The $3.8 trillion U.S. municipal bond market, sometimes called a sleepy asset class, has been partying awfully hard lately.
Consider that investors poured $1.8 billion into muni mutual funds in the week through Jan. 29, the 56th consecutive week of inflows, according to Refinitiv Lipper US Fund Flows data. Then, on Jan. 31, the biggest high-yield muni exchange-traded fund, the VanEck Vectors High-Yield Municipal Index ETF, drew in $150.2 million, the largest one-day increase in assets since inception in 2009. The amount of state and local debt on the books of Wall Street banks has dwindled to the least since late 2014. Overall, the market returned 1.8% in January, its strongest month in six years.
That sort of performance is astounding, especially when considering the difference between January 2014 and last month. Because of the “taper tantrum” that started in mid-2013, benchmark triple-A muni yields climbed to 3% by the end of the year. That gave them some room to fall as the calendar turned. By contrast, triple-A munis ended 2019 at 1.48%, barely off their record lows. In theory, they had little room to run.
Instead, the spreading coronavirus and ensuing flight to haven assets caused munis to rally anew. The yield on top-rated 10-year debt fell to 1.18% on Jan. 31, the lowest since Bloomberg Valuation data begin in 2009, while yields on 10-year New York State general obligation bonds dropped even lower, to 1.09%. According to the Bond Buyer’s 20-year index of general-obligation bonds, the oldest gauge of the tax-exempt securities market, yields are the lowest since the mid-1950s. “That is insane,” one fund manager said.
Yes, it is insane. With the benchmark 10-year Treasury yield fluctuating around 1.5%, not far from its all-time low of 1.32%, fund managers and strategists are frequently asked whether they see 1% or 2% next. For munis, 1% is already close to becoming reality in what could be a harbinger for American investors.
Because interest on most state and local debt is exempt from income taxes, investors have historically accepted lower interest rates for munis than they have for Treasuries. For those in the top federal marginal tax bracket of 37%, a tax-free yield of 1.18% is equivalent to 1.87% on a taxable bond. In that sense, triple-A munis are still a better deal than Treasuries, though worse than top-rated U.S. corporate bonds, which yield about 2.3%.
The curious part of this relentless rally is that many muni investors fit the stereotype of those who would balk at psychological yield levels. Unlike, for example, traders who aim to front-run the European Central Bank by buying negative-yielding debt and selling it at an even-higher price, state and local obligations are often held until maturity by investors looking to cut down on their tax bills. Maybe they have become accustomed to yields below 2%, but less than 1% could be a bridge too far.
Most likely, muni investors are falling into the typical pattern of chasing returns rather than taking note of prevailing yield levels. The Bloomberg Barclays Municipal Bond Index has gained in every month but one since November 2018, which of course neatly lines up with the streak of mutual-fund inflows. “The ongoing intense, prolonged rally, has led to gluttonous demand for tax-exempt paper, which has engendered strong performance, and is leading to more gluttonous demand,” Citigroup Inc. analysts wrote this week in a report that suggested munis could gain about 8% in 2020.
While there’s nothing obvious on the horizon that would cause a jump in benchmark yields, certain relative-value metrics at least suggest the market has been stretched to its limits.
The traditional way to measure the relative attractiveness of munis is to divide tax-free yields by those of Treasuries. When that ratio is lower, it means munis are comparatively more expensive. That gauge for 10-year debt dipped to 72% last month, about the lowest in at least two decades. The ratio for 30-year bonds set a record low on Jan. 8.