The Capital Group Inc Singapore: Muni Yields and Emerging Markets Debt
Municipal Bond Values Have Improved Relative to Corporates Amid Rates Market Volatility
• Factors like anticipated tax policy changes and demand had some impact on municipal bond volatility at the end of 2016, but were a relatively minor cause.
• Broader rates volatility is more to blame for yields rising for munis at the end of 2016.
• Through the volatility, the relative value of A-rated municipal bonds has recently improved compared to similarly rated corporate bonds.
The surprising U.S. election results sent shock waves across fixed income markets, and the municipal bond market was not immune to broader volatility. While a number of factors affect munis, perceived policy changes have had less impact than broader rates movements. Despite this volatility, the municipal market actually looks like a better value relative to comparable corporate bonds. That should make the market even more attractive to tax-aware investors
What Has Caused Recent Municipal Bond Volatility?
The municipal bond market began experiencing volatility in October 2016. After more than a year of positive weekly flows into the sector, flows began diminishing at that time and turned negative in November. The changing pattern in flows coincided with October’s US$53 billion in new muni bond issuance, the most of any month in the last 30 years.
The result of the election also created uncertainty over policy changes for both corporate and personal income taxes and the potential for a large infrastructure package. Both of these events contributed to the volatility of the U.S. municipal market, and municipal-to-Treasury ratios cheapened in early December.
The factor most responsible for the rise in muni yields was not policy uncertainty or supply and demand, but the rise in Treasury yields. The chart on the previous page shows the relationship between the municipal market yield and the 10-year Treasury yield. If Treasury rates are moving up or down, the municipal market generally follows in the same direction. A lag or a difference in the size of the move can most often be attributed to municipal market factors like uncertainty over tax policy or supply and demand changes.
In addition to considering factors that are unique to the municipal market, investors must also consider factors that influence the general level of rates. The drivers of the recent move in Treasury yields include enhanced growth expectations, more confidence that the U.S. Federal Reserve will continue raising rates in 2017 and heightened inflation expectations.
In spite of the recent volatility, the core fundamentals of the municipal market remain strong. The U.S. economy continues to grow, and low unemployment rates provide a positive backdrop for municipal credit.
The hospital sector demonstrates how a strong labor market can positively impact the municipal market. Private-payer health insurance traditionally offers better coverage and benefits than public plans. With more participants eligible for private plans amid low unemployment rates, this positively impacts hospitals’ revenues.
Relative Muni Valuations Have Improved
The recent volatility has led A-rated municipal credits to become much more attractive relative to similarly rated corporate credits. Municipal credit often trades at lower absolute yields relative to corporate credit due to the tax advantage offered by municipals. For most of 2016, A-rated municipals traded at an 80% discount to corporates.
At that level, A-rated municipals were still attractive for investors in the highest tax brackets. However, starting in October the spread started to tighten as municipal yields rose. Municipal yields briefly traded at higher levels than their corporate counterparts in December.
Municipal yields approaching or exceeding corporate yields in absolute terms signals that munis are a good relative value. Since the start of the year, A-rated municipals have traded above 90% of A-rated corporate yields. That makes them very attractive for those paying higher income taxes. With the fundamentals of the municipal market intact, the recent volatility has actually made municipals more attractive relative to other fixed income alternatives.
Are Investors Forgetting Why Emerging Market Bonds Had Started to Recover?
• The U.S. election has reversed some of investors’ recent optimism regarding emerging markets debt.
• However, certain factors driving the sector’s recent improvement may make emerging markets debt more durable than the consensus expects.
• Those factors include stable commodity prices, a slower path for U.S. dollar appreciation, favorable real-yield differentials and signs of economic reforms in developing countries.
Market sentiment toward emerging markets (EM) has soured since the U.S. presidential election. The trade policies advocated by Donald Trump during his campaign and increased geopolitical uncertainty have led investors to demand higher risk premiums for EM assets. In addition, U.S. dollar appreciation resulting from the new administration’s pro-cyclical fiscal policies has created another headwind. With this backdrop, should investors adopt a more cautious stance toward EM bonds or does the recent sell-off provide a special opportunity?
Until the U.S. presidential election, 2016 had witnessed a strong recovery in EM asset prices. After years of disappointing returns, the major drivers behind this recovery were:
1. A stabilization in commodity prices
2. A slower appreciation of the U.S. dollar
3. Historically low yields in developed bond markets
4. Economic reforms in developing countries
Will the new U.S. administration fundamentally derail this dynamic?
Stabilization in Commodity Prices
Commodity prices bottomed in February 2016 after the sharp correction of 2014–2015. This recovery has continued after the U.S. presidentialelection as higher growth expectations have boosted commodity demand. Commodity producers have also been aggressively cutting back capital expenditures, as many exploration projects were no longer viable at lower prices. This gradual reduction in commodity supply has been accelerated by OPEC’s decision in late November to cut production.
The acceleration in U.S. growth expected from Donald Trump’s expansionist fiscal policy is therefore supporting the ongoing recovery in commodity prices at a time when supply is falling. While the EM investment universe contains both commodity importers such as Turkey and India as well as exporters such as Brazil and Russia, in aggregate, higher commodity prices are supportive of EM bonds.
