The Tax Cut and Jobs Act of 2017 had numerous impacts on the municipal bond market. From the standpoint of the institutional investor, tax-exempt bonds became less attractive for commercial banks, property and casualty insurers and many other corporate entities. After corporate tax rates were lowered from 35% to 21%, banks reduced their municipal bond holdings by 16% in 2019, and property and casualty insurers reduced holdings by 17%, according to Federal Reserve data.1
In view of the upcoming election, it is possible tax rates will go up and tax-exempt bonds will become more attractive relative to corporate bonds. In addition, adding tax-exempt municipal bonds to a portfolio provides diversification into a higher rated asset class that typically performs well in a bear market and whose relative value increases under potential tax reform.
Diversification, high average credit ratings with lower default risk
There are many compelling reasons to diversify out of a portion of corporate bond allocations and into the tax-exempt municipal asset class. First and foremost, as sighted in Chart 1 and 2, municipals are a higher rated, lower default risk asset class than corporates:
Chart 1: Bond ratings
Source: Moody’s Investors Service
Note: Competitive Enterprises includes issuers in municipal sectors including higher education, hospitals, housing, private education, etc.
With the ongoing downward rating migration in corporate bonds, almost half of the investment grade corporate market now resides in the BBB rating category whereas almost two thirds of the investible municipal universe falls within the Aa3/AA- or higher rating categories. Additionally, the cumulative default rate is lower across all rating categories in municipals than in corporates.
Chart 2: Historical default rates
Sources: U.S. municipal bond defaults and recoveries, 1970-2019”, Moody’s, 7/15/20, 2019 Annual U.S. Public Finance Default And Rating Transition Study”, S&P, 6/11/20, 2019 Annual U.S. Corporate Default And Rating Transition Study”, S&P, 6/17/20.
Note: All default rates are for 10 year cumulative periods. Moody’s includes defaults occurring between 1970-2019 for municipal bonds and 1970-2019 for global corporate bonds. S&P includes defaults occurring between 1986-2019 for municipal bonds and 1981-2019 for U. S. corporate bonds. The rating agency statistics on this slide are based on the defaults of the issuers they rate.
In the unlikely event of default, recovery values for municipals have historically been a great deal higher due to strong legal protections for bond holders. Moody’s calculates an average recovery of 68% for municipal bonds that defaulted between 1970 and 2019, compared to the average recovery of 47.7% for senior unsecured North American corporate issuers defaulting between 1987 and 2019.
Given the higher credit rating profiles and more stable repayment streams, tax-exempt municipal bonds can often perform well during bear markets. As shown below in Chart 3, during periods when the S&P 500 declined by over 19%, tax-exempt municipal bonds outperformed corporate bonds in nine of the ten bull markets by an average of 1.8%.
Chart 3: Average pre-tax asset class returns during U.S. bear markets, 1990-2020
Source: Bloomberg Barclays
Relative value if tax reform is enacted
Beyond the “up in quality nature” of an allocation to municipals, the graphs in Chart 4 model how tax-exempt municipals represent a good value play relative to corporates in the event corporate tax rates increase. If corporate tax rates were to increase from 21% to 30% – and assuming after-tax municipal bond yields remain unchanged – corporate after-tax yields would decline relative to tax-exempt municipal bonds.
Chart 4: The value of tax-exempt income should increase further under potential tax reform
Index after-tax yields – 21% tax rate
Index after-tax yields – 30% tax rate
Based on data from Bloomberg Barclays bond indices as of 7/27/20. Muni yields are based on effective maturity, and years to maturity are based on effective maturity.
Outlook for municipals
The tax-exempt municipal market has benefited from strong municipal mutual fund inflows. Through August 19, 2020, investors added to municipal-bond mutual funds for 15 consecutive weeks, driving tax-exempt municipal yields to historic lows. Despite the rally, state and local municipalities are facing significant multi-year deficits as efforts to contain the spread of the COVID-19 have slowed their economies and reduced revenues. Expenditures have also increased in an effort to slow the spread of the virus and treat residents that have contracted COVID-19.
On March 27, 2020, President Trump signed the Coronavirus Aid, Relief and Economic Security (CARES) Act, which appropriated $150 billion to reimburse state and local governments for COVID-19 related expenditures but did not replace lost revenues. Since the CARES Act was passed, additional Federal aid bills have been discussed and negotiated in Congress, but have stalled. Economists estimate that state and local governments need at least $500 billion in federal aid to prevent austerity cuts that would slow the economy further.
While tax reform offers the potential for tax-exempt municipal bond yields to increase relative to corporate bond yields, investors should take care when adding incremental tax-exempt municipals and consider the following:
- Given the unprecedented nature of the coronavirus pandemic, issuers in the municipal market have experienced sharp drops in revenue and increased expenditures in efforts to contain the spread of the virus. Prior to the pandemic, municipal issuers were generally in good financial positions to respond to a recession, but the severity and uncertain duration of the current crisis will challenge most issuers.
- Uncertainty around presidential election results and potential tax reform are unclear relative to which candidate is elected and their respective tax policy now and into the future.
- With yields at near historical lows, investors must avoid credit events that will result in significant downgrades and cause spreads on their bonds to widen.
- Even though taxable municipal bonds are a smaller component of the overall municipal market, they provide compelling yields with similar default and quality benefits as their tax-exempt counterparts.
Chart 5: Municipal issuance ($Billions)
Source: SIFMA Data
Chart 6: Taxable Muni versus U.S. Corp Agg OAS
Source: Bloomberg Barclays U.S. Agg Corporate Avg OAS
In the event that Joe Biden is elected president and tax reform is enacted, this recent increase in taxable issuance could be a “one off” situation. Tax reform would likely allow for the return of tax-exempt advance refundings to save municipalities money. As a result, we recommend taking advantage of the taxable municipal issuance while it is still available.
1Source: Democratic Sweep in November Would Be Bullish For Munis, Bloomberg, Martin Z. Braun, 8/21/20
This paper is intended for institutional investors only. The information in this paper is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this paper.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association. Registration as an investment adviser does not imply any level of skill or training.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of March 31, 2020. Unless otherwise noted, all references to “$” are in U.S. dollars.
Nothing in this paper should (i) be construed to cause any of the operations under SLC Management to be an investment advice fiduciary under the U.S. Employee Retirement Income Security Act of 1974, as amended, the U.S. Internal Revenue Code of 1986, as amended, or similar law, (ii) be considered individualized investment advice to plan assets based on the particular needs of a plan or (iii) serve as a primary basis for investment decisions with respect to plan assets.
This document may present materials or statements which reflect expectations or forecasts of future events. Such forward-looking statements are speculative in nature and may be subject to risks, uncertainties and assumptions and actual results which could differ significantly from the statements. As such, do not place undue reliance upon such forward-looking statements. All opinions and commentary are subject to change without notice and are provided in good faith without legal responsibility.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are current as at the date of the paper unless separately stated. All data is subject to change.
No part of this material may, without SLC Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.
Past results are not necessarily indicative of future results.
© 2020, SLC Management