Fueled by the Tax Cuts and Jobs Act passed in 2017, municipal bonds have seen strong demand and robust cash flows. We take a look at the state of the muni market and the current attractiveness of its valuation.
Municipal Market Update
Thus far in 2019, the municipal market has been one of the better performing sectors within the broader bond market, outperforming Treasuries and investment grade corporate bonds on a total return basis. One of the primary drivers of this performance has been the Tax Cuts and Jobs Act (TCJA), which passed at the end of 2017. The TCJA reduced marginal tax rates, which would typically have a negative impact on tax-free bonds, since it reduces their after tax return. The tax bill, however, also limited the deductibility of state and local income taxes, (commonly referred to as SALT) to a maximum of $10,000. For individuals in higher tax brackets that reside in high tax states this limitation has proven to be particularly painful as it has increased their tax bill by a decent amount. This increased tax liability has highlighted municipal bonds as one of the few remaining tax shelters for this group of investors, which has increased demand for municipal bonds. Cash flows into municipal mutual funds, a proxy for investor demand, has been robust so far in 2019 totaling over $33 billion. This strong demand, combined with limited new issue supply has caused municipal yields to decline relative to Treasury yields and has driven the positive outperformance of municipals compared to Treasuries and other investment grade sectors. At the same time, the positive relative performance has left municipal valuations at very rich levels compared to benchmark Treasury securities. As an example, high quality municipal bonds maturing in 10 years typically trade at yields equal to 85-90% of 10-year Treasury yields. Currently, 10-year municipal bonds are trading at yields equal to approximately 72% of comparable maturity Treasury Notes. This means that 10 year municipal bonds are trading at yields roughly 0.25-0.30% lower versus historical valuations. Again, this reflects the strong desire for investors to own tax-free debt as a way to shelter income and reduce their overall tax bill.
While these rich valuations are unattractive from a historical perspective, the situation is not likely to change in the near term. Over the summer months, the positive market conditions seem likely to persist as bond maturities and called bonds are expected to be heavy. This should supply current investors with additional cash to invest in the market and fuel demand for municipal bonds. Longer term, we expect that the municipal market will continue to provide an attractive, historically safe investment for investors in higher tax brackets. Over the near term, we would be selective on new purchases and continue to emphasize higher quality bonds in the intermediate maturity range.