Muni prices decline in November

Why did municipal bond (muni) prices decline so much in November?

Donald Trump’s surprise victory caused a swift adjustment in muni prices. The president-elect’s policy proposals affected munis in two main areas, listed below. The first broadly affected most U.S. bonds, while the second was more muni market specific:

  1. Trump’s proposals are anticipated to increase U.S. economic growth and fuel higher inflation, which sent interest rates generally higher across the U.S. bond market.
  2. Trump’s proposals would cut federal personal and corporate income tax rates, and increase infrastructure spending. Lower tax rates reduce the value of the taxable-equivalent yields offered by munis, while increased infrastructure spending could boost muni supply by increasing muni bond issuance to finance infrastructure projects.

Muni yields tend to follow Treasury yields directionally. That held true as the potential for stronger growth and higher inflation caused Treasury yields to rise. For example, the 10-year Treasury yield rose from 1.82% to 2.38% in November, according to Bloomberg. As Treasury yields rose and bond prices fell, munis experienced large price declines too, exacerbated by the Trump tax cut factor and anticipation of increased issuance. The Bloomberg Barclays Municipal Bond Index declined -3.73% in November.

Another factor that magnified the muni market response was the composition and behavior of muni investors. Retail investors control a large portion of the muni market, and they tend to react swiftly to negative news. As the muni market sold off, investors redeemed holdings in muni funds, with long-maturity and high-yield muni funds experiencing the largest outflows as a percent of assets.

What is our muni market outlook?

We believe the muni market will continue to experience near-term volatility, driven by further investor outflows and uncertainty. Questions about the pace and magnitude of Federal Reserve interest rate policy and the influence of non-U.S. central bank policies in a still-soft global economy hang over the broad bond market, as well as unknowns concerning which of Trump’s proposed policies will actually be implemented, and when. We can say with more assurance that muni credit fundamentals remain strong and could grow stronger if the economy grows as expected. At this point, the only potential credit concerns are related to hospital bonds. The proposed repeal of the Affordable Care Act and the lack of information surrounding its replacement are creating uncertainty in the sector.

It also appears to us that the November sell-off may have been overdone, considering how long it may take to actually implement changes to the U.S. tax code and approve infrastructure spending.

What should I do with my muni holdings?

We believe investors should stick with their long-term asset allocations and continue holding their muni positions, particularly at this point, where buyers are coming back into the market. The recent sell-off was largely a result of rising rates, fund outflows and the perception that proposed tax reform will not be favorable for municipal bonds. As mentioned earlier, overall muni credit quality and the ability to repay debt continue to be favorable. Positive returns from equities, low unemployment, and a strong housing market have boosted tax receipts and municipal revenues. Default rates remain low.

Over the past week, muni prices have already recouped some of November’s losses. Municipal yield to Treasury yield ratios, based on 10-year securities, were 95% prior to November, weakened to 105% in November, and have since recovered back to 95% levels.

Historically, munis have posted the strongest performance following periods of negative returns and investor redemptions. In this case, we think the worst of the immediate post-election Treasury yield adjustments has passed, assuming global growth and inflation stay at these levels. Global factors remain a major influence on the U.S. bond market, as they’ve been for the past few years. Global growth remains slow, and global inflation is contained. In that context, we expect the 10-year U.S. Treasury yield to be between 1.85% and 3.00% in 12 months, with probabilities weighted toward the higher end of that range.

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