The municipal bond market may seem rather straightforward with very low default rates and reliable payments from governments.
But unless you’re holding bonds to maturity, perception can have a big impact on the market prices of these bonds. Some of these perceptions can also impact your portfolio, even if you do hold these bonds to maturity, such as changes to the tax code.
In this article, we will look at four examples of how broad perceptions drive the municipal bond market and some considerations for bondholders.
Impact of Major Events on the Municipal Debt Space
1. Impact of Elections
Democrats and Republicans have very different ideas of how the economy should work, which means presidential elections and mid-terms can have a big impact on the market.
The most obvious example is the Tax Cuts and Jobs Act of 2017, which nearly dropped a provision that would have eliminated the tax exemption for private activity bonds (PABs). These bonds are commonly used to finance airports, hospitals, universities and other infrastructure projects that are built for the public good. Moody’s Investors Service estimates that these bonds accounted for about 25 percent to 35 percent of the muni bond market in 2016.
Even if PABs remain tax exempt, infrastructure spending is largely controlled by the federal government. President Trump promised to strengthen the economy by dramatically boosting investment in infrastructure during his campaign. While the broad strokes were announced in 2017, the president is expected to detail the $1 trillion plan in early 2018. The details of these talks could have a big impact on PABs, Build America Bonds (BABs) and other related muni issues.
There are instances where the impact may be less obvious, such as changes to the Medicare system. Since the program is means tested, those who earn more must pay more in premiums for coverage. Tax-free income from muni bonds are included in modified-adjusted gross income, which means that a portfolio of current high-coupon bonds could increase your Medicare premiums.
Another example of an indirect impact is the U.S. corporate tax law. The new 20% corporate tax rate reduces the attractiveness of muni bonds for corporate buyers since there’s less of a need to realize the tax-exemption benefits. In other words, muni yields would have to increase significantly before they would be competitive with taxable investments, particularly for institutional investors such as commercial banks and insurance companies.
2. Federal Reserve Sentiment
Interest rates are the single-most important factor influencing the bond markets, and the Federal Reserve lies at the heart of predicting their movement.
The so-called Taper Tantrum in 2013 was perhaps the best example of how perceptions surrounding the Federal Reserve’s plans have a real impact on the muni market. Chairman Ben Bernanke hinted that the central bank might start winding down its asset-buying program, and investors began to panic. The muni bond market experienced significant outflows in the aftermath of the announcement that was later backpeddled.
Since the Taper Tantrum, the Federal Reserve has made a point to be very clear and transparent about how interest rate hikes will progress. The clarity of the central bank’s outlook is apparent when looking at the futures market, where there is less doubt about the pace of interest rate hikes – at least in the short term. Of course, that doesn’t mean that there won’t be any surprises from the Federal Reserve in the in the future.
3. Bankruptcy Rumors
Default risk isn’t usually a concern in the municipal bond market, but there have been several cases of bankruptcies, and even rumors can cause real issues.
Puerto Rico is a great example of these rumors having a real impact on the market. President Trump’s pledge on a Fox News broadcast to wipe out the Commonwealth’s debt in early October of 2017 caused general obligation bonds to drop from 56 cents to 37 cents on the dollar. Investors later decided that the comments were merely “noise” and the market returned to normalized levels as negotiations over the island’s debts have continued.
Problems in one muni bond market may also affect the wider market if new precedents are set when it comes to bondholder rights or other issues. For example, the courts are deciding how to handle general obligation debt versus COFINA debt that’s securitized with a lawful lien and property interest in a portion of the island’s sales tax. A decision to break these covenants could change how investors treat similar arrangements backing half of the muni market.
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4. Equity Market Performance
Investors have a finite amount of capital to deploy across many assets, which means that the performance of one asset can impact the performance of another.
Strong U.S. equity performance throughout 2017 has had a negative impact on municipal bond fund flows during several periods. For example, in February 2017, the S&P 500 rose about four percent and a benchmark municipal bond index fell about 0.6 percent. And these trends have repeated themselves throughout the year. Barron’s recently cited S&P’s findings that investment-grade muni bonds have historically had negative correlations with equity markets.
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The Bottom Line
The market’s perception can have a big impact on the price of municipal bonds and the bottom line for bondholders. Even if you’re holding a bond to maturity, some of these perceptions can influence the after-tax income that you can expect to generate from your muni bond portfolio. It’s important to be aware of these dynamics when investing in the market.
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