One sector of the US bond market has been rewarding for fixed income investors as prospects for the Trump administration’s proposed spending and tax reforms fade.
Stagnant sales of bonds by local governments and authorities as they focus on budgetary discipline have helped fuel unexpected strength in municipal bond valuations, a largely tax-free security favoured by investors domiciled in states with high taxes.
The S&P municipal bond index — the sector’s benchmark — remains less than 2 per cent below its all-time high set last July. It has returned 2.1 per cent so far this year. Taxable US Treasuries and investment-grade corporate bonds have returned 1.2 per cent and 2.6 per cent respectively over the same period, according to Bloomberg Barclays Indices.
With the Trump presidency currently beset by controversy, investors are less optimistic that the administration will implement its pro-growth agenda that includes hefty spending on infrastructure at the state and local level and tax reform.
“The fear originally was . . . won’t there be a flood of bond supply and won’t that negatively impact the muni market,” says Ben Barber, the head of municipal asset management at Goldman Sachs Asset Management. “That’s not the case any more.”
While Mr Trump actively campaigned on public-private partnerships without increased borrowing, observers weren’t convinced his goal of $1tn in spending could come without higher debt issuance from local governments.
The American Society of Civil Engineers gave the US a grade of D+ for its infrastructure, and last year estimated a 10-year investment shortfall of $2tn. At the start of the year, investors expected infrastructure spending to get a boost from the presidential election result. And if issuance had picked up as a result, the scarcity premium would be removed for munis.
However, so far this year, US states and cities have issued a tenth less debt than last year, according to data from Thomson Reuters. That fits a wider, seven-year trend: While the mostly tax-exempt $3.8tn asset class more than doubled in size between 2000 and 2009, growth has subsequently been stagnant. The amount of securities outstanding has even contracted over several years, as more bonds matured or were called than those that were newly issued.
“You are not seeing issuers embark on large-scale projects,” says Peter Block, a strategist with Ramirez & Co, an investment bank known for its municipal bond underwriting business.
Municipalities chose to tighten their belts as tax revenues fell following the financial crisis, despite strong demand for fixed income from yield-hungry investors. This increasingly includes international investors, who have been squeezed out of their traditional areas by stimulus from global central banks. Although foreign investors remain a relatively small portion of the market, their municipal holdings more than doubled between 2006 and 2016, according to Citigroup.
While the size of the muni market is essentially unchanged, the market for corporate bonds has swelled 44 per cent in the past seven years. The amount of US federal-government debt outstanding roughly doubled, according to data from the Securities Industry and Financial Markets Association.
“It’s a supply-driven phenomenon at the moment,” says Guy Davidson, director of municipal bond management at AllianceBernstein. “The story has really been a lack of supply. While new issue volume . . . should pick up in the second quarter, the number of bonds maturing and being called over the next six months is the largest on record.”
The implications of the Trump administration’s tax reform proposal for the municipal bond market also remain in question.
While investors in stocks and corporate bonds have been great proponents of tax cuts, seen as a simple way to bolster profit margins, municipal bond portfolio managers have hoped for the opposite. If passed, cuts to personal taxes — including capital gains — could make taxable investments such as corporate bonds or Treasuries even more competitive with municipals. It ultimately could weigh on demand for municipal bonds.
But despite an outline on what the Trump administration plans, including reducing the top personal rate from 39.6 per cent to 35 per cent and slashing the headline corporate tax rate to 15 per cent, municipal bond prices have barely budged.
“Investors are getting more comfortable with the concept that tax reform will be harder to pull off,” says James Iselin, head of municipal securities for Neuberger Berman. “It may take longer . . . and where we end up may not be as bad as the worst-case scenarios people were talking about right after the election.”
There is also a chance the administration’s proposed removal of the state and local tax deduction and alternative minimum tax could encourage investors in high-tax states to buy more municipal bonds, according to Standish Mellon Asset Management. The firm wrote after the proposal’s release that while a corporate tax cut could lead to a gradual decline in demand for municipal bonds, “widespread selling is unlikely”.
With the prospect of meaningful tax reform farther in the distance, investors have turned their attention back to the fundamentals of the market, which broadly bode well for investors.