The tax-exempt municipal market has faced some challenges this fall: Yields trended higher in early October as the market struggled to digest the largest new issuance period of the year, and the indigestion has only increased following last week’s U.S. election outcome.
Municipal investors are now mulling what the shifting policy agenda under a Donald Trump presidency and Republican Congress could mean for their portfolios – and we see opportunities for active management amid the related volatility.
Heads or tails? The impact of tax policy
Changes to top marginal tax rates are nothing new, and historically they’ve offered little to fear for municipal investors. Since 1982, the top individual tax rate has changed eight times – and history has not shown a clear relationship between top tax rates and muni valuations (see chart).
Perhaps this is because municipals still offer value for U.S. tax-paying investors even well below the top marginal tax bracket. For example, at current valuations, muni investors in a 33% federal tax bracket (the top rate under Trump’s current tax proposal) would earn a higher after-tax yield than in similarly rated corporates: The Barclays AA Municipal Index yield of 2.15% offers a spread of 58 basis points (bps) over similarly rated duration-matched corporates on an after-tax basis (as of 14 November 2016).
Rising rates add to the tax exemption’s appeal
Following the election outcome, we continue to forecast two to three fed funds rate hikes before the end of 2017. And as absolute interest rates move higher and taxes eat up a greater absolute level of a U.S. investor’s taxable income, the value of the muni tax exemption increases. This helps explain why municipals have outperformed other fixed income asset classes in previous Fed hiking cycles – and this cycle is unlikely to be the exception.
Mixed impact from health care and infrastructure policy
It’s still early, and we have much to learn about President-elect Trump’s policy plans. But we do know that changes to the Affordable Care Act and a program to boost infrastructure spending are top priorities.
Lower federal health care subsidies could pressure margins at not-for-profit hospitals that issue municipal debt. Large systems with durable balance sheets and those that rely less on Medicaid are better positioned, while smaller standalone hospitals and safety-net providers have more to lose.
Bipartisan support for investment in aging infrastructure was likely regardless of who won the election. A policy shift toward public-private partnerships with tax credits to encourage private capital commitments would likely be the best scenario for the municipal asset class. Meeting the deferred capital expenditure needs of transportation and utilities without direct tax-exempt issuance would strengthen municipal credits’ balance sheets without saturating the market for traditional tax-exempt bonds.
Given the recent spike in yields and the murky policy picture, tax-exempt municipals may face continued near-term volatility. This has created opportunities for active management, as valuations have already adjusted to levels that benefit U.S. investors in federal tax brackets well below 33%.
The markets have quickly priced in a shift in policy, but actual policy execution will likely unfold over multiple years. Meanwhile, muni credit fundamentals have strengthened, and an agenda focused on fiscal stimulus and infrastructure may offer further support. In line with our secular (three- to five-year) outlook, we continue to suggest conservative positioning within clients’ municipal allocations. Over the cyclical (six- to 12-month) horizon, the municipal opportunity set is poised to become “three-dimensional” as active managers seek to add value through top-down macro analysis, bottom-up credit selection and appropriate pricing of risk amid shifting policy paths.
To read more PIMCO insights on municipals, please visit pimco.com/munis.
David Hammer is head of PIMCO’s municipal bond portfolio management.