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From Our Briefings Newsletter

26 NOV 2018

The article below is from our BRIEFINGS newsletter of 26 November 2018:

Briefly . . . on the Evolution in the US Muni Bond Market 

Last year’s US tax law altered the supply-and-demand dynamics of the muni bond market, creating potential opportunities for investors. We sat down with Goldman Sachs Asset Management’s Municipal Bond Portfolio Managers Ben Barber, Scott Diamond and David Alter who explained the near- and long-term trends that are shaping one of the oldest and largest fixed income markets in the world. 

Muni bonds, municipal bond funds and muni ETFs have long been an attractive investment because they offer interest that’s tax-free at the federal level and at most state and local levels. How did last year’s tax legislation affect demand?

Ben Barber: For corporations, whose tax rates fell to 21% from 35%, holding the tax-exempt bonds became less appealing, so we saw a moderation in demand from institutions, pensions and endowments. At the same time, retail demand for muni bonds increased because the tax law limited the state and local tax deduction, spurring residents of high-tax states, such as California, to invest in municipal bonds to be more tax efficient. As a result, we believe the technical environment became – and remains – relatively strong, despite the outflows in October amid a broader risk-off sentiment and interest rate concerns. Today, the overall demand picture has remained anchored, with demand shifting materially towards retail buyers. At the same time, supply remains light and supportive of bond spreads, after a couple years of net negative issuance and a longer downward trend in supply after a rapid growth during 2009-2010 to help finance the post-crisis fiscal stimulus. 

How has the economy affected the fiscal health of the cities and states issuing bonds? Are there any concerns about credit deterioration at this point in the economic cycle?   

Scott Diamond: We believe credit fundamentals are in solid shape, supporting the case for munis alongside fair valuations after cheapening since the summer months. The downgrade and default outlook for the municipal market continues to look benign, with municipalities boasting a lower default rate than similarly rated corporate bonds. And state and local revenue trends remain constructive, though trends vary across states. California’s economy, is showing signs of moderation, but from a strong 5% growth rate. The reduction in state and local tax deductions is having an incremental impact on fiscal policies in high tax jurisdictions, such as California, but the upshot is that demand for in-state bonds could increase. With some exceptions, most municipalities are exhibiting healthy credit metrics and remaining fiscally austere.

Amid a changing interest-rate environment, can you explain the relationship between interest rates and muni bonds? 

David Alter: The pickup in interest rate volatility has had an outsized negative impact on retail demand for muni bonds, especially in longer-dated products where duration1 is longer and liquidity is lower. But overall, we believe that higher rates as a function of better economic growth prospects should actually be interpreted as a positive sign for muni investors in the current environment, as yields look more attractive and the relative cheapness of municipal bonds to US Treasuries should provide a cushion to investors in the event of continued rate volatility.

The correlation between rates and municipal bonds has changed dramatically, however, since the crisis after municipal bonds largely lost their AAA-rated2 status after February 2008. Today, a much smaller share of the market is AAA-rated as well as insured, driving a massive recalibration of the muni market relative to other fixed income sectors. A less stable correlation between rates and munis may provide greater potential opportunities to find value by investing across the quality spectrum and varying duration exposure.
 

Disclosures:
 
1. Duration is a measure of a bond’s price sensitivity to changes in interest rates.
2. AAA refers to the credit rating of these bonds as calculated by Moody’s.
 
Risk Considerations
 
Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk.
 
Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT).
 
Although Treasuries are considered free from credit risk, they are subject to interest rate risk, which may cause the underlying value of the security to fluctuate.
 
General Disclosures
 
This material is provided at your request for informational purposes only. It is not an offer or solicitation to buy or sell any securities.
 
Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.
 
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of November 2018 and may be subject to change, they should not be construed as investment advice.
 
Individual portfolio management teams for GSAM may have views and opinions and/or make investment decisions that, in certain instances, may not always be consistent with the views and opinions expressed herein.
 
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by GSAM and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes.
 
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
 
Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.
 
Confidentiality
 
No part of this material may, without GSAM’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.
 
Goldman Sachs & Co. LLC, member FINRA.

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