Municipal Bond Outlook: Tailwinds Still Blowing, Just Not as Strong | Capital Group

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Municipal Bond Outlook: Tailwinds Still Blowing, Just Not as Strong

Key takeaways

  • Modest growth is supportive for municipal bonds, as are the Federal Reserve and fiscal policy.
  • Investor appetite for the asset class seems robust.
  • The constructive post-tax reform environment remains intact.
  • With valuations near record highs, emphasize higher quality municipal bonds and use election-year setbacks as entry points for longer term investments.

After a banner year, municipal bonds face some uncertainties.

Election years and municipal bonds. It’s a combination that has sometimes struck fear in the hearts of investors. The reason? Uncertainty around how tax and other fiscal policies may evolve.

This time around, the election also comes on the heels of six consecutive years of positive returns for municipal bonds. In 2019 alone, investment-grade municipal bonds climbed 7.5%.

Some market watchers think similar gains are in the cards for 2020. Others worry the market is overdue for a “bad” year given the extended rally.
In the view of fixed income portfolio manager Mark Marinella, 2020 will likely play out somewhere in the middle. “After such healthy returns, and with valuations now so stretched, it’s only sensible to moderate return expectations for muni bonds in 2020,” Marinella says.

But tailwinds haven’t disappeared: Here are three factors that could give a boost to municipal bonds.

Marinella sees three key reasons to be constructive: the first applies to fixed income broadly, while aspects of the other two have the potential to shape near-term prospects for municipal bonds in particular:

1. Modest growth and inflation can be positives.

Many investors intuitively equate strong economic growth with outsized investment returns, especially in equities. For bonds, however, moderate growth and inflation can actually be positive.

Upward pressure on the price of goods and services is often muted in an economy that is merely ticking along. This can help put a lid on inflation, preserving the value of the income that investors earn from bonds.

With little indication that growth in America will race ahead (or indeed, lurch lower), economic conditions in 2020 should, therefore, be supportive of municipal bonds.

2. Unchanged Fed and fiscal policies could also be supportive.

Unless some unexpected severe economic challenge necessitates a rate cut, the Fed is now on pause.

Interest rates that are low (or merely unchanged) can make for a benign environment for bond yields. That’s because yields and bond prices move inversely: When the Fed hikes rates, yields rise, and the value of bonds falls.

A healthy labor market and consumer spending suggest growth should keep chugging along in 2020. And, even if the economy were to be derailed by trade or geopolitical tensions, the Fed still has room to cut rates — a move that would likely lift municipals and other bonds.

On the fiscal side, it seems almost inconceivable that there will be a major shift in taxation or federal spending in an election year. Putting political partisanship to one side, Capitol Hill has shown little appetite for adding to the deficit, now on track to hit $1 trillion by September.

Tax policy changes hold the potential to sway both the supply of new bonds as well as demand from investors. “Whatever the 2020 election result, it’s reasonable to assume that major upheaval in tax policies are off the table until well into the next administration. Near term, that removes a major risk for muni investors,” Marinella adds.

3. Investor appetite for tax-advantaged income has been robust.

By some measures, 2019 was a record-breaking year for the popularity of municipal bonds. The asset class attracted an unprecedented amount of investor money amid the broader hunt for yield.

Over $89 billion flowed into municipal bond funds in 2019 — about the same as the net amount received in the previous five years combined.

“Amid such stretched valuations, it’s prudent to emphasize higher quality in municipal bond allocations,” says Capital Group fixed income portfolio manager Karl Zeile. “All our investment decisions at Capital center on individual bonds. Bond-by-bond credit research is central to how we invest,” Zeile adds.

Sector positioning in Capital portfolios therefore naturally emerges from investment decisions with regard to specific bonds. That said, Capital’s team of municipal bond investment analysts do see solid fundamentals across most sectors from the nearly $4 trillion market, with tobacco settlement bonds a notable exception.

In a market of this size, there are likely to be pockets that are not as closely researched by investors. Single-family housing bonds are a case in point. These bonds are issued by various state and local housing authorities, with bond proceeds used to help low-income and first-time buyers purchase their homes.

In some cases, the credit story around these bonds has improved: The underlying mortgage pools are either federally insured or are structured in ways that can reduce the risk of default.

From a valuation standpoint, these bonds look attractive. “For very high-quality credits, it’s not uncommon to see housing municipals offer around 0.60% additional yield over similarly rated munis from some other sectors. Typical pre-tax yields on investment-grade municipals are around 1.5% to 2.0% lately,” Zeile says.

Marinella says that recent moves lower in yields across fixed income have him worried that some investors may consider giving up on bonds. “We all want a 10% coupon. I would take it if I could get it. But high-quality bonds, including municipals, are meant to be an anchor for investors, providing three of the key roles of fixed income: equity diversification and capital preservation, as well as income,” he adds.

And, if history’s any guide, this election year is likely to include some bouts of volatility. “Decades of investing have taught me that when valuations are this elevated, it’s important to view market setbacks as possible investment entry points and focus on longer term value,” Marinella says.

 


 

Mark Marinella is a fixed income portfolio manager with 34 years of investment experience. He holds an MBA from Boston College and a bachelor's in economics from the University of Massachusetts. He holds the Chartered Financial Analyst® designation.

Greg Ortman is a fixed income investment director with 25 years of industry experience. He holds a master’s degree in economics from Claremont Graduate University.

Karl Zeile is a fixed income portfolio manager with 29 years of investment experience. He also serves on the Fixed Income Management Committee. He holds a master's in public policy from Harvard. He also holds the Chartered Financial Analyst designation.

Posted January 23, 2020

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