Great stuff here from LPL Research. The lede: Municipal bonds have underperformed the taxable high-quality bond market by a significant margin over the past month. The Bloomberg Barclays U.S. Aggregate Bond Index, a benchmark for the high-quality taxable market, gained 0.32% from October 27 through November 29, while the tax-free Bloomberg Barclays Municipal Bond Index lost 0.70%. The interest rate sensitivities of these indexes are similar, so what caused the recent divergence?
More: The short answer is: tax reform. But, more specifically, a proposal in the House bill would disallow tax-free treatment of private activity, tax credit, and advance refunding bonds issued after December 31, 2017. This would mean that beginning next year, if these types of issuers want to raise new capital, they would have to sell bonds in the taxable municipal market, which would likely require them to pay higher yields. This has led issuers to push new bond sales forward to get ahead of the deadline, resulting in a surge in supply that has hurt municipal bond prices.
The potentially positive news for investors is that if this proposal is passed into law, tax-free municipal supply will likely shrink in the future, which could lead to upward pressure on prices once the year-end supply surge has passed. However, a lower federal tax rate means tax exemption is less valuable on balance, which may at least somewhat offset potential supply-related price gains. Additionally, the Senate version of the bill allows private activity bonds to retain their tax-exempt status, and several members of the House GOP recently sent a letter to their leadership asking to remove the changes to private activity and advance refunding bonds from the final bill that is negotiated with the Senate. So assuming the Senate is able to pass their version of the bill, the longer-term impact to the municipal market will depend on how the House and Senate come together to reconcile differences in their respective bills. But in the meantime, issuers aren’t taking chances, and the coming surge in supply may continue to impact the market as we head toward year-end.
Hat tip Ryan Detrick of lplreasearch.com