Strong Municipal Demand Remains Unabated in the Face of Higher Rates and Tax Reform
Relative valuations stayed consistently expensive during the third quarter, buoyed in large part by the excessive levels of reinvestment flows of coupons/calls/maturities. Supply was also a factor as the new issue calendar was down 20% relative to the second quarter and down 25% relative to the third quarter of 2016. It appears that although yield levels are very conducive to executing additional refinancings, the opportunity set of deals that can be refinanced is not large enough to generate the level of refinancings that occurred during the record levels that were executed during 2016 and 2015. Refinancings on a year-to-date basis are down 40% through the end of the third quarter, and with rates moving higher over the last 3 weeks of the quarter, this downward trend is now likely to continue through the balance of the year.
Since the end of the quarter, 10 year Treasury rates have continued their upward trend with rates rising by another 9 basis points (bps). The increased prospects for the passage of tax reform and the resulting potential for increased Treasury issuance, budget deficits and inflation from economic stimulus have helped pressure yields to higher levels. The higher yield levels have also resulted in the Treasury curve flattening by another 3 basis points from 2 to 30 years, after flattening by 8 bps during the quarter.
In regards to tax-reform, on September 27th, the ”Big Six”, which includes Paul Ryan, Mitch McConnell, Kevin Brady, Orin Hatch, Steve Mnuchin and Gary Cohn, released the framework for their tax-reform proposals. Although the framework was short on details, some of the major issues tackled would be to reduce tax brackets from the current seven down to three: 12%, 25% and 35%. Additionally, corporate rates would decline from 35% to 20%.
Although the current reform proposals don’t appear to impact the demand for tax-exempts from retail investors, (even less so if a fourth tax bracket is added above the proposed 35%) institutional investors could see some major changes to their demand profile. If the corporate rate is cut to 20%, property and casualty companies (P&C) and banks, who make up ~28% of the market would find it difficult to remain fully invested in tax-exempts. Under a 20% rate, tax-adjusted yield levels would decline sharply relative to the yields of competing taxable alternatives. Those concerns have already led to the muni curve to steepen by ~57 bps on a relative basis to the Treasury curve since the beginning of the year through the middle of September. Institutional investors provide a substantial amount of sponsorship to the long end of the curve and these investors have remained on the sidelines much of the year as they await more clarity on the tax-reform issues. Another potential area that could keep the pressure on the curve to stay steep is that P&C carriers are expected to see downward pressure on their profitability as they absorb losses related to hurricanes Irma, Harvey and Maria, and the wildfires in northern California. The net effect of these events lessens the need for tax-exempt income and could generate liquidity needs to pay claims.
However, outside of the aforementioned curve steepening bias, from a relative valuation standpoint, it appears that the tax-exempt market has remained indifferent to the risks related to tax-reform and has continued to enjoy solid technical conditions. While 10 year Treasury rates have risen by 39 bps since September 8th, 10 year nominal spreads to Treasuries have contracted by 23 bps, which is based on both continued strong demand as well as supply levels that are running below expectations. New issuance was expected to reach $40B during October, but during the first three weeks the market has only produced approximately $23 billion, while demand flows from coupon/calls/maturities have remained solid. Mutual fund flows have also been supportive. Inflows reported by Lipper reached $536 million for the period ending October 18th, increasing aggregate inflows for the year to $15.2 billion. The net result is that, as of the date of this writing, munis have moved to their most expensive relationship to taxables, with 10 year Municipal-to-Treasury ratios reaching a 2017 low of 81%.
In terms of our outlook for the balance of the year, with Municipal-to-Treasury ratios hovering around 81% in 10 years and tax-adjusted yield spreads to Treasuries of -9, -3 and 11 basis points, in 3, 5 and 7 years respectively, we continue to believe that the market is overvalued. Although the higher rate environment is expected to slow new issuance, there are major concerns related to tax-reform and the potential for an asset allocation shift out of tax-exempts by institutional investors. At a 20% corporate rate, current “AAA” tax-adjusted yield levels for insurance companies would fall 48 bps to 2.38%, and a spread of -4 bps versus 10 year Treasury levels. To put that number into further context, that would be a full 73 bps through 10 year “A” rated industrial corporate yield levels. In the 5 year maturity, muni spreads to corporates would be negative by 83 bps. At these spread levels, those institutional investors that seek to optimize after-tax income would find the asset allocation shift out of tax-exempts and into taxables to be a compelling strategy. Consequently, we are maintaining our underweight bias in the tax-exempt sector.
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