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U.S. Fixed Income and Municipal Bonds

Video Transcript

Municipal Bond Market Opportunities in 2017

TOM BUTCHER: What's your outlook for municipals for the rest of the year?

JIM COLBY: I think we're past the extreme volatility of the end of last year. Investors have returned to the muni market, and it looks like traditional patterns will persist. This means that returns should be positive, perhaps through the first quarter and into the second. We expect refundings of existing bonds to be an important factor in whether returns will be positive or negative. And of course, interest rates will dictate whether those refundings happen and, as a result, whether we end up with positive returns.

BUTCHER: What do you see as the greatest uncertainties at the moment and going forward?

COLBY: I see two. One is refundings and the other is tax reform, which was at the heart of the market’s move in November and December.

Whether some type of tax reform can take place in the next 90 or 100 days is certainly open to question. The potential for a change in corporate and individual tax rates is a big wild card. And if interest rates remain relatively stable in the current low-rate environment, there could be plenty of refundings — which would add to muni supply — even if the Fed raises the Fed funds rate in March or May by 25 or 50 basis points. This creates some balance between inflows and the supply-demand equation and augurs well for muni performance through the first half of the year.

BUTCHER: The last time tax rates fell was during Ronald Reagan's presidency, and the muni market had quite a time adjusting. Will it suffer the same fate or have as much difficulty adjusting this time around?

COLBY: Reaganomics introduced the notion that a significant change in the tax code could occur, and it did occur: Tax rates for the highest marginal tax bracket came down during his administration to 28% from 50%. To some degree, there is a parallel to what we could experience in the coming months.

A reasonable thought is that lower tax rates mean less demand for the tax exemption that municipals offer. But throughout the 1980s, there was considerable growth in municipal tax-exempt money market funds and municipal tax-exempt bond funds. Assets in the muni space increased significantly, from about $300 billion under management to $1 trillion.

The question is whether the same jump in demand will occur this time. While we don't yet know the answer, the experience of the Reagan era shows that munis cannot only survive, but also flourish in a lower-tax environment.

BUTCHER: Where do you see opportunities?

COLBY: There are good stories to tell in the investment-grade and high-yield parts of the market. The main advantage of municipal high-yield compared to other asset classes these days continues to be that nominal municipal yields are higher than those found in corporate high-yield. Corporate high-yield has had a terrific run in the past two or three months due to great demand, which has brought corporate yields down. But municipal high-yield has lagged somewhat, giving it the slight advantage.

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