Finding Opportunities In Today’s Municipal Bond Market by James Dearborn, Columbia Threadneedle Investments

James Dearborn, head of municipal bond investments and senior portfolio manager at Columbia Threadneedle, discusses today’s municipal bond market and where he sees opportunities for tax-sensitive investors.

Q: How would you characterize the current environment for municipal bonds?

A: Fundamentals are stable to improving as revenues continue to increase while spending remains relatively restrained. The technical environment is also favorable with high tax rates driving strong demand and net issuance remaining low. Muni bond funds saw over $18 billion in positive flows in the first quarter and have had 29 consecutive weeks of inflows through mid-April. Muni bonds finished 2015 among the best performing asset classes, just as they did in the previous year.

Q: What about the recent negative headlines concerning Puerto Rico, New Jersey and Chicago?

A: While it’s natural to focus on a few outliers, investors should be mindful that our market includes nearly 50,000 municipal issuers. Revenues at both the state and local levels have eclipsed the peaks they experienced prior to the great financial crisis. Of course, challenges related to pensions and healthcare costs are concerning, but we believe the overall market for muni bonds remains strong and stable.

Q: What impact will the presidential campaign have on the municipal bond market?

A: There are some big and less-than-specific tax plans being offered up by the candidates, some of which may include the taxation of municipal bond interest. However, we believe that widespread or comprehensive tax reform is very unlikely with a divided government, and we do not anticipate comprehensive tax reform that would affect munis next year.

Q: Does today’s interest rate environment favor short-term municipal bonds over longer term maturities?

A: It’s not a given that a rate hike — or even a series of hikes — by the Fed would negatively affect the long end of the curve. Let’s suppose the front end of the curve went up by 50 basis points because the Fed raised rates 50 basis points. That wouldn’t necessarily mean the long end would also go up by 50 basis points. Higher short rates may slow the economy and ultimately lessen inflationary pressures, which would support longer bonds. If inflation remains under control, longer term bonds can do very well.

Q: What are some of your favorite opportunities in this market?

A: I think the intermediate space offers that middle ground where you can take advantage of the steepness of the yield curve without taking on all of the duration risk of longer bonds. You’re able to add yield by buying in the 5- to 15-year part of the curve, but you’re not adding a lot of duration or interest rate risk if rates do rise. For investors who believe we are in a low inflation and lower-for-longer rate environment, we also see value in longer muni bonds for the attractive yields they offer.

Q: What do you think about high-yield municipal bonds?

A: I think the high-yield muni space is close to fully valued, with investors being adequately compensated for the risk they are taking. That said, credit spreads are fairly narrow and yields are lower than what is typical. With high-yield munis, you’re probably just buying into more of an income story — a clip-the-coupon environment — rather than a price appreciation story. Also, as the high-yield market has been quite volatile, investors need to be cautious and not overpay for the risk they’re taking.

Q: What role does credit research play in finding opportunities in a market with headline risk?

A: Fundamental credit research plays a vital role, not just in identifying opportunities but helping to avoid potential pitfalls. For example, our credit team may internally rate a bond as a single-A credit, while the rating agencies and market price it two notches lower, as BBB+. In this case, we can buy the bond and earn a higher yield than a single-A bond would be expected to offer. Plus, if the market reprices the bond to single-A, we would further benefit from price appreciation. Conversely, if we own a bond we believe is a BBB+ credit, but which the market is pricing at A-, we can sell the bond and avoid the price decline that would occur if the market eventually reprices the bond at BBB+.

Q: Why should investors pay attention to an investment’s taxable-equivalent yield?

A: With corporate bonds, you pay ordinary income taxes and you might also pay the 3.8% net investment income tax (NIIT), potentially bumping your top federal rate to 43.4%. With muni bonds, you don’t pay ordinary income tax or the 3.8% NIIT. Investment-grade muni funds currently offer taxable-equivalent yields of better than 7%. I don’t think there are many investment-grade corporate funds — and certainly not Treasuries — that can offer a similar yield with a similar risk profile.

Q: What is your outlook for the rest of 2016?

A: We see a stable market for the remainder of the year. Fund flows continue to be strong and there is an insufficient amount of supply of new issues. This technical environment helps create a really strong underpinning of support for current prices in our market. However, we will pay close attention to headline risks because our market is dominated by retail investors, who often overreact to negative headlines. Those overreactions can present some of the best buying opportunities for savvy investors.

Municipal Bond Market