Municipal bonds can continue to provide a number of potential benefits for tax-sensitive investors as we move into 2020, according to Shelia Amoroso, director of Franklin Templeton Fixed Income Group’s Municipal Bond Department. However, following the strong results in 2019, she and the team expect total return potential to be muted in 2020, with likely increased volatility.
Municipal Market Technicals Remain Favorable…
Municipal bond supply and investor demand continue to represent important factors in the context of the municipal bond market. In terms of supply, several themes have emerged following the elimination of tax-exempt advance refundings, a component of the 2017 tax reform legislation that has led to the reduced supply of tax-exempt bonds in 2018 and 2019.
Meanwhile, the market has seen a significant increase in the supply of taxable municipal bonds, as issuers have turned to them for opportunities to refinance through advance refunding higher coupon tax-exempt bonds thanks to attractive fundamentals versus similarly rated investment-grade corporate bonds. While taxable issuance is likely to remain elevated in 2020, the net issuance of tax-exempt municipal bonds—which continue to represent the vast majority of the overall market—is likely to remain low, in our view.
At the same time, municipal bonds have continued to see strong investor demand, with 2019 expected to break historical records for inflows. Although we believe municipal market performance potential will likely be more muted over the next 12 months, we expect investor demand to remain strong given the variety of benefits that municipal bonds can provide within a broader investment portfolio, particularly their tax-exempt status.
…But the Potential for Volatility Remains
Unfunded pension liabilities continue to be an overhang for municipalities in general, but particularly for local governments.
Over the past several decades, due largely to inadequate funding, pension programs have seen ever-increasing liabilities, causing significant budget stress as these expenses have grown faster than revenues. Despite legislative efforts in some areas to increase funding, contributions to retirement programs remain below levels needed to meet obligations in many places. In certain instances, we feel that the market and rating agencies have underestimated the burden that these liabilities pose to local and state governments.