Finding Bonds When The Muni Supply is Tight

Klotz on Bonds

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<h3>James A. Klotz</h3>

James A. Klotz

A tighter muni supply doesn’t mean investors can’t find the bonds they want.

In fact, supply might not be an issue at all.

Finding bonds when the muni supply is tight

More demand, fewer issues fuel tight muni supply

The story of increased demand and fewer outstanding bonds has made headlines recently. First-quarter figures show $3.6 trillion of municipal bonds outstanding, down from about $4 trillion a decade ago.

A major factor affecting supply was the tax overhaul, implemented in 2018, which eliminated the exemption on advance refunding bonds. The lack of these bonds hit the muni supply and also wiped out an important money-saving tool for state and local governments (“Reviving Advance Refunding Bonds”).

Additionally, state and local governments cut back on their issuance. Stung by the Great Recession, public officials have been reticent to take on debt, foregoing the opportunity to finance critical infrastructure needs at attractive rates (“Munis’ Looking-Glass Moment”).

While supply is contracting, investors have been pouring money into the market at prodigious rates. In fact, Lipper data going back to 1992 shows investors have bought more muni funds so far this year than at any time since the financial crisis in 2009, according to Barron’s.

Helping fuel demand for tax-free income is the limit on state and local tax deductions, another feature of the new tax law. Residents of well-known higher-tax states are snapping up munis, and residents elsewhere are pumping more funds into the market as well.

Widen the muni search

So where can investors find bonds that suit their needs?

While investors usually look for bonds issued in their home states to take advantage of the interest exemption from local, state and federal taxes, it can also make sense to consider bonds from other states. Often, even after paying these taxes, the net effect can be a higher yield.

Also, not all sectors of the bond market are shrinking. There are other corners of the market where the supply is actually growing, which makes it critical for investors to comprehensively analyze every opportunity.

Another factor

But a crimp in the muni supply and a surge in demand only partly explains why some investors remain reticent to invest. Although there are more investors pursuing fewer outstanding bonds, the real reason some people park their funds on the sidelines is because they think they can’t find value amid relatively low yields.

Behind this idea, of course, is the fairy tale that it’s possible to time the market and jump in when yields spike. Meantime, as they weigh these impossible-to-know factors, their hesitancy is costing them money, as they’ll never make up the tax-free income they sacrificed.

There are more than 50,000 different issuers. For investors seeking tax-free income, the issue isn’t a shortage of bonds. It’s much simpler: They’re not always looking in the right place.

James A. Klotz is the President of FMSbonds, Inc.
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Jul 15, 2019

Please note that all investing entails risk. Fixed income securities are subject to risks that will affect their value prior to maturity. Some of these risks can be related to changes in market conditions, issuer creditworthiness, and interest rates. This commentary is not a recommendation to buy or sell a specific security. All references to tax-free income refer to U.S. federal income tax. Income earned by certain investors may be subject to the Alternative Minimum Tax (AMT), and or taxation by state and local authorities. Please consult with your tax professional prior to investing. For more information on these topics please click on the “Bond Basics” link below or search by keyword at the top of this page.