Munis and the Markets, October 2018

SUMMARY

We believe U.S. economic expansion and federal tax cuts will be generally supportive of municipal credit fundamentals in 2018.
We believe the federal tax-exempt municipal market may offer attractive benefits to U.S. investors late in this economic expansion.
We expect municipals to outperform taxables on a taxable-equivalent basis as they have in prior tightening cycles.
However, credit quality will likely be a key performance driver when the economic cycle turns, making strong research and active selection critical.

Market Snapshot

Month in Review

The Bloomberg Barclays Municipal Bond Index returned -0.62% in October. The Bloomberg Barclays Municipal High Yield Index underperformed the investment grade segment of the market, returning -1.25% on the month, driven by weak returns in the tobacco and industrial revenue sectors.
Over the month, muni yields sold off across the curve. The long end sold off the most by between 15 – 20 bps. While munis underperformed the U.S. Treasury Index over the month, on a duration- and quality-matched basis, MMD/UST ratio performance was mixed with 5y and 10y ratios cheapening and 30y ratios becoming slightly richer.
Muni bond mutual fund demand was negative during the month. Lipper reported -$3.96 billion in net outflows for the month, largely from flows out of long term funds.
October supply was up 41% versus previous month at $35 billion, and down 13% year over year. Annualized supply is tracking down 22% versus 2017. This is as expected, given heightened supply in late 2017 in anticipation of tax-reform, and the elimination of advanced refunding transactions.
While the late-cycle performance of municipals has been strong historically, it’s important to consider what might be different this time around. A key shift from past cycles is the sharp reduction in bond insurance on new muni issuance, from over 50% before the crisis to about 5% today. This has, in many ways, transformed the municipal market into a credit market. We expect underlying credit fundamentals to play a larger role in performance at the turn of this cycle, making strong research and active selection critical.

Sector Returns

Munis In Focus

Short term rates have been on the rise over the past few years as the Fed has implemented its consistent, yet gradual, rate hikes, including the most recent increase in the Federal Funds Rate in September. Volatility also returned to the markets in October, affecting both stocks and bonds, as geopolitical tensions, trade frictions, and mixed earnings guidance fueled a broad market sell-off. Additionally, muni funds have seen several consecutive weeks of outflows, totaling $3.96 billion in the month of October. These outflows have been across all fund categories, starting in September and continuing through the entirety of October. The chart below shows the connection between the increasing volatility in the muni market and the subsequent outflows.

Together, these market conditions have culminated in muni yields increasing to levels that have not been seen since 2014, across all portions of the municipal yield curve. Municipal yields have been rising for the majority of 2018, reversing course after falling throughout 2017 (see chart below). Tax reform, along with the increased volatility in markets and the recent outflows in muni mutual funds, has led to a slightly steeper muni curve than September’s curve. The MMD curve also remains significantly steeper than the US treasury curve. At the end of October, the 30 year MMD/UST ratio was 100% with the 30 year AAA GO yield at 3.38, versus 3.39 for the 30 year treasury yield. At the short and intermediate portions of the curve, the AAA GO 5 and 10 year yields have been climbing steadily for much of 2018, and both are at their highest levels in years, at 2.30 and 2.73 respectively, as of October 31. When adjusted for taxes, munis have offered returns in line with equities with about half the volatility – a key potential benefit when markets turn. And despite isolated high profile downgrades, municipal fundamentals have improved and defaults remain low versus comparably rated corporate bonds. While credit challenges when the cycle turns will likely make active credit selection critical, we believe munis may offer U.S. taxpayers compelling advantages as they contemplate the end of the economic expansion.

Muni Open End Flows vs Volatility

AAA Go Historical Yields

DISCLOSURES

Past performance is not a guarantee or a reliable indicator of future results.

A Word About Risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investors will, at times, incur a tax liability. Income from municipal bonds is exempt from federal tax but may be subject to state and local taxes and at times the alternative minimum tax.

The Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long term tax-exempt bond market. The Bloomberg Barclays High Yield Index is an unmanaged market-weighted index including only SEC registered and 144(a) securities with fixed (non-variable) coupons. The Bloomberg Barclays High Yield Municipal Bond Index is a rules-based, market-value-weighted index that measures the non-investment grade and non-rated U.S. tax-exempt bond market. It is not possible to invest directly in an unmanaged index.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.
The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO.

CMR2018-1119-365893

Munis and the Markets, October 2018

Muni Open End Flows vs Volatility

Sponsored Content

Trending Topics View All

Upcoming Virtual Events View All