4Q 2018 — Tax-Free Fixed Income

Jamie Mullen
Senior Portfolio Manager

The fourth quarter rally in municipals was a welcome respite to the previous three quarters of negative performance, helping to push 2018 muni returns to 1.69% for the Bloomberg Barclays 5-Year Municipal Index. While there tends to be a bit of seasonality for municipal performance in December, the late innings of 2018 helped amplify returns for tax-free investors and firmly establish municipal bonds as one of the best performing fixed income asset classes last year.

As uncertainty regarding the future path of the Fed and continued U.S./China trade jarring weighed on investors, the 10-Year U.S. Treasury preceded to rally almost 42 basis points in the fourth quarter, while tax-free bonds followed along with the 10-Year AAA muni yield dropping by 32 basis points.

The final issuance numbers are in, and as expected, the loss of advanced refundings and overhang from 2017 implementation of tax reform contributed to a decline in municipal issuance of almost 22% year-over-year. Had it not been for a strong uptick in new money issuance, this figure would have sagged even further.

We anticipate that the demand patterns for municipals will remain somewhat fractured in 2019, with an expected uptick in the retail/SMA space and continued absence of a strong institutional appetite. The reduction in the corporate tax rate from 35% to 21% decreased the overall demand of financial institutions, such as banks and insurance companies, that were previous buyers of tax-exempts.

We continue to believe that these buyers are content to let existing bonds mature, and absent of an unforeseen credit event, will not be large sellers of munis in 2019. Further, we anticipate consistent and strong demand for municipals from the retail market/individual investors, especially from those buyers in higher tax states who are heading into the first full tax filing period, post tax-reform, for which the outcomes are highly uncertain.

While we expect the trend of new money issuance to continue to be net positive in 2019, our view is that total municipal issuance will still remain below longer-term averages with a projection of $330 billion for 2019.
Future tax-free returns will be dependent upon a combination of U.S. Treasury rate movements and the pace of municipal new issue supply. With the implementation of tax reform in the rear-view mirror, municipals should be free to feel the full impact of the January effect to start 2019.

Our focus in the tax-exempt fixed income strategy continues to center on current income, managing duration, and prudent credit selection. Focus on essential service issuers, as well as solidly capitalized healthcare and higher education names, provides portfolio diversification away from public pension and fixed cost ratio risk that are growing trends in the tax-backed sector. As we continue to monitor the indicators of a recession on the horizon, this could place even more pressure on the ad valorem tax backed sector.

Source: Bloomberg, Ned Davis Research

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