Reflections on Growing Economies and Fading Stimulus

2018 Global Investment Outlook

Muni Bonds: A Sense of Déjà Vu Dec 1, 2017

2018 Outlook: “Looking at 2018, we expect demand for fixed income investments such as municipal bonds to be based primarily on inflation expectations and the resulting changes in long-term interest rates rather than on prospects for tax reform. We believe isolated challenges in municipalities such as Puerto Rico and Illinois represent a cautionary tale to investors and highlight the importance of an experienced portfolio management and research team.”

For yet another year, the performance of municipal bonds in 2017 has been relatively strong when compared with other fixed income asset classes. Over the period through November, total return was driven primarily by tax-free income to bondholders, while price gains also helped overall performance, albeit on a marginal basis (though we did see a pretty strong rally during November due to some expectations of lower supply that some think could result from the proposed tax reform bill). We expect and hope that 2018 will be similar to 2017. We base that expectation on continued tepid US economic growth, virtually non-existent inflation or expected inflation (which affects expectations of long-term interest rates), and an appropriate balance between supply and demand.

In November 2017, President Donald Trump nominated Jerome H. Powell to succeed Janet Yellen as chair of the US Federal Reserve (Fed) when her term expires in early 2018. Powell has been a member of the Fed’s Board of Governors since 2012 and is widely considered a centrist and a pragmatist. We expect that if the US economy continues to grow he will continue to stay the course Yellen has followed.

US Tax Reform

As of this writing, Congress is working on a tax reform bill. While both the House and Senate bills have some proposals affecting aspects of municipal finance, neither version of the tax reform bill contemplates the elimination of the federal tax exemption of municipal bond interest in general. There has been some discussion surrounding private activity bonds and pre-refunding bonds, but no final agreement had been reached.

Often, when individual tax rates are changed through tax reform, investors and analysts try to predict an effect on municipal bond prices. For example, if it looks like income tax rates will be raised, people believe municipal bond prices should rise due to increased demand from those individuals looking to shelter their income from higher tax rates. Conversely, if rates are expected to be lower, people may expect demand for municipal bonds to decline. Neither argument is correct, in our assessment. Bond prices, municipal and otherwise, tend to react to changes in long-term interest rates, which are in turn influenced by the inflation picture.

Puerto Rico

In 2017, Puerto Rico entered bankruptcy and defaulted on its general obligation debt, sales-tax backed debt, and issues of other agencies and authorities, like the Puerto Rico Electric Authority (PREPA). By the time these bankruptcies and defaults took place, they were somewhat expected by the municipal bond market, and the direct effect on the municipal bond market overall was relatively muted. Of course, the damage caused by hurricanes Irma and Maria should have an effect on whatever ultimately happens to creditors in Puerto Rico.

Concerns and Opportunities

While we believe the situation in Puerto Rico did not greatly affect the municipal bond market in general, that is not to imply that it did not affect certain parts of the market significantly. It must be remembered that the Puerto Rico bankruptcy is only the most recent (and largest) of a series of municipal bankruptcies in the last few years, including Vallejo, Stockton and San Bernardino in California and Detroit in Michigan. Cities and states that have been experiencing an increasing lack of flexibility in their fiscal situations as retirement obligations demand a larger percentage of their budgets each year are seeing their credit ratings reduced significantly and are beginning to pay higher and higher premiums (interest rates) when they borrow. Among the most visible of these issuers are the State of Illinois, the City of Chicago, the Chicago Public School System, the State of New Jersey and the State of Connecticut. We have seen through hard experience that the advisors hired by troubled issuers have been taking increasingly aggressive stances against creditors when insolvency nears. While we are not predicting defaults in any of the aforementioned municipalities, we believe that governments would come to seek concessions from bondholders before seeking real concessions on the part of their own residents, taxpayers and labor unions. We have learned in Puerto Rico that a general obligation pledge is not truly worth what the market used to think it was when the issuer is insolvent…or claims to be. It has been a cautionary tale to investors and highlights now more than ever the importance of an experienced portfolio management and research team. We fully intend to benefit from the lessons we have recently learned.

In terms of opportunities, there don’t seem to be particular municipal bond sectors that we regard as inordinately undervalued. The best opportunity, as we see it, would be to have rates increase moderately so that we could invest at those higher rates and thereby seek to increase the income profile of our portfolios. But once again, that will be more dependent on the inflation picture than it is on any sector or security selection we might make.

ADDITIONAL COMMENTARY

Michael Hasenstab, Ph.D.

Global Macro

Identifying Value in the Post-QE Era

Christopher J. Molumphy, CFA

Fixed Income

Constructive but Cautious for 2018

Ed Perks

Multi-Asset

Optimism and Selectivity in 2018