They are the primary objectives of municipal bond investing: Safety. Income. After-tax return. But the market doesn’t always provide the ideal environment, and the coming year looks to be no exception. How can muni investors avoid getting knocked off course in 2018? They can adhere to these five strategies.
1. Stay invested. Muni investors may be anxious about what’s ahead for the municipal market given recent changes to tax code. But technical factors are exceptionally supportive of municipals right now.
That’s because, as 2017 drew to a close, municipal issuers raced to market ahead of expected tax reforms that could eliminate some types of municipals, such as private activity bonds.
As a result, the fourth quarter saw the biggest municipal supply surge in 20 years. State and local governments issued $60 billion of municipal bonds in December, shattering the previous record of $55 billion set in 1985, prior to the 1986 tax act.
Long-term issuance for 2017 broke $409 billion; it’s expected to reach only $333 billion in 2018, according to SIFMA respondents. In other words, expect significantly less supply ahead. And less supply means the market is likely to rally.
We saw a similar supply surge and subsequent slump in 2010 and 2011. At the end of 2010, the taxable Build America Bond program concluded, bringing a mass of issuance into 2010 that would otherwise have taken place in 2011. The following year, market supply topped out at just $287 billion, and the Bloomberg Barclays Municipal Index rallied, returning 10.7%.
Investors who stay on the sidelines during supportive supply conditions in 2018 will miss out on a potential rally.
2. Be mindful of the Fed. Of course, supply conditions aren’t the only variable affecting the market. Over the near term, yields and inflation may remain low and the US curve relatively flat. But with the US economy operating at full capacity, the Fed isn’t going to tolerate these easy conditions for very long. They’ve planned three more rate hikes for 2018.
We actually expect them to hike rates four times to counter global pressures and tap the brakes on the US engine more firmly. It could take even more hikes if the recently passed changes in US tax policy cause growth and inflation to accelerate more than they expect.
As the Fed taps on that brake, the currently flat US Treasury and muni curves will begin to steepen, and those long-dated muni yields will begin to climb. These are conditions that call for an underweight of long bonds.