Q2 Investors Have a Taste for Plain Vanilla Market
Even as they lived up to their reputation as “plain vanilla” investments, municipal bonds delivered in the second quarter of 2018 what many retail investors want: positive total returns and tax-free income.

The quest for income did not abate during the quarter, which was characterized by strong demand and relatively low levels of issuance. Investors have now been rewarded with good performance for five of the past six quarters, and long-term returns have been attractive, too.

The ICE BofA Merrill Lynch AAA Municipal Securities Index – the AAA subset of the broader ICE BofA Merrill Lynch US Municipals Securities Index – ended the quarter where it began, with a yield of 2.40%. The municipal bond market as a whole generated a total return of 0.87% in the second quarter and 1.56% for the 12 months ended June 30, 2018, according to the Bloomberg Barclays Municipal Bond Index.

The U.S. equity markets continued to rally during the quarter, albeit unevenly: The Dow was up 0.7%, the S&P 500 rose 2.9%, and the Nasdaq Composite led the way, with a 6.3% increase.

Yields on AAA-rated municipal bonds held relatively steady, with slight declines for 1- and 5-year munis and for munis with maturities greater than 15 years and slight increases at the middle of the curve. For the quarter, the yield curve for AAA-rated securities remained flat and the spread increase, at 2 basis points, was minimal.

The Treasury yield curve continued to flatten during the quarter as yields of shorter maturity bonds rose. Flatter yield curves provide investors with fewer incentives to purchase longer-maturity bonds and typically reflect expectations of rising interest rates.

The decline in short-term Treasury prices was widely anticipated, given the signals from the Federal Open Market Committee (FOMC), which increased the Fed Funds target rate to the range of 1.75% to 2.00% at its June meeting. The Fed Funds rate has had seven quarter-point increases since December 2015. In June 2018, citing a strengthening labor market and a “solid rate” of economic growth, the central bank indicated that it foresees two additional rate increases, bringing the 2018 total to four increases; earlier, it had signaled a total of three increases for the year.

In the municipal bond market, technicals remained strong throughout the quarter, and demand for munis continued to exceed supply. For the second quarter of 2018, volume for bonds maturing in more than one year was down 11.2% versus the same quarter of 2017. Supply in the first half of 2018 was 20% lower than in the same period in 2017, despite a 48% improvement in the second quarter of 2018 versus the first quarter of the year. Volume totaled $96.2 billion in the quarter ended June 30, 2018 and stands at $161.0 billion year to date. The market had negative net issuance for the quarter, which is a positive for bondholders.

During the quarter, issuers frequently came to market with bonds that had shorter call dates than the standard of 10 years. This phenomenon, driven by the Tax Cuts and Jobs Act’s elimination of pre-refunding bills, means that municipalities are accelerating the timeline for refunding bonds. During the quarter, securities with call dates of 3, 5, and 7 years were added to the mix of offerings, allowing issuers near-term opportunities to adjust their debt levels. Importantly, the federal tax exemption on the net investment income generated by municipal bonds and muni bond funds remained intact despite some noise from Washington that it might be eliminated as part of the tax reform. Investors are reminded that this type of noise occurs – and then fades away – frequently, without impact. 

The overall size of the market for municipals fell by $20 billion in the first quarter of 2018, to $3.84 trillion, according to Federal Reserve data released in June. After 9 years of steady or increasing muni holdings, U.S. banks reduced their positions by nearly $16 billion in the first quarter. With corporate tax rates reduced to 21%, from 35%, munis have become less appealing to banks. At 2.8%, the first-quarter decline in bank holdings represents the second largest in the sector, according to market analysts; the biggest decline occurred after the tax reform of 1986. The household sector was virtually unchanged quarter to quarter, and mutual funds were off slightly.

The ruling in June by the U.S. Supreme Court in South Dakota vs. Wayfair – requiring certain online retailers to collect sales tax on purchases – is expected to raise state revenues significantly and has the potential to lead to improved state credit ratings. Across the board, the performance of bonds issued by individual states and the District of Columbia improved during the second quarter. According to the Bloomberg Barclays municipal bond indices, all of the geographic municipal indices had positive results as of June 30, 2018.

As portfolio managers, we hope that our approaches to fund construction, investing, and risk management will continue to whet the appetites for investors who are seeking tasty yields in a plain vanilla market.