1Q 2019 — Tax-Free Fixed Income

Jamie Mullen
Senior Portfolio Manager
Eric Kazatsky
Portfolio Manager

A lower and flatter yield curve took center stage for tax-free bonds through the first quarter of 2019, taking an encore from the sound performance during the back half of 2018. Safe haven assets, in general, did not skip a beat from the close of 2018, as the broader U.S. Treasury rally took its cue from a more dovish Fed and helped push municipal ratios reaching their lowest levels since 2017.

Both the Bloomberg Barclays Aggregate Municipal Index and the SMA-focused Bloomberg Barclays 5-Year Municipal Bond Index are off to strong starts, with the former having its best first quarter since 2014, and the latter having its strongest start in over a decade. Municipal bonds outperformed their taxable equivalents by a wide margin, driven by the lower supply and increased demand due to the impacts of tax reform. The 10-year AAA municipal rate declined by approximately 40 basis points since the start of the year compared the 10-year U.S. Treasury, which declined by only 28 basis points.

Despite the continued rally trend in bonds, the movement post-Fed meeting has created a tale of two yield curves in a sense, as a flatter curve has rewarded those investors who were at the long end of the 30-year spectrum. To illustrate, year-to-date returns for the Bloomberg Barclays 5-year Municipal Bond Index were 2.11%, while returns for the Bloomberg Barclays 30-year Municipal Index were almost double at 3.85%. Out of that 3.85% year-to-date return, more than half was generated in March alone. The municipal yield curve slope, while not inverting like its taxable equivalent, did compress to the flattest levels that are available to track on Bloomberg.

With positive performance providing huge tailwinds to start the year, we remain focused ahead on the next three quarters. While we cannot predict future performance, we can tease out the likelihood of return direction given issuance statistics and general muni market seasonality.

Compared to the first quarter in 2018, tax-free municipal bond issuance has increased by almost 22% year-over-year. While this number appears strong, it is important to keep views tempered given how anemic the start to 2018 was after tax-reform took hold. It is reassuring to see issuers return to the market and continue to take advantage of historically low absolute borrowing rates.

Deals that have come to market have seen solid demand, evidenced by continued compression of credit spreads for “headline” names such as Illinois, Chicago and Connecticut. The current cash rolls for April combined with projected issuance would lead us to believe that municipal bonds will continue to have a firm foothold that will be supportive of positive performance.

As tax season continues, the realization that State and Local Tax (SALT) limitations may have adversely impaired a fair number of 2018 returns, which will only help increase the valuations for bonds in states such as California, New York and New Jersey, as high net worth households look for ways to offset taxable income. While absolute rate movement lower will depend on the direction of the U.S. Treasury, the increasing likelihood of a rate cut this year is another positive tailwind for muni bonds.

Our focus in the tax-exempt fixed income strategy continues to center on current income, managing duration, and prudent credit selection. As the curve becomes flatter, we can gain exposure to the longer end of the curve by taking on increasingly less duration, even more so than a month ago. Our credit focus continues to be on essential service issuers, as well as solidly capitalized healthcare and higher education names, which will help provide portfolio diversification away from public pension and fixed cost ratio risk that are growing trends in the tax-backed sector.

Source: Bloomberg, Ned Davis Research

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