How to distill the market reaction to the Republican sweep? Maybe this: investors expect huge infrastructure spending, less regulation and much lower tax rates to mean big fiscal stimulus. It registered in a rally for equities and a sell-off in the bond markets, especially municipals, where tax rates matter—a lot.
So, do municipals still offer fair value? To answer that question, investors must consider two things: the potential effect of changes in tax rates and economic growth.
First, taxes. On Election Day, investors subject to the top federal tax could earn an extra 66 basis points after taxes by buying a 10-year AAA-rated municipal bond instead of a comparable Treasury bond.
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After Trump won, 10-year municipal yields rose by 48 basis points and Treasury yields by 38 basis points. Suddenly, municipals were offering nearly 100 basis points more than Treasuries—provided, of course, that tax rates stay the same.
The Republican sweep makes that unlikely. During his campaign Donald Trump proposed a reduction of the top tax rate to 33%. But think twice before selling those municipal bonds. Sure, if Trump gets his tax cut through Congress, municipals’ after-tax yield advantage over Treasuries would drop—but only to 69 basis points, nearly where it was on the eve of the election.
In other words, the municipal market appears to have already priced in a significant cut in federal tax rates. This suggests that, for now, at least, municipals are a hold. And remember, it remains to be seen what tax and spending plans Congress will actually pass.
In Bond Portfolios, Time Heals
When it comes to economic growth, it’s important to look at the municipal market historically and how it’s dealt with volatility and down periods. There is, after all, a reason that bonds are generally considered safe havens.
Since 1988, intermediate high-grade municipals (as represented by the Bloomberg 1-10 Year Municipal Bond Index) have posted negative monthly returns 30% of the time. Month to date, municipals have returned –1.8%, putting this period on par with some of the more difficult periods the market has experienced. But not the worst.
Even so, over 12-month rolling periods, the frequency of a negative return has been just 4%. And even more amazingly, the municipal market has never experienced a negative return over a rolling 24-month period (Display).
What’s the takeaway here? Don’t get caught up in the month-to-month volatility of bond returns. Whether economic growth accelerates more or less than expected, or whether tax rates fall more or less than expected, one thing is pretty certain in the bond investors’ world: the yield and “roll”—the tendency of a bond’s value to rise as it approaches maturity—of bond portfolios combine to produce positive returns over time.
Checking In on Your Municipal Portfolio
Look for a buying opportunity. It’s difficult to call a bottom, but Treasury yields have risen 38 basis points in one week. By comparison, the 10-year German yield has jumped 12 basis points. It’s hard to imagine a significant further increase without concrete policy proposals and/or a similar rise in international bond yields.
Consider adding inflation protection. Inflation expectations are currently near Fed targets, but stronger-than-expected economic growth could lead to more price pressure. And, if inflation expectations rise, inflation-protected municipal bonds could outperform.
Diversify for flexibility. Flexibility to use taxable bonds opportunistically can be critical to helping preserve capital during periods of heightened uncertainty and volatility. Small positions in Treasuries can help buffer municipal portfolios during this period of tax-related uncertainty.
Limit the maturity of your municipal holdings. Longer-maturity bonds have more exposure to a decline in the value of their tax exemption than do short- or intermediate-maturity bonds.
So what’s the upshot of it all? Simply this: don’t make big, sweeping decisions about your portfolio based on short-term volatility and price movements. Investors will likely endure more market unrest as the new administration fine-tunes its policies. But those who stay flexible and pay attention to detail stand a good chance of coming out ahead in the long run.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Article by Guy Davidson