For 26 of the first 36 weeks of 2018, the muni market has had positive flows as investors continue to search for opportunities to keep more cash in their own pockets and send less in taxes to Uncle Sam. Market technicals have been strong, and we believe they are likely to stay that way.
As expected, supply has been thin – it’s currently 20% lower than at this time in 2017 – and we anticipate the market will once again end the year with negative net issuance. This occurs when the volume of bonds that mature or are called exceeds the volume of new issuance. Negative net issuance, which occurred in 2016 as well, typically represents good news for existing bondholders.
Treasury rates and muni rates are higher now than at the outset of the year, though both remain at historically low levels. And while the muni market as a whole has seen flat performance year to date, we are still finding value, especially among high-yield credits. For example, tobacco bonds – which are backed by the proceeds of the landmark 1998 Master Settlement Agreement – have generated a total return of nearly 8% year to date. Our team’s credit expertise and our willingness to invest across the credit spectrum have led to overweight tobacco positions in some of our funds—to the benefit of investors seeking higher levels of tax-free income.
Among investment-grade muni securities, AAA- and AA-rated bonds are fair to fully valued, in our opinion. Bonds rated A through BBB-minus continue to offer some value. Munis are currently considered “cheap to Treasuries,” meaning they provide more after-tax income than the government-issued bonds; the latter, of course, are backed by the full faith and credit of the United States.
The nominal yield on 30-year, AAA-rated municipals currently exceeds the yield on Treasuries with the same maturity. Since net investment income on muni bonds is exempt from federal and, where applicable, state and local taxes, the income advantage of muni investing exists even before taxes are levied. On an after-tax basis, the gap between the amounts of income generated by munis versus Treasuries is even greater. For bonds maturing in 10 years, the yield ratio is approximately 85%, which is in line with historic norms.
The yield curve for AAA-rated munis continues to be relatively flat, which means that long-term investors are not being amply rewarded for the risk of lending for longer time periods. At the same time, the credit spread is fairly tight: Yields on BBB-rated paper are approximately 90 basis points (0.9 percentage points) higher than the yields on AAA-rated paper with comparable maturities. Again, the rewards for taking on added risk may not be especially compelling for the individual muni investor.
Individuals, who are more likely to hold many fewer bonds than the typical fund, tend to employ a more conservative calculus when it comes to fixed-income investing. They try to steer clear of bonds that might provide higher levels of income because they don’t trust their insights about the market and because they know how problems related to a single risky bond could affect their small portfolio. By focusing on highly rated securities, individual investors also forgo the potential income advantages that can be found with lower-credit or longer-maturity bonds.
We remind investors that corporate bonds are far more likely to default then bonds in the municipal market. Moody’s Investors Service, which closely monitors the default rates for the nearly 13,700 muni bonds and nearly 3,500 corporate bonds it has rated between 1970 and 2017, reports that the average cumulative default rate among all muni bonds at the 10-year mark is 0.17%; for corporate bonds, the comparable figure is 10.24%. For investment-grade bonds, the figure is 0.10% for munis versus 2.32% for corporate bonds.
Despite the relative safety of muni securities, finding the right mix of bonds to maximize tax-free income can be a daunting task for individual investors. The Oppenheimer Municipal Fund Management Team has been a leader in the muni fund business for more than 30 years and is dedicated to providing competitive levels of tax-free income through active fund management. The team champions a value-oriented, research-intensive, and security-specific approach to building portfolios and creating shareholder value, and it takes pride in delivering the competitive levels of tax-free income that fixed-income investors seek.
Fixed income investing can entail credit and interest rate risks; as interest rates rise, bond prices generally fall and a fund’s share price can fall, too. A portion of a municipal bond fund’s distributions may be subject to tax and may increase taxes for investors subject to federal alternative minimum tax. Capital gains distributions are taxable as capital gains.
Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Under certain market conditions, some unrated securities may trade less actively than rated securities. Our funds can have a relatively high portion of their portfolio holdings in particular segments of the municipal securities market, such as tobacco bonds or real-estate-related securities. They may also invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. Funds may also invest substantially in Puerto Rico and other U.S. territories, commonwealths and possessions, and could be exposed to their local political and economic conditions. Deterioration of the Puerto Rican economy could have an adverse impact on Puerto Rican bonds and the performance of the Rochester municipal funds that hold them. Diversification does not guarantee profit or protect against loss.