Municipal market: A review of last quarter and a look ahead

March 1, 2018

 

Chris Alwine, head of Vanguard's Municipal Group, and Ed Saracino, the senior product manager for Vanguard Municipal Bond and Money Market Funds, share their perspectives on the municipal market and give you a glimpse behind the scenes at the management of our muni bond funds.

Christopher W. Alwine

Christopher W. Alwine, CFA
Principal and Head of
Vanguard Municipal Group


Ed Saracino

Ed Saracino
Senior Product Manager

A volatile fourth quarter in the municipal market demonstrated that demand for tax-exempt bonds continues to outstrip supply. That's usually a better time for investors to take the long view and not react to transitory events.

Republicans in Congress, perhaps inadvertently, shook up the earth under the market when some suggested that the GOP tax plan eliminate private activity bonds (PABs) and advance refundings. The muni market, already constrained by limited supply, was looking at issuance potentially shrinking by about a quarter. As can happen in nature, a tsunami followed: Municipal issuers rushed to put out as many PABs and advance refundings as they could before the proposed rules could take effect.

More than $64 billion in bonds was issued in December. Up until this time, the single week with the largest issuance we had ever seen was $15 billion. After the proposed rules were announced, multiple weeks produced a torrent of more than $20 billion. Surprisingly, investors absorbed all the new bonds. And instead of rising, yields fell, proving that the demand for tax-exempt income is deep. The investment-grade1 muni market was up 0.75% for the quarter, although the short end of the curve underperformed the long end. Some investors—including Vanguard—sold short-end bonds to free up capital to buy the new issues. It was the rare municipal market where you had to get it while it was there. We may never see advance refundings again.

Municipal market performance

As the chart below shows, both lower-credit-quality and longer-dated bonds did markedly better over the quarter. Supply should be constricted in the first half of this year. Lower corporate tax rates may mean that banks and insurance companies have less incentive to purchase munis in the future. Nonetheless, munis remain an attractive option for taxable investors because the new tax law does not lower rates for households meaningfully enough to reduce demand. The new cap of $10,000 on the federal tax deduction for state and local taxes means investors in high-tax states are likely to look for a way to shield income, which could result in increased demand for the bonds in those states.

Municipal market performance

 

Positioning the Vanguard portfolios

To the degree that we could, Vanguard prepared for the wave of new bonds at year-end. In November, we slowed down on buying bonds and allowed our liquidity rates to rise in order to build reserves. We purchased more than $5 billion worth of bonds in December, largely from issuers with stable-to-improving finances, even as we sold $3 billion of mostly short- to intermediate-term bonds. Vanguard has been positioning the portfolios away from recent trends in the market. We avoided the earlier rush into the short end of the curve and then the push toward bonds with longer durations. However, we believe inflation may creep up a bit, slightly higher than expected. That would cause some volatility and result in a neutral to short bias in our duration positioning during 2018.

We are underweight bonds from states with large structural deficits, such as New Jersey and Connecticut. We prefer PABs and revenue bonds.

Why prudence matters now

At some point, some heat may come. We will see meaningful underperformance and downgrades in already stressed credits when a recession occurs. The pension-shortfall problem is growing larger, and the distance to fiscal stress is getting shorter.

If solvency becomes a question, the legal landscape in each state will determine how bondholders are treated. Some states, such as New Jersey, have some flexibility to deal with pension problems, whereas others, such as Illinois, are constrained by constitutional protections that limit flexibility. It’s an idiosyncratic situation. Vanguard believes our prudence will be rewarded at that time. Our 45-person municipal team, which oversaw more than $180 billion in assets as of the end of 2017, will continue to help steer our funds through these fluid, complex scenarios.

On a more positive note, there are rumblings about a potential bill in Congress to fund long-overdue infrastructure repair and improvements. If such a law is enacted, it may provide more supply—but not a tsunami—to an eager market. We believe that the vast majority of municipal issuers are healthy, and the muni market will remain so for some time to come.

For the full commentary, read Vanguard municipal perspectives.

1 Investment-grade bonds include U.S. Treasuries and other fixed income securities with a credit rating of Baa3 or higher by Moody’s or a credit rating of BBB– or higher by Standard & Poor’s or Fitch.

Notes:

  • Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • The information contained herein does not constitute tax advice, and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code. Each person should consult an independent tax advisor about his/her individual situation before investing in any fund or ETF.

 

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