The Pension Crisis And The Muni Bond Market

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Underfunded pension plans grab the headlines. But that’s not what drives prices in the municipal bond market, according to Tom Doe. It’s the interplay between supply and demand – and right now yields are depressed due to a shortage of high-quality bonds.

“It’s all about investing the massive amount of money coming into this sector,” Doe said. He added that this is the biggest supply shortage since the fall of 2013.

Doe is the founder and chief executive officer of Concord, MA-based Municipal Market Analytics (MMA), an independent research firm that provides strategic market and credit research on the U.S. municipal market and industry. I spoke to him on June 23.

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Yields on municipal bonds are still attractive, though, for taxable investors. The taxable-equivalent yields on 10-year and 30-year municipal bonds are considerably higher than comparable maturity Treasury bonds.

Doe recounted the pension problems facing several key states. But he said that, even in those states, individual investors who hold high-quality bonds to maturity should be confident they will receive all interest and principal payments.

Let’s look at what Doe said about conditions in the muni market and the implications for investors who hold bonds in pension-plagued states.

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On a nominal basis, 10-year AAA-rated munis yield 10 basis points less than equivalent maturity Treasury bonds and the spread on 30-year bonds is only 12 basis points. Those spreads are wider than earlier this year. On a taxable equivalent basis, though, Doe said that 10- and 30-year munis trade 100 and 200 basis points above Treasury bonds, respectively. Doe said those spreads are “appropriate” and reflect the greater credit risk in muni market.

Spreads for the two- and five-year maturities are at the same levels as before the financial crisis, while the 10- and 30-year spreads are wider, Doe said.

According to Doe, yields are a function of supply and demand and for munis demand is driven by the Baby Boomer generation’s preference for fixed-income investments. By 2020, 70% of that cohort will be 65 years and older.

There is also an international demand for short-term muni bonds. Does said that due to a change in regulation in the fourth quarter of last year, insurance companies in Asia now own approximately $120 billion in munis.

In a curious move, Doe said that some significant high-net worth non-U.S. investors are positioning themselves in anticipation of Trump’s proposed $1 trillion infrastructure program. To enhance their lobbying efforts, he said they bought bonds to “reflect their commitment to infrastructure projects.”

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But Trump’s infrastructure will have a “benign” effect on the muni market, Doe said. Some privately-funded projects might expand issuance, he claimed, but stadium financings might contract, offsetting one another.

There hasn’t been a pickup in muni issuance this year. June is typically the biggest issuance month, he said, but it is on track to be 13% below the 10-year average, consistent with the pattern this year. Doe had expected 2017 issuance to be more than $400 billion, but he now projects $360 billion.

“That is generating an amplified valuation of municipal yields,” he said, “driving them down.”

Refundings might increase supply as they did in 2016, Doe said, but that component of supply won’t be anywhere near where it was in last two years.

“The demand for muni product has continued to drive investors down the ratings spectrum and further out the yield curve,” Doe said.

A key issue is whether the federal government will preserve the tax-exempt status of muni bonds. Doe said there is “nothing on the table” that would remove that status, but he said the muni industry is too complacent. Gary Cohn, Trump’s chief economic advisor, is not in favor of the tax-exempt status of munis, Doe said. Others higher up in the administration are divided, he said, and some favor public-private partnerships as an alternative to the tax-exempt status.

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“If tax reform moves forward,” Doe said, “the exemption is still at risk but that is a low probability.”

By Robert Huebscher, read the full article here.

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