Given the low yields that are a feature of the current investing environment, return expectations across fixed-income asset classes have been falling. So why are we reviewing munis now?
While starting yields significantly limit return expectations for munis, our research and ongoing conversations with the active managers we follow show positive fundamentals and favorable supply and demand dynamics. For our clients with taxable accounts in our balanced portfolios, we believe maintaining an allocation to munis is warranted and can provide valuable diversification during periods of poor returns for risk assets. Below, we share details of our recent analysis of the asset class.
We continue to view the U.S. market as having healthy overall fundamentals and supportive technicals. Credit quality, apart from a few high-profile trouble spots such as Puerto Rico and Illinois, is stable to improving with state and local entities seeing increased revenue.
Municipal bonds have outperformed taxable intermediate-term bonds over the trailing one-, three-, five-, and 10-year periods, even before adjusting for the effect of taxes. Muni bonds continue to benefit from strong demand and limited supply, not surprising given 10 consecutive months of gains through April. This marks the longest unbroken stretch in over 30 years. Muni bond funds have also seen 30 consecutive weeks of inflows. In the first quarter alone, net fund inflows totaled $14.4 billion, exceeding the roughly $13 billion of inflows for the full year 2015. While retail investors make up the majority of buyers, crossover institutional demand from investment-grade taxable bond investors has increased.
Net negative supply in 2015 was in the ballpark of $75 billion. That marked the fifth consecutive year of negative net supply—with municipalities retiring more bonds than they issued. In the first quarter of 2016, municipalities issued nearly $100 billion of securities, about 10% lower than in the same period of 2015. Refundings represented about 60% of first quarter issuance. As more money absorbs fewer bonds, muni prices have moved higher.
As of early May, the yield on 10-year AAA-rated general obligation bonds was 1.58%, the lowest level we have seen since 1994. Relative to Treasury bonds, munis seem to be more or less in a fair value range along the yield curve, with yield ratios near historical averages. But on an absolute basis, yields are low, and we expect low single-digit absolute returns for the sector. We would not be surprised to see bouts of volatility as a result of headline news out of Puerto Rico, Federal Reserve rate hikes, or other seasonal factors that impact muni market supply/demand dynamics.
CALIFORNIA MUNICIPAL BONDS
For tax-sensitive clients who are California residents, we use California municipal bond funds in place of national municipal bond funds to avoid incurring taxes on out-of-state income.
California seems to be in relatively good fiscal shape overall. Both Fitch and Standard & Poor’s upgraded its general obligation credit ratings in 2015. The state’s current credit ratings are now the highest they have been in years. Meanwhile, California home values have increased 6% year over year, while the state’s unemployment rate has decreased slightly from 5.9% at year-end to 5.4%, a level not seen since the middle of 2007 (Bureau of Labor Statistics).
Governor Brown’s revised budget, shows revenue increasing from $113 billion for 2014/15 to $117 billion for 2015/16, and $120 billion in 2016/17 driven by higher capital gains taxes and wage growth.
Capital gains tax revenues, which have been very volatile historically, are expected to total $13.4 billion for the 2015/16 fiscal year, the highest ever. Personal income taxes generally account for about 70% of state revenues and can also be volatile and tough to accurately predict. Currently the state has $6.7 billion in reserves, with Governor Brown looking to increase the rainy day fund established by Proposition 2 in 2014.
Despite what we view as generally healthy nearer-term financials, we expect low absolute returns for California muni bonds given the current level of yield (1.9%). While low on an absolute basis, on a tax-equivalent basis this yield compares favorably to the 2.1% yield of investment-grade taxable bonds.
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