Municipal bonds have experienced an unusual performance period since the 2008 financial crisis. Sharp sell-offs followed by recoveries seem to be the new normal.
It began with the credit crisis of 2008, when the Bloomberg Barclays Municipal Index ended the year with a loss of 2.47%.1 In 2010, we had a sharp sell-off following Meredith Whitney's call on 50 to 100 sizable defaults2 that never materialized. The historic “taper tantrum” of 2013 spooked markets and pushed yields higher, resulting in municipals declining 2.55% for the year.1 A relatively quiet period followed, with rates slowly falling following the first U.S. Federal Reserve (Fed) hike in December 2015.
Coming into 2016, the United States was the center of much of the news cycle. As election season drew to a close, it appeared Hillary Clinton would be the clear winner until late on election night. Early in the morning, news broke that Donald Trump was in fact the surprise winner—a victory few predicted. What followed in the United States and globally was yet another sharp sell-off with large amounts of uncertainty surrounding Donald Trump and his policies. Yields quickly spiked, with municipals down 3.73% in November alone, the worst month for municipals since September 2008.1 As 2016 drew to a close, we remained uncertain about new policies and their possible implications for the municipal bond market.
Some of the major themes we anticipate include the Trump administration's policy initiatives regarding tax reform, infrastructure spending, and healthcare. A plan to lower income-tax rates in the highest tax brackets could make municipal bonds less attractive to investors in these brackets. Increased spending on infrastructure could be financed through a substantial increase in municipal bond issuance, which would likely exert downward pressure on municipal bond prices. Healthcare is a sizable component of the municipal bond market; any changes to the Affordable Care Act will have an impact. Until we get more clarity on the new administration's policies, there will likely be continued volatility and a tendency toward risk aversion.
Another significant theme is the funding of pension liabilities for state and local governments. As a recent example, the city of Dallas saw its credit rating downgraded3 because of concerns about an underfunded pension plan for its public safety employees. Select state and local governments, most notably in California, have begun to address their pension issues, but these are likely to remain a source of concern for an extended period of time.
We see a number of headwinds in 2017: pension liabilities, uncertainty around President Trump's policies, continued U.S. economic improvement leading to additional Fed rate hikes, and global macro uncertainties. Given these headwinds, we're relatively neutral on municipals. We expect volatility to continue into next year, although it may potentially ease as tax policies, infrastructure spending, and healthcare changes become clearer.
1 The Bloomberg Barclays Municipal Bond Index tracks the performance of the U.S. investment-grade tax-exempt bond market. It is not possible to invest directly in an index. Past performance does not guarantee future results. 2 "Meredith Whitney on the Future of Muni Bonds," Forbes, June 2013. 3 "Summary Rating Rationale," Moody's, October 2016.