Remember the flood of municipal bonds issued at the end of 2017?
Don’t look for a repeat in 2018. In fact, expect the flow to slow dramatically.
As investors recall (“Muni Bond Issuers Hedging Ahead of Tax Law”), state and local governments trying to beat the clock on the tax overhaul issued bonds at a record-setting pace at the end of last year.
But instead of a glut, munis were eagerly snapped up and yields barely budged.
This year, the supply of munis will likely drop sharply, with no expectation that demand will abate.
As tax professionals assess the myriad effects of the tax overhaul, the key takeaway for tax-free municipal bond investors is simple: demand for munis will outstrip supply.
Tax cut hasn’t curbed appetite for munis
Some figured the provision in the tax law cutting the top marginal income-tax rate might make munis less attractive and demand would slacken.
But there’s no evidence that’s happening. Trimming the top rate from 39.6% to 37% is hardly a disincentive for investors looking for a steady stream of tax-free income.
Further, demand from investors in high-tax states like New York and California, where the new tax law limited the deductibility of state and local taxes, will certainly continue.
Plus, analysts say, political volatility in areas such as health care and infrastructure also makes munis more attractive.
In fact, munis still compare favorably to taxable bonds and are attracting investors who have no need for the tax-free attribute – so-called crossover buyers – including non-U.S. residents who face rock-bottom yields in their own countries.
Munis undervalued in current environment
It’s been a painful time for investors who’ve parked their cash in money-market funds waiting for rates to rise.
They’ve whiffed on the opportunity to earn tax-free income while yields have dipped and their assumptions on inflation and rate hikes have been undermined.
The so-called experts, who heralded the end of the 30-year bull market in bonds, now find themselves forced to predict the end of the 35 year bond bull.
What might be even more startling to these market timers, though, is that munis now are a bargain.
Municipal bonds are trading as if the top income-tax rate is 30% to 32%, not the actual 37%.
In other words, they’re currently undervalued and providing unusually high after tax returns.
In addition, changes in the tax law eliminate the ability of issuers to pre-refund bonds, which is likely to lead to issuance of shorter maturity bonds (less than 30 years), meaning longer maturities will be in shorter supply.
Will yields take off under the new head of the Federal Reserve?
How might a plan to fund massive infrastructure improvement change the market, if at all?
Is a spike in inflation just around the corner?
We don’t think so, but we don’t have a crystal ball for 2018.
What we do know however, is certain signs are obvious: Demand is high, supply is limited and trying to outguess the market will once again, cost you dearly.
