Municipal Fixed Income

Cowabunga! What a year!

Typically, fixed income returns would be below average in the face of strong equity markets. But that was far from reality.
February 2020

Last year, investors were strongly encouraged to adopt a “risk on” behavior as the U.S. Federal Reserve (Fed) quickly pivoted from hawkish to dovish at the start of the year. As the year progressed, the Fed cut interest rates three times for a total of 75 basis points (0.75%). Additionally, the Fed reversed course on its balance sheet reduction towards the end of the year to improve market liquidity.

The Fed insisted it was not QE4, but it sure smelled like quantitative easing to the markets. The easing led to a rally not only in riskier assets like equities, but in tangible assets as well — gold, real estate and fine art. For example, Leonardo da Vinci’s Salvator Mundi sold for $450 million. If you prefer modern art, Jeff Koons’s 1986 Rabbit sold for $91 million, the most expensive work sold by a living artist.

In this cash-a-plenty environment, the S&P 500® was up over 31.5% for the year. Typically, fixed income returns would be below average in the face of strong equity markets. But that was far from reality as municipal bonds gained 0.74% during Q4 and 7.54% for the year (Bloomberg Barclays Municipal Bond Index). Municipal bonds outperformed Treasury bonds, which returned 6.86% (Bloomberg U.S. Treasury Index). Figure 1 shows movement of the MMD AA GO curve over the past year, with the curve bull flattening as a result of the strong performance during 2019.

Figure 1: AAA GO yield curve movement

Cowabunga What a year - Figure 1 - AAA GO yield curve movement

Source: Bloomberg

A portion of the strong performance for munis is attributable to the ongoing investor search for tax havens after 2017’s tax law capped deductions for state and local taxes. We can see this in demand for tax-exempt mutual funds and ETFs. Net flows into these products hit an annual record level of $105 billion, according to the Investment Company Institute. This demand should remain in good shape as we start 2020 with significantly high January bond redemptions and coupon payments; albeit, lower absolute interest rates may serve as a moderating influence on investor demand.

Figure 2: Municipal/ETF fund flows with yield

Cowabunga What a year - Figure 2 - Municipal ETF fund flows with yield

Source: Bloomberg, ICI

Currently, geopolitical concerns are elevated; however, they’ve been elevated over the past year. We are getting a bit of clarity. Brexit is now a forgone conclusion given the December election results in the United Kingdom. Also, a “Phase One” trade deal with China was signed on January 15th, so some reduction in trade worries. An abundance of news coverage continues to focus on the impeachment of the President; however, heightened tensions in the Middle East are likely to dominate market worries over the next few months. And let’s not forget the 2020 election year. Despite these bumps, the U.S. continues to trudge along the growth path. The latest result was 2.1% growth in the third quarter — not too hot and not too cold, but heavily dependent on consumer spending.

We’d love to see an encore to 2019’s performance, but we don’t think it is very likely to happen. We do anticipate positive returns for municipal bonds, but not to the degree of last year’s performance. Most of the municipal bond performance will likely come from the income, not price appreciation. Market participants will have a good idea of the Democrats’ presidential candidate after “super Tuesday” on March 3rd. Over a third of the U.S. voters will go to the polls that day, including primaries in California and Texas. The last year a Democratic candidate won Super Tuesday but was not the party’s nominee in the general election was in 1984 — Gary Hart. Needless to say, it will be a stimulating year.

The grass is always greener…

It definitely is greener on the other side of the mutual fund fence. If you haven’t heard of ESG, you must have been Rumpelstiltskin-ing over the past year. Well then, ESG stands for Environmental, Social and Governance investing. Self-explanatory, right? No? Well, you are not alone. We are continuing to explore the best way to incorporate ESG into our investment process. And, when you throw terms like socially responsible, sustainable, or impact investments into the mix, things get confusing fast. There’s a huge surplus of lingo used in marketing these investment products that are intent on helping the greater good. Let’s look at two extremes: you could invest in a stock or bond purely for its profit potential with no regard for its impact on society at large. On the other hand, you could buy an asset expecting some investment return, but that consideration is secondary to its impact on society. We think ESG is somewhere in the middle — a balance of an investment’s return potential with its impact on society.

So, we’d like to grow the good. However, the lack of standardization of what defines ESG and “green” muni bonds does make it difficult to implement. It’s not easy to isolate factors that can quantify an ESG “score” across all municipal sectors. For example, state and local government bonds will be weighted more heavily on social and governance factors while transportation bonds will incorporate more social and environmental factors. Additionally, a major hurdle for municipal ESG investors is a general lack of data. And what data we have is inconsistent and primarily available for large issuers.

One could argue that most of the municipal bonds issued improve society. The essential purpose of government is to provide services to its residents including education, affordable housing, public transportation, safety, hospitals — the list is long. So, our current methodology in reviewing municipal issuers already takes into account many factors that can be used in an ESG “scoring” system. For example, when reviewing a new general obligation bond issue for a city, we take into account the issuer’s strength or weakness of public and financial policies, financial transparency to taxpayers, crime statistics, flood/hurricane risk and planning for these climate events, etc. These and many other factors are taken into account when assigning a rating to the issuer. The credit rating will be positively correlated with the issuer’s ESG standing. However, we can do a better job of making these ESG considerations more transparent to our investors.

The BMO GAM Muni team is working on building its own ESG framework that relies on many qualitative and subjective factors. Municipal analysis has always been part art and part science. Over time, the muni market will develop additional tools and better quantitative data to measure an asset’s ESG ranking. While differences in ESG rankings of various municipal entities has yet to impact the value of its debt, we believe that, over time, the market will move in that direction as demand for bonds that improve society grows. We will be positioned to help you grow the good as well as participate in the increasing value of assets that contribute to that end.

Current Positioning and Outlook

Duration

  • We increased interest rate sensitivity relative to peers in Q4 based on strong demand and we are maintaining this longer duration for the start of 2020.
    • Tensions in the Middle East will cap yields to some extent over the next few months. Periodic flights to quality resulting in lower yields are likely to occur.
    • We are constructive on muni bond performance over the next few weeks as record-breaking demand continues and as we enter the seasonal strength of January’s reinvestment of coupon payments and maturing bond distributions.
  • The Fed signaled a long pause for monetary easing and a somewhat better outlook for the US economy.
    • Fed Funds rate unlikely to move from current 1.50%-1.75% until late 2020.
    • The Atlanta Fed’s running GDP estimate is currently tracking 2.3% for 4Q—higher than Blue Chip forecasts.
    • With very low unemployment, we continue to monitor increases in wage inflation.

Yield Curve

  • In 2019, we significantly reduced our exposure in short, floating rate bonds and reinvested on the longer end of portfolios’ investment horizons. With the Fed on an extended pause, we are maintaining this positioning.
    • The weekly municipal floating rate index (SIFMA) is 1.32% (1/01/2020) versus 1.63% last year — moved lower with Fed easing.
    • SIFMA is 78% of 1-month Libor — muni money market paper is more attractive versus last month.

Credit and structure

  • Most of our recent purchases have been five-percent coupon bonds. However, we have been purchasing some lower-coupon bonds which could outperform over January reinvestment period.
  • Selectively purchasing lower quality to maintain income and looking for underrated bonds.

Geography and sector

  • We continue to be more cognizant of financial impact of future climate change on municipal entities. Language in offering prospectuses needs to improve as does municipal planning.
  • We have seen many headlines on responsible investing over the past few months, which is not unexpected given the damaging effects of rapid climate change we’ve seen globally. Environmental, social and governance (ESG) strategies will drive more demand for bonds impacting renewable energy, natural resources, and community development. However, it’s difficult to determine how much of an effect this will have on the muni market. We continue to research implementation.
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Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. All of these factors can subject the funds to increased loss of principal.

Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a Fund’s portfolio.

Credit risk is the possibility that an issuer will default on a security by failing to pay interest or principal when due. Lower credit ratings correspond to higher credit risk.

Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors.

You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon sale of your shares or temporarily suspend your ability to sell shares if the Fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not a deposit of BMO Harris Bank N.A., or any of its affiliates, and is not insured or guaranteed by the FDIC or any other government agency. The Adviser has no legal obligation to provide financial support to the Fund, and you should not expect that the Adviser will provide financial support to the Fund at any time.

Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors.

Interest income from tax-exempt investments may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes.

Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes.

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