WHILE THE NEW TAX LAW MAY POR­TEND

The Bond Buyer - - Front Page - By John hal­lacy

a dif­fi­cult year for the mu­nic­i­pal mar­ket, higher short-term rates and low sup­ply should pro­pel de­mand in 2018 . . . .

Given the enor­mity of the tax re­form law, we ap­pre­ci­ate that the com­ing year will be one of the most dif­fer­ent in a long time. Here’s how the im­mi­nent New Year’s de­vel­op­ments may cre­ate some op­por­tu­ni­ties.

Flat­ter is Bet­ter? There is lit­tle doubt that the yield curve will keep mov­ing to­wards a flat­ter con­fig­u­ra­tion if the Fed has any­thing to do with the pic­ture. In the old days, we used to yearn for a flat­ter curve so that ad­vance re­fund­ings would be more in the money. Neg­a­tive ar­bi­trage would be con­quered. Alas, ad­vance re­fund­ings are no more, and more cre­ativ­ity will be re­quired in ad­di­tion to the work­horse of cur­rent re­fund­ings in or­der to find sav­ings for Is­suers. We are heart­ened by the fact that a rise in shorter rates tends to at­tract more re­tail in­ter­est. Re­tail needs a place to put all of the gains that have been se­cured over the past year. What bet­ter place to put some up­side into re­li­able mu­nic­i­pals.

On the in­sti­tu­tional side, par­tic­i­pants will be bid­ding up the mar­ket in an en­vi­ron­ment of lower sup­ply. The rollover in Jan­uary will prob­a­bly por­tend what will hap­pen for the rest of the year and at key ma­tu­rity times. The sec­ondary mar­ket also stands to be bid up. Older sea­soned po­si­tions will be prime can­di­dates to be traded to keep per­for­mance up when sup­ply is on the wane.

We don’t see a ra­tio­nale for an in­verted yield curve at this time. Nor do we yearn for same. The sup­ply out­look can be very chal­lenged by such a de­vel­op­ment, even though long rates would be be­low short rates.

We must re­main dili­gent about credit con­cerns. The ex­pan­sion has per­sisted over nine years, but the feel­ing is that some cred­its should be ex­pe­ri­enc­ing more ro­bust rev­enue growth than what is be­ing re­al­ized.

Bud­gets also re­main quite tight. One only has to think of Con­necti­cut and New Jersey as ex­am­ples. On the other end of the credit spec­trum, high yield has been sought af­ter with con­tin­u­ous fret­ting about high yield sup­ply. We do not be­lieve that these con­cerns will ebb in the near term. With no re­ces­sion be­ing se­ri­ously con­tem­plated at this time, the trade out of high yield is post­poned for a time to come.

We would en­cour­age sound use of pri­vate ac­tiv­ity bonds while we still have use of them. The fact that Tax Re­form has al­ready con­trib­uted to dis­cus­sion of find­ing sav­ings else­where in the fed­eral bud­get au­gurs more po­ten­tial at­ten­tion to mak­ing changes to mu­nic­i­pals in the fu­ture. The re­cent process con­tin­ues to demon­strate that mu­nic­i­pals can be viewed as “easy pick­ings” for sav­ings in fed­eral bud­get de­lib­er­a­tions. Medi­care, Med­i­caid and So­cial Se­cu­rity are much more dif­fi­cult en­ti­tle­ments to re­duce with­out ma­jor con­se­quences. That means that all other cat­e­gories ex­cept for De­fense and Home­land Se­cu­rity (Anti-Ter­ror­ism) re­main vul­ner­a­ble.

Di­min­ished sup­ply will have many im­pli­ca­tions for the mu­nic­i­pal mar­ket. Es­ti­mates of 2018 vol­ume have ranged from $275 bil­lion to $400 bil­lion. We are in the camp that sup­ply will prob­a­bly be in the low $300 B range. Af­ter the last tax re­form, sup­ply in the sub­se­quent year came in at about half. Cir­cum­stances are dif­fer­ent now, so there is a bet­ter than even chance new money sup­ply will grow, hold­ing other fac­tors con­stant.

We had our an­tic­i­pa­tion level on red alert last year in re­gards to a forth­com­ing in­fra­struc­ture plan from the ad­min­is­tra­tion. Once again, we are be­ing in­formed that a plan is in the works. How­ever, it would seem that this plan may be even more dif­fi­cult to launch given the fund­ing pres­sures and given that bi­par­ti­san co­op­er­a­tion will be re­quired. The lat­ter should be forth­com­ing de­spite any po­lit­i­cal con­sid­er­a­tions. We are even more vexed this time about where the fund­ing will come from if states and lo­cal­i­ties will be pressed harder for their match fund­ing. Most states are not in a po­si­tion to raise taxes or add fees and charges to pro­duce a match. If this tenet is ad­hered to in the fi­nal ver­sion of any bill, the orig­i­na­tion for projects may come in lower than ex­pected.

On the reg­u­la­tory front, we an­tic­i­pate a greater em­pha­sis and the im­ple­men­ta­tion of ex­ist­ing reg­u­la­tions and re­quire­ments. Markups, mu­nic­i­pal pric­ing and en­hanced dis­clo­sure are all suf­fi­cient to gar­ner a lot of at­ten­tion. What is gain­ing more trac­tion is re­view­ing re­cent en­force­ment ac­tions for more clear di­rec­tion about where the lines are drawn on spe­cific reg­u­la­tions. Be­ing de­sirous of com­ply­ing and ac­tu­ally com­ply­ing are two dif­fer­ent con­cepts last time we checked.

Liq­uid­ity is an ever present fo­cus in our mar­ket. The good news is that liq­uid­ity is quite good at present. Af­ter all, there is even a mar­ket in Puerto Rico bonds, though it is prob­a­bly not as wide and deep as one would want. This is a good mar­ket for cross­ing bonds. We have not heard as much this year about tax swap­ping, but we can only as­sume that it has been business as usual. The ac­tiv­ity in equities has tended to drown out a lot of other dis­course. Sound liq­uid­ity has been main­tained in the face of greater reg­u­la­tion and more lim­its on dealer in­ven­tory. We have not had a real test of liq­uid­ity in some time and we do not an­tic­i­pate one in the near term.

We all know that many projects are pend­ing. Fund­ing and rates are al­ways a con­sid­er­a­tion. Public pri­vate part­ner­ships can con­tinue to evolve given that the at­tack on PABs has been called off for now. Given the paucity of fund­ing op­por­tu­ni­ties, P3s must be con­sid­ered as an al­ter­na­tive. Per­haps, we should be re­as­sured about the ap­proach that higher ed­u­ca­tion and health­care have taken over the re­cent past. These en­ti­ties have gone tax­able when the spread of tax ex­empt to tax­able has not been that wide. While it is gen­er­ally harder for a gen­eral obli­ga­tion credit to jus­tify tak­ing this route, it should be con­sid­ered more. We know there is solid de­mand for tax­able mu­nic­i­pals.

We re­solve to keep nur­tur­ing the mu­nic­i­pal mar­ket as one of the most ef­fi­cient on the globe.We wish all a very pro­duc­tive 2018 that will con­tinue to demon­strate how crit­i­cal mu­nic­i­pals are in the over­all eco­nomic growth drive. ◽

”We must be dili­gent about credit ◽ual­ity con­cerns,” Bond Buyer’s John Hal­lacy writes.

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