Bonding with municipals at tax time

Highlights

• The worst performance month historically was a boon for munis this year.
• Investor demand outpaced moderate supply while interest rates declined.
• We expect demand to stay strong as tax payers realize the effects of tax reform.

Market overview

March was the fifth consecutive month of strong muni bond performance, with the broad S&P Municipal Bond Index rising 1.48%, bringing the year-to-date total return to 2.76%. While March has historically been the worst month for the muni market, the combination of voracious investor demand and a moderate level of supply against a backdrop of sharply declining interest rates fueled strong returns.

Interest rates declined as the Fed solidified its policy pause by removing expectations for a 2019 rate hike from its Summary of Economic Projections. (Bond prices generally rise as interest rates fall.) In the municipal market, supply and demand dynamics were particularly favorable, largely as a result of tax reform.

Muni bond supply usually increases significantly at this time of year; however, the elimination of the tax exemption for advanced refundings has, to some degree, quelled issuance this year. Gross issuance of $26.4 billion in March was 22% below the historical five-year average for the month.

At the same time, strong demand for the asset class continued unabated, logging 12 consecutive weeks of inflows. Investors particularly favored longer-term bonds and high-yielding credits, driving outperformance in those segments of the market.

Given the supply and demand imbalance, the market generally saw tighter spreads, which was further aided by positive budget news out of some of the more distressed states, most notably, Connecticut.

Watch this 2-minute video to hear Peter Hayes’ views on the current municipals market and how to leverage munis to position portfolios for the year ahead.

Strategy

We have shifted our stance on municipal bond duration slightly short of neutral given the low levels of interest rates and historically rich valuations of munis versus Treasuries across most of the yield curve. We employ a barbell strategy with concentrations in maturities of 0-2 and 20 years+. We prefer revenue bonds, lower-rated investment grade credits, and issues in high-tax states.

View full report

The Morningstar Rating^TM for funds, or "star rating," is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.

Performance data quoted represents past performance and is no guarantee of future results. Investment returns and principal values may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. All returns assume reinvestment of dividends and capital gains. Current performance may be lower or higher than that shown. Refer to blackrock.com for most recent month-end performance.