The municipal bond market is appealing to many investors due to its stability and attractive yields compared to other fixed income asset classes.
While there was some concern that the new tax law would eliminate muni bond benefits, the bill did not touch tax exemptions on interest income or exclude private activity bonds from favorable tax treatment. Investors with high tax exposure may still want to use them as a way to increase their after-tax yields.
If you’re interested in purchasing muni bonds, we have taken a look at how the economy is likely to perform over the coming years and identified five muni bonds that are liquid and should outperform municipal bond indexes given our economic and monetary policy forecasts.
Check out the different ways to invest in muni bonds to stay up to date with the current investment strategies.
We used a top-down approach to select these five municipal bonds. We began by looking at likely changes to the unemployment rate, economic growth rates, inflation and interest rates. Next, we determined where the economy was within the business cycle to estimate how the yield curve might change in response to these dynamics. The final five bonds were then selected based on their duration, liquidity and the municipality’s financial strength.
Be sure to check out our newly launched Municipal Bond Screener to explore muni bond CUSIPs across the U.S. based on custom parameters including the issuing state, insurance status and a range for different bond attributes such as maturity, coupon, price and yield.
The Tax Cuts and Jobs Act of 2017 lowered the corporate tax rate from 35 percent to 21 percent and reduced most individual income taxes through 2025. At the same time, President Trump signed a $1.3 trillion federal spending bill on March 23 and has announced plans to spend upwards of $1.7 trillion on infrastructure over the next decade. These factors could lead to greater consumer spending and faster economic growth over the short-term.
While these are all signs of future inflation, there’s also evidence of current inflation. President Trump’s trade war with China and higher oil prices have contributed to higher packing costs at many companies, while greater consumer spending could lead to inflationary pressure as businesses raise prices to maximize profits on limited inventories. The tight labor market could also keep unemployment low in the short-term and eventually lead to stronger wage inflation.
With historically low unemployment at just 4.1 percent and interest rates hovering at 1.75 percent, there is a high likelihood that the Federal Reserve will continue increasing interest rates to contain inflation. We believe the economy could be approaching the peak of the business cycle sometime over the next two to four years, as interest rates approach 3.5 percent, sending inflation down, unemployment up and economic growth down.
Be sure to check out our previous article depicting how rising interest rates might impact munis..
2. Yield Curve
We believe that the yield curve is likely to flatten as expectations for future inflation declines in the mid- to long-term. If interest rates approach 3.5 percent and economic growth slows, investors may assume that future inflation will be modest and longer-term maturities could see their yields level off to levels similar to that of short-term maturities. On the contrary, short-term maturities could still see elevated yields as current interest rate hikes continue to drive them higher.
If the yield curve begins to flatten, long-term maturities are likely to outperform all other maturities, as the flattening drives prices of long-dated maturities higher to induce the lower required yields of longer-dated municipal bonds. We believe that municipal bonds with durations in the 15-to-20-year range will benefit the most from price increases in longer-dated maturities, while lower coupons (< 5 percent) will be preferable as they drive up duration.
Check out this article to determine whether muni bond ladders are right for you.
There are many different factors to consider when selecting state municipal bonds, including unfunded pensions, healthcare benefits and liquidity. After taking these accounts into considerations, we have focused on municipal bonds located in Texas and Florida.
Top 5 Municipal Bonds
These are the top five municipal bonds based on the criteria mentioned above. As an added bonus, the lower demand for longer maturity municipal bonds from institutions means that the current municipal yield curve hasn’t flattened as much as the Treasury curve. This means that the flattening of the municipal yield curve is likely to be even more pronounced for munis than Treasuries in the future, creating an even more compelling opportunity.
|Denton Texas Certificates Obligation||248866E43||2045-02-15||4%||No|
|Tarrant County Texas Cultural Education Baylor Health Care System Project A||87638QGZ6||2043-11-15||4%||No|
|Tampa Florida Health System Revenue Baycare Health||87515ECA0||2046-11-15||4%||No|
|Miami Dade County Florida Water and Sewer System Series A||59334DJQ8||2044-10-01||4%||No|
|Texas State Water Financial Assistance Series D||882723E47||2045-05-15||4%||No|
The Bottom Line
The economy is likely to experience a peak in the business cycle over the next two to four years as rising interest rates take a toll on economic growth. Given these trends, longer maturity munis are likely to outperform their shorter maturity counterparts as the yield curve flattens.
Note: These opinions are based on our forecasts and investors should do their own due diligence before making investment decisions.