Fixed Income

Are current muni valuations taxing your portfolio?

Muni issuance is at an exceptionally high pace, and we think it’s time for investors to pump the brakes as valuations are making this segment unattractive within a multi-sector bond context.

06/14/2019

US Multi-sector Fixed Income Team

One of the benefits of having a relative-value mindset is the ability to rotate to segments of the US bond market that offer more attractive value compared to others. Today, we think municipal relative value is currently flashing a strong sell signal versus investment-grade corporates.

Why?

The municipal market is heavily influenced by supply & demand, and year to date we have seen over $38 billion of municipal bond inflows. The last time we saw such heavy issuance was 2016.muni1.png

Source: Lipper US Fund Flows, JP Morgan. Reflects the four best yearly campaigns since the data has been collected from 1992, plus YTD 2019 versus YTD 2016 for comparison

From a performance perspective, munis underperformed corporates in 2016, based on Bloomberg Barclay indices. Furthermore, munis underperformed even on an after-tax basis.

Coincidence? We think not.

muni2.png

Source: Bloomberg Barclays and Schroders, through 2018.  Past performance is no guarantee of future results. See below for important information. [1]

In terms of gauging relative value, we use a measure call the Net Implied Tax rate (or NIT), which captures the relative valuations between tax-exempt municipals and similarly rated corporates.

In over 30 years of running tax-aware strategies, the only time this proprietary metric was more expensive was in the summer of 2016, when the NIT dropped to -2.7. At this level, investors at the higher tax rates were giving up income owning munis versus corporate bonds, on an after-tax basis.

Today, we are near those lows again with the NIT hovering around 3.20. Coupled with low muni treasury ratios the muni market is without a doubt expensive. To put the expensiveness of munis into greater context, we have had only had 42 instances out of 2,278 when the NIT was more expensive than where it is today. This is illustrated in the following histogram.

muni3.jpg

Source: Schroders, through June 7, 2019, using data sourced from Thomson Reuters and Bloomberg. For illustration only based on the Team’s views. Not a recommendation to buy/sell any security.

So what should you do?

To be clear, munis are still a good investment as a stand-alone allocation, and there are idiosyncratic opportunities to be had within areas such as housing and essential services revenue bonds. Up until recently, all US bond segments including munis have performed well (thank you, Mr Powell). But going forward, however, we would strongly caution against buying munis especially within a core-plus or multi-sector portfolio, as we think there are more attractive areas of the market.

For now, taxable segments seem the way to go (even on an after-tax basis), especially areas where you can pick up spread over Treasuries, and that are supported by strong consumer-driven fundamentals.

[1] Indices are unmanaged and not available for direct investment.
US Corporates are represented by the Bloomberg Barclays US Credit Corporate 5-7 Year Index; US Treasuries are represented by the Bloomberg Barclays US Treasury 5-7 Index for 2009, 2018 and the Bloomberg Barclays US Treasury 4-7 Year Index from 2010-2017 and US Municipals are represented by the Bloomberg Barclays Municipal Index 7-year Index. All indices have a duration of +/- 0.50 years of one another. Tax rate used: 35% for 2009 – 2012, 43.4% for 2013 – 2017 and 40.4% for 2018. Returns do not reflect state and/or local taxes, nor do they reflect the AMT. Investors cannot invest directly in any index. Other effective tax rates would have achieved different results. Actual results will vary.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.