Q&A: Baird’s McAllister Discusses The Impact Of Rising Rates, Tax Reform

Baird Short-Term Municipal Bond (BTMIX) and Baird Core Intermediate Municipal Bond (BMNIX) Funds Reach a Three-Year Milestone

 

MILWAUKEE, September 4, 2018 –– Just over three years ago, Duane McAllister joined Baird Advisors bringing a talented team, significant experience and a strong track record.  Baird launched two municipal bond funds after the team’s arrival, Baird Short-Term Municipal Bond Fund (BTMIX) and Baird Core Intermediate Municipal Bond (BMNIX) Fund.  On the occasion of this three-year milestone, McAllister addressed a few questions about the outlook for municipal bonds: 

The Tax Cut and Jobs Act of 2017 lowered marginal tax rates and made other changes that will impact the municipal bond market.  What impact are you seeing?

The biggest impact of tax law changes has been the reduction in supply due to the loss of advance refundings. While demand for tax-free bonds was little-changed for individual investors, even at lower marginal rates, supply has fallen roughly 15 – 20% from 2017’s pace. The market is now in a negative net supply position; there are more bonds maturing or called than are being issued leading to tighter supply conditions. The other important outcome of the tax bill was that the change in the corporate tax rate has reduced the appeal of tax-free bonds to some institutional investors such as banks and insurance companies. The result has been some selling by corporate investors, but that has only helped to offset the overall decline in supply.

So the supply of municipal bonds did not decline as much as some would have expected, right?

We were expecting supply to decline roughly 20% this year relative to last year, and through June that was essentially where things stood. Supply did improve a bit in July and August closing the year over year supply gap a bit. Helping to prevent an even larger decline in supply has been a nice pickup in “new money” borrowings. These are issues that fund new projects or upgrades to existing infrastructure. Some of the new borrowing is simply a function of a growing economy. As the pace of economic growth has improved, municipalities have more needs and at the same time more revenue to fund those needs. Thankfully, the pace of issuance for new money financings has risen approximately 30% to help offset the loss of refunding supply.

The Federal Reserve began normalizing short-term interest rates in December 2015. What impact do you expect rising rates will have on your portfolios?

The impact of the Fed’s gradual path of rate adjustments, from near 0% to 2.0% has been relatively mild for most municipal investors. And while the negative aspects of a rising rate environment on a fixed income portfolio are well covered, the less reported story is the beneficial impact that higher rates have for fixed income investors in the form of higher income. Tax-free bonds, in particular, have held their value better than most sectors of the bond market. This is due, in part, to the modest supply we talked about earlier, but also tax-free yields tend to be less volatile than taxable yields. When Treasury rates rise, tax-free bond yields tend to rise less – and that has been the case so far in this Fed cycle.

Do you expect an inverted Treasury yield curve?  Is there a difference now between the Treasury and municipal yield curves? 

Although we don’t yet see signs of an end to this economic cycle, the Treasury curve typically inverts at some point before a cycle ends. The curve began flattening before the first rate hike, and the fact that the curve has flattened as much as it has over the last several years is no surprise. Inflation has remained moderate, and the demand for long duration fixed income from pension managers and others has kept long-term rates stable. The market has confidence in the Fed’s ability to contain inflation, particularly in light of the macro headwinds that still exist – namely demographics, technology, and the unfunded liabilities we face as a nation.

But your question also points to an important distinction between the Treasury curve and the municipal curve that investors should understand. Although the Treasury curve has inverted prior to every recession in modern history, the municipal curve never has—and that’s an important distinction to emphasize. The two biggest reasons for this are simply the uncertainty of where tax rates may be in the future and the segmented nature of buyers and issuers in the municipal market. Short-term muni yields should most closely reflect current marginal income tax rates because the tax rate is known. But no one knows where income tax rates will be in 10 or 20 years, which leads to an inefficiency in pricing longer term tax-free yields at those same theoretical tax rates. The second influence on the steeper slope of the municipal curve is simply that most tax-free investors want to buy short- to intermediate-term maturities, while most municipalities want to issue long-term debt to match the long-term nature of their assets – like school building, hospitals, or toll-roads, for example.

Tax-free investors benefit from the relative steepness of the municipal curve because they pick up more yield by easing out along the curve a bit, and they also capture more “roll-down” benefit as those bonds age along the steeper curve. The roll-down can be a powerful additional source of return to help offset rising rates.

What is the credit backdrop for Municipal bonds today? The financial health of many municipalities has improved significantly since the financial crisis in 2008-09. Where are you seeing the healthiest credits? 

All boats have been lifted as the economic tide has risen; the vast majority of municipalities are seeing stronger tax revenue today than they were a year or two ago. Home prices are up and property tax assessments have largely caught up with prices now, and both sales tax revenue and income tax revenue is also fully reflecting a growing economy.

The strongest credits tend to be found in the states with the most diverse set of industries. Right now, those tend to be some of the largest states, such as California, Texas, Florida, New York, and even Illinois. Illinois tax revenues rose 30% in the last fiscal year or roughly $9 billion, a big part of which was due to higher income and corporate tax rates. California revenues were up 10% last fiscal year, even as U.S. economic growth was less than 3%. Revenue backed credits are also benefiting, particularly those that are closely correlated with improving economic growth. Sales tax revenue debt and transportation related credits are in a cyclical upswing right now as well.

Where are you finding the most value on the yield curve right now?

The intermediate segment of the yield curve is currently the most attractive. The best risk/reward tradeoff is in the 8-  to 15-year maturity range where you capture most of the yield and also benefit from roll down. More generally, with credit spreads on the tighter side, we are increasingly looking for additional yield through structural opportunities in individual securities rather than credit. We might find a unique call or put feature that could offer excess yield or find housing bonds issued by state housing authorities where a thorough analysis of expected cash flows can often lead to additional yield above a standard fixed maturity bond. The good news in the municipal market is that the sheer number of issuers and the uniqueness in each individual bond means there are multiple opportunities in the market if you’re willing to work hard and do your research. 


Investors should consider the investment objectives, risks, charges and expenses of each fund carefully before investing. This and other information is found in the prospectus and summary prospectus. For a prospectus or summary prospectus, contact Baird directly at 866-442-2473 or contact your Financial Advisor.

This is not a complete analysis of every material fact regarding any company, industry or security. Fixed income is generally considered to be a more conservative investment than stocks, but bonds and other fixed income investments still carry a variety of risks such as interest rate risk, credit risk, inflation risk and liquidity risk. In a rising interest rate environment, the value of fixed income securities generally declines and conversely, in a falling interest rate environment, the value of fixed income securities generally increases. High-yield securities may be subject to heightened market, interest rate or credit risk and should not be purchased solely because of the stated yield. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates. All investments carry some level of risk, including loss or principal. Past performance is no guarantee of future results. Baird does not offer tax or legal advice.