By William D. Black, CFA

Key Takeaways:

  • 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.

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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.

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For a full list of the articles in this series, read our Quarterly Update Q4 2017: Economic and Investment Management Perspectives

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

Investments in emerging market bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

Index Definitions

The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a nongovernmental organization, which determines the value of the index from the values of ten key variables.

The Goldman Sachs Financial Conditions Index (GSFCI) is a weighted sum of a short-term bond yield, a long-term corporate yield, the exchange rate, and a stock market variable.

The Standard & Poor’s (S&P) 500 Index represents 500 large U.S. companies. The comparative market index is not directly investable and is not adjusted to reflect expenses that the SEC requires to be reflected in the fund’s performance.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.