By William D. Black, CFA
- Tax reform to limit issuance trends in 2018
- Demand should support prices for high yield municipals
- Careful security selection will be critical in year ahead
A post-election high yield municipal bond market was poised to enter 2017 with a constructive backdrop of attractive prices and stabilizing technicals. Throughout most of the year, strong demand for tax-efficient income outpaced the available supply of bonds, thus catalyzing the “search for yield.” As a result, high yield municipal investors were rewarded with stellar outperformance, as reflected by the Bloomberg Barclays Municipal High Yield Index, which returned 9.69% in 2017.
Another contributor to last year’s gains was the broad U.S. economic expansion, which generated stronger credit quality across the municipal space for many issuers. Defaults remained low (ex-Puerto Rico), and an appetite for high yield led investors to purchase bonds of lower qualities and characteristics. Consequently, diligent credit analysis and sector selection were key contributors to a successful investment strategy. For example, our bias toward better-performing, asset-backed and revenue-secured bonds provides repayment advantages over a typical government obligation that may be exposed to elevated political risk or pension stress.
The most discussed topic within the municipal asset class has been the impact of tax reform on market demand and pricing. Policy uncertainty created periodic volatility, but an overwhelming need for tax-exempt bonds marginalized any market disruption. The municipal market experienced a record supply of approximately $60 billion in long-term debt in December, with issuers pulling forward bond deals to avoid the potential constraints of tax reform. In particular, the inability to advance refund older, higher-interest cost debt, will likely diminish the future supply of bonds.
In 2018, we expect high yield municipal bond supply to be very limited, underscoring our view that an atypically light first quarter should provide price support. Demand should remain healthy for high yield municipal bonds, and we expect tax optimization efforts by high-net-worth investors to favor the asset class. Although policy tightening measures such as Fed rate hikes and the unwinding of its balance sheet could influence rate trajectory, the economic tailwinds should have a positive impact on the high yield municipal bond market. We remain focused on well-structured bonds with compelling credit fundamentals.
For a full list of the articles in this series, read our Quarterly Update Q4 2017: Economic and Investment Management Perspectives
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