In our view, 2017 will be a year of adjustment and opportunity for the municipal market on a number of fronts: governance, policy, rate structures, credit trends and volatility.
A sweeping victory by Republicans suggests a directional shift in governance away from gridlock. Key policy initiatives are centered on tax reform, defense spending, infrastructure spending, protectionism, immigration, deregulation and Obamacare. Whether fully implemented or diluted, the agenda is viewed as pro-growth and inflationary. This suggests higher rate structures and more modest returns.
The proposed tax reform includes cuts in personal and corporate taxes. Mathematically, the proposed reforms would reduce the relative attractiveness of municipals. In addition, there is a growing rumble on the tax-exempt status of municipals in general. Although unlikely, the debate alone will inject uncertainty. Both the status and degree of tax cuts and the debate on exemption will likely exacerbate volatility and pressure valuations.
We expect relative stability in credit trends in 2017 but note: (1) significant divergences in economic growth rates across regions of the nation; and (2) increased pension cost pressures given the underfunded status of many plans. A diligent emphasis on credit analysis is warranted. Risk avoidance will be critical in maximizing returns.
Supply should be restrained by: (1) a declining universe of bonds eligible for refunding; (2) higher yield curves which are not supportive of the economics of even those bond eligible; and (3) uncertainty over the timing and structure of infrastructure financing. Restrained issuance lends support to the market.
Higher yields and heightened policy uncertainty interrupted the relative calm of the market which had persisted in recent years. Yields and valuations are being pressured, but more attractive opportunities are actually presenting themselves. At the highest yield levels in over two years, the hurdle is high in reducing overall allocations and/or durations. At the margin, the municipal market looks more attractive than it has in recent years and we will look to take advantage of uncertainty, volatility and higher all-in yields to enhance our existing portfolios.
By Greg Cobb