Mu­nic­i­pal bond mar­ket set­tling down

Milwaukee Journal Sentinel - - Business - Stan Choe AS­SO­CI­ATED PRESS

NEW YORK – Mu­nic­i­pal bonds took investors on a roller coaster at the end of 2017, as prices swung on con­cerns about what Wash­ing­ton’s over­haul of the tax sys­tem will do to the $3.8 tril­lion mar­ket.

Investors, par­tic­u­larly those in top tax brack­ets, have long sought the in­come paid by muni bonds be­cause it’s free from fed­eral in­come taxes. It will re­main that way, even af­ter Congress ap­proved sweep­ing changes to taxes, but lower tax rates for work­ers di­lute the ben­e­fit a bit. Wash­ing­ton did elim­i­nate a cor­ner of the muni bond mar­ket called “ad­vance re­fund­ings,” where state and lo­cal gov­ern­ments re­fi­nance their debt. There was a rush to is­sue such bonds be­fore the Dec. 31 dead­line.

The topsy-turvy last few weeks capped a strong year for the mar­ket. The largest muni-bond mu­tual fund by as­sets, Van­guard’s In­ter­me­di­ate-Term Tax-Ex­empt fund, re­turned 4.5% for its best per­for­mance in three years.

Peter Hayes, head of the mu­nic­i­pal group at Black­Rock, re­cently talked about what investors can ex­pect in 2018. An­swers have been edited for clar­ity and length.

Ques­tion: Do muni investors have a good sense now of what ef­fects the tax over­haul will have?

Hayes: Now that the bill has passed and the de­tails are out, we know what that means for sup­ply and de­mand, and the mar­ket has def­i­nitely set­tled down. Right now, it’s more a func­tion of val­u­a­tions: Did we pull too much per­for­mance for­ward? What will hap­pen? That’s the new back­drop.

Q: Do you think it’s fair to call the tax over­haul a slight negative for muni bonds over­all?

Hayes: That would be the per­cep­tion at first glance: As tax rates go down, muni bonds be­come less valu­able. But the re­al­ity was, and this hap­pened al­most im­me­di­ately af­ter the pres­i­den­tial elec­tion, the mar­ket se­verely over­re­acted, and it was fac­tor­ing in a much lower tax rate.

Even cur­rently, it trades (as if the top in­come-tax rate is) 30% to 32%. At this point, you could say it’s still a touch cheap with the mar­ginal tax rate at 37% (as ap­proved in the re­cently passed over­haul).

The mar­ket is ac­tu­ally cheap. On top

of pulled that, out the of ad­vance-re­fund­ings the mar­ket di­min­ishes be­ing sup­ply, the mar­ket. and that’s an­other pos­i­tive for

Q: Is there threat of muni bonds los­ing their tax-free sta­tus?

Hayes: What’s hap­pened over the last cou­ple years is there’s been a greater recog­ni­tion about the im­por­tance of the muni mar­ket in re­gards to in­fra­struc­ture. We’ve heard (pres­i­den­tial eco­nomic ad­viser Gary) Cohn say that. We’ve heard the pres­i­dent say that.

There’s a greater recog­ni­tion of what this mar­ket does as an im­por­tant source of fi­nanc­ing for in­fra­struc­ture in the U.S., rather than be­ing one just bought by wealthy in­di­vid­u­als. I think it’s changed enough that the tax ex­emp­tion won’t be (brought up) again.

Q: Should muni investors ex­pect more volatil­ity in 2018?

Hayes: For the near term, I’ll say two to three months, I think volatil­ity re­mains pretty min­i­mal and will be driven more by what in­ter­est rates do in gen­eral.

I do think volatil­ity be­gins to ap­pear as is­suance be­gins to pick up, in prob­a­bly April or May. We’ll also have the Fed in play at that time. From then to the rest of the year, we’ll have more volatil­ity than we saw in 2017.

Q: Should investors ex­pect lower re­turns?

Hayes: They have to. I do think you’ll get lower re­turns than in 2017. It won’t be negative. It will be pos­i­tive, just not as ro­bust as last year. It’s an­other im­por­tant area where investors have to re­set their ex­pec­ta­tions a bit.

Where do you de­rive re­turns from? I don’t think we’re go­ing to get any­thing from prices (ris­ing). And yields are lower (lead­ing to less in­come).

Q: How will Wash­ing­ton’s in­fra­struc­ture push af­fect the muni mar­ket?

Hayes: There are a cou­ple things we know. It seems both Democrats and Repub­li­cans would like to invest in in­fra­struc­ture in the U.S. But there’s not one so­lu­tion on how to fi­nance it or fund it. There’s go­ing to be sev­eral, and the mu­nic­i­pal mar­ket will be a part of it.

But I don’t think it will have a big, big im­pact. I don’t think we’ll see a sig­nif­i­cant is­suance in the mar­ket be­cause, at the end of the day, state and lo­cal gov­ern­ments have to be able to pay for them. That in it­self will keep a cap on is­suance.

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