Eaton Vance
January 11, 2017
Eaton Vance provides advanced investing to forward-thinking investors, applying discipline and long-term perspective to the management of client portfolios.

Muni Bond 2017 Outlook (Part 1)

Eaton Vance Municipal Insight Committee


This is the first installment of a series of four blog posts on our outlook for the municipal bond market in 2017. We will publish one blog post a week in January. Look for our next posts on the potential impact of a Trump presidency on munis, a deep dive into the fundamentals, and top investing ideas.


New York and Boston - When we look at the municipal bond market as 2017 begins, it reminds us of past trading environments when sell-offs in Treasury bonds spilled into munis, presenting an attractive entry point. We think another buying opportunity is potentially at hand.


We have heard some clients complain about the "sticker shock" of low yields in recent years. Our view is that the move lower in muni prices in the wake of the U.S. presidential election is a chance to purchase munis at higher yields and potentially generate higher future returns. In particular, this is a much better spot for investors looking to put money to work, compared to last summer when U.S. Treasury yields were at all-time lows.


t's not surprising that some investors have been unnerved by the fourth-largest move in the muni market going back to 1990. Yet, if history is any guide, the muni market, which is dominated by individual investors, is sensitive to mutual fund flows and has a tendency to overreact to negative news.


For example, during the financial crisis in 2008, munis fell sharply only to rally back in 2009 once the dust settled. Then in 2010, a significant drawdown was triggered by analyst Meredith Whitney's warning of hundreds of billions of dollars of defaults in the muni market -which never materialized. And finally, the 2013 "taper tantrum" turned out to be another attractive entry point for muni investors.


Today, after the recent move higher in rates, we believe munis are attractively valued relative to Treasurys of similar duration. Since the July low in yields, long-term muni yields have moved even more than Treasury yields, and the ratios of 10-year and 30-year AAA muni yields, versus 10-year and 30-year U.S. Treasury yields, currently stand at 95% and 99%, respectively.


Fund outflows and expectations of lower taxes under the Trump administration have likely impacted the valuations of munis. During the campaign, President-elect Donald Trump proposed cutting personal taxes in addition to potentially adjusting the corporate tax rate. Some argue that lower personal tax rates would make the tax advantages of munis less attractive, and curb investor demand. However, as we blogged in November, changes in the top marginal tax rates going back to 1980 have had little impact on 10-year muni valuations.


Further, there hasn't been much detail yet on the specifics of Trump's policies, what will get through Congress, and when. Quite simply, there are a wide range of potential outcomes and potential market impact. However, the sharp rise in Treasury yields seems to indicate the market is pricing in Trump will get much of what he wants, which is by no means certain.


In our view, this historic move has created an emerging opportunity. In recent history, the municipal market has proven to be resilient, and sharp increases in yields have resulted in buying opportunities and rewarded investors with strong returns in subsequent months. This opportunity must be somewhat tempered by the backdrop of heightened uncertainty, particularly around the Trump administration. Potential risks to the muni market include another jump in Treasury yields due to an aggressive tax-cut plan, rising deficit or other factors. Investors will also be keeping a close eye on any moves to cut the muni tax exemption, although that seems unlikely at this point.


Despite this uncertain backdrop, we continue to think that rates could move back down a bit in 2017, for several reasons. First, U.S. Treasury yields are still historically low but very attractive when compared with other developed markets such as Europe, where rates are negative in some cases. Second, the dollar, despite recent weakness, has strengthened meaningfully over the past year, which may be a drag on growth and contain inflation in 2017. And finally, if the Federal Reserve hikes rates three times in 2017, that may control inflationary pressures. In previous tightening cycles, rising short-term fed funds rates did not lead to an expected high level of volatility for long-term municipal bonds.


Bottom line: Given the muni market's historical resilience, we believe the short-term reaction after the U.S. election provides tax-sensitive investors a chance to scale into munis at higher yields and cheaper valuations.



An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Rising interest rates could reduce the value of the bonds in the portfolio, thus adversely affecting the value of the overall investment. Longer-term bonds typically are more sensitive to interest-rate changes than shorter-term bonds. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments.

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