The 2019 rally in interest rates has triggered municipal investment bankers to dust off their refinancing calculators and pitch to their clients the financial benefits of taking out legacy high cost debt with new issuance at today’s lower interest rates.
Historically, this was a popular maneuver as municipalities were free to refinance outstanding tax-exempt bonds by issuing new bonds, also tax-free, at a lower interest rate. When the bonds being refinanced have a call or maturity date well into the future, this financial maneuver is known in the marketplace as an “advanced refunding” deal.
Historically, advanced refundings comprised a large portion of new municipal issuance. This activity ground to a halt in 2018, however, as a provision in the 2017 tax law change barred municipalities from bringing advanced refunding deals to the market, no longer granting the newly issued bonds tax-free status. As such, new municipal bond supply fell dramatically.
But yields have now dropped far enough to entice municipalities to re-engage in advanced refundings, with a twist—the twist being the newly issued bonds are fully taxable for investors. And even though the interest rate on a taxable bond is higher than that of a comparable tax-exempt bond, the math still works for municipalities to save money. Taxable municipal issuance is now on pace to reach levels not seen since 2010, when the popular Build America Bond program was in place.
For us, increased taxable municipal supply is welcome news, as we have long allocated to the sector across our various strategies. We look at taxable municipals as corporate bond alternatives and have been pleased with the risk-adjusted returns of the sector versus corporates. Currently, we are seeing value across longer portions of the yield curve in taxable munis and are allocating across our various portfolio strategies accordingly.
Source: Bloomberg, JP Morgan