Municipal Bonds: Relative Value Trumps a Measured Fed

The municipal bond market has outperformed its taxable counterparts so far in 2015. 1 Given current conditions, we believe this trend could continue in 2016.

The municipal market has seen its share of challenges in 2015, including uncertainties regarding future monetary policy, credit specific headlines from the likes of Puerto Rico and elevated supply. Yet generally solid fundamentals have helped municipals remain resilient and perform relatively well heading into year-end.

In 2016, we see two major factors driving market performance. First, the Fed is likely to pressure absolute returns as it moves off its zero-rate target. This could have an uneven impact on the yield curve, highlighting the potential benefits of active yield curve management. Second, and potentially offsetting the Fed's impact, the municipal market stands to benefit from still-attractive valuations relative to other high-quality fixed income alternatives, especially on a tax-adjusted basis. Fundamentally, we believe the U.S. economy will maintain its upward trajectory with modest inflation. However, given the length of the current U.S. recovery and the challenges constraining spending, incremental returns from credit improvement could be modest.

Flatter Yield, Less Supply Pressure

Given this backdrop, we anticipate municipal yields flattening somewhat during 2016, with short-term rates rising more than long-term rates. While the attractiveness of the asset class' relative valuation started to be realized toward the end of 2015, we believe this trend could continue due to solid demand tied to continued high tax rates. Municipalities have aggressively taken advantage of low rates in 2015 to refinance existing debt and lower borrowing costs. This activity could decrease in 2016 in what we anticipate will be a rising rate environment, which could in turn lead to favorable supply dynamics.

Among other factors, investment sentiment could be challenged in 2016 by headlines surrounding the lingering effect of Puerto Rico's debt restructuring and other one-off credit events, while the run-up to the November election could include rhetoric regarding tax law changes. However, we think broad-based tax reform is an unlikely prospect given current dysfunction in Washington, DC.

In conclusion, while market volatility could remain elevated, we have a generally positive outlook for the municipal market, and believe security selection and active yield curve management could be key drivers of returns. Overall, we think investor demand will be robust, especially in light of the relative attractiveness of the tax-free market.

Municipal Bonds Remain Attractively Valued

Yield on 10-Year General Obligation Bond vs. Equivalent U.S. Treasury

Source: Thompson Reuters, data through November 30, 2015. Municipal Market Data generic, 10-year AAA general obligation bond compared to the 10-year U.S. Treasury bond.

1 Year-to-date through November 30, 2015.

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