The current volatility in the supply and demand dynamics for municipal bonds should pass and could well create some appealing entry points in the near term, according to the top investors in the asset class.
The best managers in the Intermediate Municipal Debt category over the past three years on a risk-adjusted basis – and with strong absolute returns over one, three, and five years too – are the Citywire-AAA rated trio of Peter Hayes, Michael Kalinoski and James Pruskowski, alongside AA-rated Theodore Jaeckel, on the BlackRock Strategic Municipal Opportunities fund.
Hayes, who is also head of the municipal bonds group at BlackRock, highlighted the positive technical backdrop for municipal debt, despite what may have appeared to be weakness in recent weeks.
‘Although municipal fund flows were negative in February, this was likely a result of some giveback of January’s historically robust inflows, and year-to-date net flows still exceed $9 billion,’ he explained. ‘The impact of tax reform has resulted in depressed issuance in 2018 – a trend we expect to continue for some time. February issuance was down 24% on the same month last year and down 31% versus the month’s 10-year average.’
However, Hayes acknowledged that March has been the third-largest month for issuance in the past 10 years, as well as the worst-performing month since 1992. ‘Against this historical backdrop, it is our view that any significant pick-up in near-term supply could pressure the market,’ he said. ‘However, the resetting of valuations to more attractive levels could create buying opportunities.’
A-rated Gregory Steier – who has the category’s third-best manager ratio over the past three years on the BBH Intermediate Municipal Bond fund – expressed a similar view.
Steier observed that issuance in January had ‘dropped sharply’ from its record level in December, as many municipalities brought forward their plans in response to the new tax reforms. However, he also wondered what that legislation would mean for demand for municipal bonds among banks and insurance companies.
‘We suspect that these corporate investors will not significantly trim their municipal bond holdings since many of these holdings carry attractive embedded book yields,’ he said. ‘However, it is likely that corporations will pare back new purchases. We are already seeing some evidence of this subdued demand, as some new issues had their terms and pricing revised before they could be successfully placed.’
Another factor, Steier added, would be the risk that the Federal Reserve accelerates its pace of monetary policy normalization as a consequence of fiscal stimulus. ‘This, combined with apparent subdued marginal demand in the municipal market, may offer more attractive valuation opportunities in coming months,’ he said.
AA-rated Brian Steeves and A-rated Matthew Dalton of Belle Haven Investments, who subadvise the Transamerica Intermediate Muni fund, have the category’s second-best risk-adjusted returns over the past three years. They agreed that weakened demand from corporations should not create any significant selling pressure, as these groups’ municipal holdings are already low.
On the other hand, though, Steeves and Dalton felt that demand might be supported by the fact that there is a greater supply of AAA- and AA-rated municipal bonds than there is of similarly rated corporate debt.