Trump tax cut sets off boom in taxable munis

Once sleepy corner of municipal bond market has seen issuance double this year

Nov 22, 2019 @ 1:18 pm

By Bloomberg News

At Eaton Vance's daily 8:45 a.m. meetings with fixed-income executives, a usually overlooked segment of the bond world has been coming up more often.

That's because a deluge of debt sales unleashed this year in the $485 billion taxable municipal-bond market is luring buyers unfamiliar with the world of public finance.

So traditional corporate-debt investors are getting crash courses on concepts like a general-obligation security pledge — which is basically just a promise to repay — and gauging how easy it will be to resell the securities when they need to raise cash.

Others are dialing up their long-standing municipal-bond teams as they wade into a market that dangles higher returns and low odds of default, a standout at a time of negative interest rates overseas and frequent speculation about mounting credit risks in corporate America.

Vishal Khanduja, who heads Eaton Vance's investment-grade portfolio management, and Craig Brandon, who leads the firm's municipal-bond investing, have been talking about taxable municipals more and more.

"In the morning meeting, the discussions have been lively over the last two months," said Mr. Khanduja, who has been buying taxable munis for his corporate-bond portfolios, as his team has in the past on occasion.

The surge in issuance is a side effect of President Donald J. Trump's 2017 tax-cut law, which took away the power of states and cities to sell tax-exempt bonds for a key refinancing technique.

But rates have fallen far enough that state and local governments can sell taxable bonds — which carry higher yields — to pay off old tax-exempt debt and still come out ahead.

As a result, states and municipalities have sold about $69 billion of taxable bonds this year, nearly twice as much as last year and the most since the Build America Bonds program lapsed after the end of the recession.

The swift pace of issuance has pushed up yields on certain taxable munis, which offer about 86 basis points more than Treasuries for those due in 10 years. That's about 18 basis points more than what AA-rated corporate bonds offer.

Lesya Paisley, an investment director at Aberdeen Standard Investments who is leading the firm's taxable muni purchases, said corporate accounts that can buy them are increasing their exposure. "We've been welcoming the supply that's coming," she said.

Ms. Paisley pointed to a triple-A-rated taxable deal by the Texas Transportation Commission in November, which priced to yield 52 basis points more than Treasuries due in 2027. Debt maturing in 2027 issued by Microsoft Corp., which is also rated AAA, traded Nov. 20 at a 36-basis-point spread.

"You get a big pickup for similarly rated credit," she said.

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Banks buying

Banks may also be buying. Their muni-debt holdings rose for the first time since 2017 during the third quarter, marking a shift from the record retreat they had made from the market as the tax cut lessened their interest in traditional state and local government bonds, according to research firm Municipal Market Analytics. Foreign investors facing negative interest rates overseas have also boosted their holdings.

The interest is coming as corporate-bond buyers try to improve the credit quality of their portfolios amid concerns about economic growth and the large pile of debt many businesses have amassed. And there's a dearth of highly rated corporate issuers: The Bloomberg Barclays AAA rated long-dated corporate bond index includes just Microsoft and Johnson & Johnson, while the other issuers in the index are colleges that sold debt with a corporate bond ticker rather than a municipal one.

It also helps that buyers of taxable municipals won't have to worry about mergers or share buybacks negatively affecting the value of their holdings, according to Loop Capital. And between 1970 and 2018, municipal bonds rated by Moody's Investors Service had a default rate of 0.09%, compared to a global corporate default rate of over 6%.

The securities have also returned about 12% this year, almost as much as the 14% for the corporate debt market, according to Bloomberg Barclays indexes.

"The attributes to the muni asset class resonate," said Scott Sprauer, a managing director for MacKay Shields. He said insurance companies, pension plans and endowments are interested in taxable munis.

[More: Hunt for tax havens fuels $47 billion stampede into muni debt]

Expertise draw

USAA Investments, which is a franchise of Victory Capital with over $40 billion in assets under management, is drawing on the expertise of its municipal-bond team as it looks to diversify away from corporate credit, said John Spear, the chief investment officer.

"It's a different language, it's a different way of thinking about things," he said of the municipal market.

One frustration with the asset class? Size. For all the talk of a deluge in sales, the amount that has been issued this year is less than what corporations sold in November alone.

Kurt Daum, corporate bond portfolio manager at USAA Investments, said taxable municipal-bond deals are offered in tranches that are a fraction of what is sold in the corporate bond space.

"You're like, well, I'll take all of it," Mr. Daum said. "And instead of getting all of it, we'll get one million of each. The amount of supply is much harder to get used to."

But banks expect that states and local governments will keep eschewing the traditional tax-exempt market as long as interest rates stay low. Barclays strategists said this week that sales could rise as much as 30% next year to $90 billion.

"The more opportunities for us to choose from, the better it is for us," said Arvind Narayanan, co-head of investment-grade credit at the Vanguard Group.

[More: Biggest firms win fight for cash flooding muni funds]

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