasing) and municipal bonds (steady).

The bulk of those have been in treasuries and investment grade corporate bonds. 

The muni market is actually the exact same size.  Supply has not grown over the last decade.

So, supply is stable, and we set that against demand that we expect to increase over the next several years due to two reasons.  One is aging demographics here in the US. As we see Baby Boomers retire and convert riskier equity portfolios to high-quality, income-producing assets, we believe munis are a perfect fit.  And the other is potential tax policy.  Investors are now focused towards the next presidential election and the risk that maybe tax rates might go higher than they have been in the past.

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Disclosure


Recorded 23 May 2019

Correlations are derived from the prior ten years of monthly returns ending 31 December 2018. “Investment-grade munis” and “high-yield munis” are based on the Bloomberg Barclays Municipal Bond Index and Bloomberg Barclays High Yield Municipal Bond Index, respectively.

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 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 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. Investors should consult their investment professional prior to making an investment decision.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. 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 for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. It is not possible to invest directly in an unmanaged index.

PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.

This material contains the 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. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO.

CMR2019-0617-402043

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