What’s Next? Munis React to Trump’s Victory

What's Next? Munis React to Trump's Victory

Donald Trump’s surprise victory in November caused a swift adjustment in municipal bond (muni) prices, as the market factored in the president-elect’s policy proposals. The first broadly affected most U.S. bonds, while the second was more muni market specific:

  1. Inflation:Trump’s proposals are anticipated to increase U.S. economic growth and fuel higher inflation, sending interest rates generally higher across the U.S. bond market.
  2. Taxes: Look for lower federal personal and corporate income tax rates, and higher infrastructure spending if President-elect Trump gets his way. Lower tax rates reduce the value of the taxable-equivalent yields offered by munis – the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. Additionally, increased infrastructure spending could boost the supply of munis if more bonds are issued to finance infrastructure projects. This could affect the price of munis as well.

Muni yields tend to follow Treasury yields directionally. That held true as the prospect of stronger growth and higher inflation caused Treasury yields to rise. Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline. Therefore, when the 10-year Treasury yield rose from 1.82% to 2.38% in November, bond prices fell and munis experienced large price declines as well. The Bloomberg Barclays Municipal Bond Index declined -3.73% in November.

Another factor that magnified the muni market response was the composition and behavior of muni investors. Retail investors control a large portion of the muni market, and they tend to react swiftly to negative news. As the muni market sold off, investors redeemed holdings in muni funds, with long-maturity and high-yield muni funds experiencing the largest outflows as a percent of assets.

What’s Next for the Muni Markets?

We believe the muni market will continue to experience near-term volatility, driven by further investor outflows and uncertainty. The broad bond market still faces questions about the pace and magnitude of Federal Reserve interest rate policy and the influence of non-U.S. central bank policies on a still-soft global economy. In addition, it’s still uncertain which of Trump’s proposed policies will actually be implemented, and when.

We can say with more assurance that muni credit fundamentals remain strong and could grow stronger if the economy grows as expected. At this point, the only potential credit concerns are related to hospital bonds. The proposed repeal of the Affordable Care Act and the lack of information surrounding its replacement are creating uncertainty in the sector.

It also appears to us that the November sell-off may have been overdone, considering how long it may take to actually implement changes to the U.S. tax code and approve infrastructure spending.

What Should I Do with My Muni Holdings?

We believe investors may consider continuing to hold their muni positions, particularly at this point, when buyers are coming back into the market. The recent sell-off was largely a result of rising rates, fund outflows and the perception that proposed tax reform will not be favorable for municipal bonds. As mentioned earlier, overall muni credit quality and the ability to repay debt continue to be favorable. Positive returns from equities, low unemployment and a strong housing market have boosted tax receipts and municipal revenues. Default rates remain low.

In this case, we think the worst of the immediate post-election Treasury yield adjustments are past, assuming global growth and inflation stay at these levels. Global factors remain a major influence on the U.S. bond market, as they’ve been for the past few years. Global growth remains slow, and global inflation is contained. As always, for investors who are investing appropriately in munis and muni funds, we suggest interpreting periods of market volatility as an opportunity to add to muni positions.

Maturity is the date on which the life of a bond ends and its principal is repaid.

The taxable-equivalent yield represents the yield on a municipal bond when the effect of taxes is taken into account. It indicates what yield a fully taxable bond would have to give in order to be equivalent to a tax-free municipal bond.

The opinions expressed are those of the Municipal Markets Team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio.

This information is for an educational purpose only and is not intended to serve as investment advice.