Interest Rates, Tax Changes, and the Muni-Bond Market

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Rising interest rates have roiled the bond market so far in 2018. Joining me to discuss the state of the municipal bond landscape is Beth Foos. She is a senior analyst with Morningstar.

Beth, thank you so much for being here.

Beth Foos: Thanks for having me, Christine.

Benz: Let's talk about rising interest rates. It's interesting when you look at the high-quality taxable bond funds, they have actually done a bit worse than muni funds so far in 2018, and of course, it's early days. What do you think is going on there?

Foos: It's really difficult to know exactly what's driving the difference in performance between the taxable market and the tax-free market. I will say that Morningstar's long-term category is rather small, and it includes some funds that are very long. They have a lot of sensitivity toward rising rates. With that, the muni market is also long, and I think, honestly, it's been propped up in the last couple of weeks because of promising supply and demand dynamics. That's really what's giving it the edge over the taxable counterparts.

Benz: Let's talk about that, because we did see that giant tax package passed in the late hours of 2017. Let's talk about the interplay there with the muni market. You said there was a big rush to issue new municipal bonds in 2017. First, why was that, and what were the implications for how munies performed or how you expect them to perform in the future?

Foos: The debate over the U.S. tax reform alone was enough to provide a significant amount of activity in munis in the fourth quarter of 2017 as you said. Issuers rushed to the muni market to get their deals passed before the Jan. 1 start date for the new tax bill. That resulted in muni issuance in December of 2017 which was roughly about $70 billion, which was three times what December of 2016 saw.

Benz: Why were they rushing to get the deals done and to get the bonds to market?

Foos: They weren't quite sure exactly what was going to pass, what was going to be included and excluded from that particular bill and how that would impact the market moving forward. Because we saw all of that issuance come forward in December in particular in 2017, there has been a lull in supply in the early parts of 2018 which they expect to continue moving forward. That should bode well for current muni investors if that demand holds up.

Benz: Let's talk about that. From an individual taxpayer standpoint, there might be increased demand for munis, because in high-tax states, for example, people are able to deduct less than they could in the past. Do you think that that will be a tailwind for the muni market going forward?

Foos: That is something that market participants are hoping. There are new limits on tax deductions for certain individuals, and in those high tax states that should make munis more attractive for them as they try to keep their tax bills down.

Benz: There aren't that many tax breaks you can take advantage of anymore; municipal bonds remain one.

Foos: Right. On the other hand, there are some aspects of the tax reform bill that could actually dampen demand moving forward. Participants are looking to track those aspects as well. In particular, with the decrease in the corporate tax rate, that may make muni bonds less attractive for, say, banks and insurance companies that are traditionally large holders of municipal bonds.

Benz: How about from a credit picture standpoint? When you look at the overall health of the municipal market, health of municipal finances, are things kind of holding steady? I know they have been improving with the exception of a few high-profile basket cases like Illinois. Is that still the case?

Foos: That is. For the most part, we would say that the overall credit quality, the credit picture of the muni market is strong, default rates remain pretty low. Most states right now are reporting general fund operating revenues as stable or as growing, which kind of coincides with that stronger U.S. economic picture that we have seen. With that, like you said, there are still some pockets of concern that we will continue to watch. The debt issued by the struggling Puerto Rico and Illinois and New Jersey. But those aren't big new stories in the muni market. They haven't been surprises for anyone.

Benz: The last thing I want to talk about with you, Beth, is the passive funds landscape. In the past, everyone went with active products for their municipal bond exposure, active funds. But we have seen increased number of passive products coming to market. What do you and the team make of those funds today? Have you issued ratings on them, and do you think any of them are any good?

Foos: We have seen an increased number of passive options in the muni market, particularly in the last three years, which has been really interesting. Several of those ETFs have earned strong Morningstar Analyst Ratings. I think a solid option for folks that are looking for that kind of exposure is a Bronze-rated iShares National Muni Bond ETF. MUB was one of the first entrants into this space, I want to say, in 2017, and it's the largest, it's most liquid, and it's offered just at 25 basis points.

Another strong option is Silver-rated Vanguard Tax-Exempt Bond Fund. Vanguard launched that fund in August of 2015 and it features an ETF as a share class and that's offered at a very low 9 basis points.

Benz: That's an index product. Vanguard has a suite of actively managed muni funds as well but that's an index product.

Foos: That's an index product. Both of those funds track very closely to the S&P AMT-Free Muni Index, which is focused on higher-quality bonds. The returns might lag a bit as investors reach for yield as they have over the past couple of years. I still think they are very strong options for folks looking for that indexlike product.

Benz: Beth, always great to get your insights. Thank you so much for being here.

Foos: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.