On the Rise
Summer is here!
The sun is shining. Impending vacations are upon us. Overall, everyone’s mood seems to be on the rise.
Speaking of “on the rise”, I wanted to give you a quick update on our Freeway Income model, and more specifically, the municipal bond part of those portfolios. We continue to believe that now is a great time to deploy any excess cash into the Freeway Income Strategy, given that the market is already talking about the Federal Reserve cutting rates over the next 12-18 months. Forward returns on cash are likely going down.
The Freeway Income Model is built for taxable money. As such, we want to exploit the tax-advantaged nature of the municipal bond market. If you attended our Solution Series in May, you know that we increased the allocation to municipal bonds earlier this year in order to generate higher after-tax yields for clients.
First, let’s look at the after-tax yields for muni bonds compared to corporate bonds.
The graphic from Nuveen below does a good job of making this comparison (https://www.nuveen.com/opportunities-in-municipal-bonds):
The difference is especially large for high income folks. Factoring in a 37% marginal federal tax rate plus a 3.8% Medicare tax on investment income, one can see that high earners achieve a higher yield with municipal bonds across the maturity and quality spectrum. (Some income may be subject to state and local taxes, as well as the federal AMT).
Using muni bonds is one of the best ways to help save money on your tax bill.
Positive Supply and Demand Dynamics
Municipal bonds have been on a tear this year. Both supply and demand factors-- as well as the overall interest rate environment— have offered a great tailwind for muni bond holders.
Here are a few drivers behind the good performance from muni bonds in no particular order:
- Repricing of short-term interest rate expectations. The Fed reversed its tightening bias early this year which overall helped any bonds with duration associated with them. Interest rate policy went from a headwind to a tailwind almost overnight.
- Steeper muni yield curve. Published inflation numbers continue to remain subdued. While longer term interest rates on Treasuries have fallen quite a bit this year, the muni curve has stayed relatively steep so that muni investors have been rewarded for going out on the curve.
- Fewer tax deductions. The new tax laws reduced the number of deductions available—especially the cap on SALT (State And Local Tax) deductions—increasing the demand for municipal bonds.
- Elimination of advanced refunding options. The Tax Cuts and Jobs Act eliminated the ability for advance refunding for muni bonds issued after 2017 by making the interest on advanced refunding bonds taxable. This will remove a good chunk of supply from the market each year. Some estimates have issuance down 25% in 2018. Bullish, all else equal.
- Good credit quality. Appetite for good credit quality bonds has continued unabated. Below is a snapshot of the credit quality in the muni universe from Nuveen. Most of it is investment grade:
- Upgrades vs downgrades. The upgrade cycle continues to be strong. According to Lord Abbett upgrades have outpaced downgrades for the last several years:
Where The Rubber Meets The Road
So, we’ve laid out the bullish case for muni bonds. Now the big question—how have they performed?
In a word—well!
Below are the returns for a few S&P Municipal Bond Indexes:
YTD Return (through 5/31/19)
1 Year High Grade
Investment Grade Short Duration
Investment Grade Intermediate Duration
20 Year+ Duration
As you can see, there have been solid returns for both investment grade and high yield munis this year.
We are very pleased with the muni bond performance in our Freeway Income model. Given the supply and demand factors we laid out above, we expect that to continue. Rather than using individual bonds, we use a combination of exchange traded funds to capture these returns in a very liquid way. In other words, if you need cash, or your money back for any reason, you can get it back in two or three days with little to no cost. That wouldn’t be possible if we used individual bonds.
Chief Investment Officer