2017 has been a good year so far for municipal bonds. Despite investor concerns entering the year about a multitude of issues, including tax reforms, rising rates and a continuation of fund outflows, the municipal market has managed to outperform all other investment grade market segments. This has been driven primarily by a strong technical environment that has provided support to the market, and to a lesser degree, by a reversal of the cheapness and underperformance we saw at the end of last year. The strong technical environment is quite simply demand outweighing supply. So far this year new money issuance has underwhelmed expectations for a material increase. At the same time, a decline in refunding issuance has also helped keep supply low. The higher interest rate environment means that there are fewer eligible deals to be refunded. The net effect has been a drop in total issuance this year relative to the last 2 years (though it is worth noting that despite last year’s record issuance, the year actually started off slowly and only reached the record due to a major surge that began late in the 3rd quarter). Meanwhile, demand has been relatively consistent and supported by generally positive mutual fund inflows.
Traditionally, March is a seasonally weak month for municipals, as individual investors sell positions or redeem fund shares to help with tax bills due in April while issuance tends to be higher relative to other months. This year we witnessed no such weakness because demand handily absorbed a lower than average swell in issuance. Now we are headed into what is traditionally a very strong period for the market, when coupon payments and maturity cash flows pick up from June through August, concurrent with a decline in issuance as a majority of local governments focus on passing budgets (typical fiscal years run from July 1 to June 30). Barring an acceleration in tax reforms with details that are particularly detrimental to the value of munis, we would expect a continuation of the strong relative performance from the muni market over the summer months. Another risk, though not our base case, would be that a jump in rates sparks another spurt of fund outflows – though this would create opportunities for our clients should it occur.
Source: Fidelity Research, Citi, Bloomberg