January is usually a stellar month for the municipal bond market. Not this year.
The combination of rising interest rates and uncertainty over tax reform contributed to the worst January for municipal bonds since 1981, with the Bloomberg Barclays Municipal Bond Index down 1.18 percent for the month. While turmoil in the stock market has recently led investors to safety in the form of Treasurys and muni bonds, the outlook for the tax-exempt market remains murky.
"The negatives in the market appear to be winning out over the positives," said Peter Hayes, head of the Municipal Group at BlackRock. "We're a bit cautious in the near term and expect the market to be in a discovery mode over the next two months."
The market needs to discover two things: how far and how fast interest rates will rise, given the strong economy, and what effects tax reform will have on the supply and demand for tax-exempt bonds.
On the first front, the 40-basis-point rise in the 10-year Treasury bond yield since the beginning of the year has been tough on muni bonds, as well.
"Interest rates have hurt the market," said Tom Hession, managing partner of Riverbend Capital Advisors. Hession focuses exclusively on municipal bonds and acts as a subadvisor for separately managed accounts.
"People see rates going up and they sell," he said.
So far, muni bonds virtually have tracked the move in Treasurys. While the rise in rates has begun to taper, more signs of a strong economy — particularly wage inflation — could prompt the Federal Reserve Board to move more quickly than expected in raising short-term rates. That in turn could push longer rates up further.
"We're certainly moving in the direction of higher rates," said Hayes at BlackRock.
When it comes to the Tax Cuts and Jobs Act passed by Congress last year, the effect on the muni bond market is even less certain. On the one hand, the bill did not touch the tax exemption for interest income from municipal bonds, as many feared. Nor did it exclude private-activity bonds from favorable tax treatment. States and municipalities use such bonds to finance specific infrastructure projects. Roughly $30 billion in private-activity bond issuance was pulled forward into December due to fears about the tax bill.
Yields are more attractive than they've been in a long time, so if someone is comfortable with a more volatile environment, this could be a good time to consider municipal bonds.Tom Hessionmanaging partner of Riverbend Capital Advisors
However, for many people with hefty state and local tax bills, the new federal tax law gives municipal bonds some appeal. The new law caps the state and local tax deduction that can be claimed on federal returns at $10,000. For many households, that cap will outweigh any potential benefits from other changes in the law.
For these people, tax-free investment income (like muni bonds) becomes quite valuable. Industry experts warn that despite the appeal of municipal bonds, investors need to be careful because the municipal bond market can be complicated.
Other elements of the reform bill, however, could adversely impact longer-term demand for tax-exempt muni bonds. The bill disallowed the common practice of advance refunding, which enabled municipalities to lower their costs by refinancing debt at lower rates.
Hession said that advance refunding had accounted for approximately 15 percent of muni bond issuance over the last 10 years.
"It's like refinancing a mortgage," said Hession of Riverbend Capital Advisors. "The bill eliminates the ability of [municipalities] to issue new debt to retire older deals and save money." With interest rates on the rise, however, these refinancing moves would likely diminish, anyway.
More from Advisor Insight:
Why investors can't gauge their own risk tolerance
Crazy tax moves clients wanted advisors to try for 2018
Don't put all your financial eggs in one investment basket
Lower tax rates could also affect demand for muni bonds. With lower marginal tax rates, tax-free income is relatively less valuable. The lowering of the top bracket to 37 percent, from 39.6 percent, may diminish demand slightly in the high-net-worth market segment, but most analysts believe the impact will be muted.
"The need for income hasn't changed for retail investors and retirees," said Hayes at BlackRock, which currently manages $129 billion in its muni bond funds. "People also see municipal bonds as a safe investment."
The changes on the corporate side of the demand equation, however, could have a bigger impact. With the corporate tax rate reduced to 20 percent, down from 35 percent, both Hayes at BlackRock and Hession of Riverbend Capital Advisors expect the banks and insurance companies that make up about 30 percent of the market will now have less interest in tax-free bonds.
"We'll likely see diminished appetite for tax-free bonds on the institutional side," said Hession. "There will still be interest in munis from institutions, but this will impact demand."
Hayes at BlackRock said there is already evidence that banks and insurance companies are reallocating assets from municipal to investment-grade bonds.
One potentially mitigating factor is an increase in demand for munis in high-tax states such as New York and California. Because the tax bill capped the deductibility of state and local income taxes at $10,000 per individual, taxpayers in those states will be looking to maximize other deductions and minimize taxable income. Municipal bonds in those states already have been outperforming the market.
What do all these countervailing forces mean for the muni market outlook? "It's been such a volatile start to the year, and it's very hard to say how changes to tax rates will play out," said Riverbend's Hession. "Yields are more attractive than they've been in a long time, so if someone is comfortable with a more volatile environment, this could be a good time to consider municipal bonds."
Jon Yankee, co-founder of registered investment advisor FJY Financial, hasn't lost his confidence in the municipal market.
"Municipal bonds are still an important part of most of our clients' investments," he said. "Their main purpose is to provide stability for a portfolio."
He prefers, however, to outsource the job to a manager focused solely on the muni market.
"We do financial planning, and investment management is a piece of that, but we outsource [municipal bond investments] to experts," said Yankee.
Indeed, the days of investing in a municipal bond and rolling it over into a new one when it matures are over. With the demise of the bond insurance industry in the financial crisis, credit quality in the market has become a much bigger concern for investors — one big reason mutual funds and ETFs have become a far more attractive option. With thousands of issuers in the market having very different financial profiles, analysis has become too big a job for financial advisors, let alone individual investors.
"It's a tough market to dabble in," said Riverbend's Hession. "It's important to be engaged at all times."
— By Andrew Osterland, special to CNBC.com
