Muni bonds surge as Trump's aims stall

Municipal bonds were supposed to be among the biggest losers under a Donald Trump presidency.

Shortly after the November election, muni bonds -- issued by states, municipalities and local agencies to finance government projects -- faced a "triple whammy," said Terri Spath, chief investment officer at Sierra Investment Management.

First, there was a sharp rise in market interest rates late last year in anticipation of the new Trump policies helping economic growth. And rising rates are a head wind for bonds in general. Then there was the president's pledge to lower income tax rates, coupled with concerns that he might eliminate the tax-exempt status of municipal bond income.

And finally, Trump has promised to increase infrastructure spending by possibly $1 trillion -- which, if it happens, could flood the muni market with additional supply, weighing on the price of existing municipal bond securities.

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But it hasn't turned out that way so far.

"Here we are, several months later, and the administration has had problems getting anything done," said Nicholos Venditti, a portfolio manager who helps run several municipal bond funds at Thornburg Investment Management. "There's been no health care reform yet, no tax reform and no clarity on spending."

Meanwhile, concerns about a slow-growing economy have resurfaced, pushing the yield on 10-year Treasury notes back down to 2.3 percent at the end of June, from as high as 2.62 percent in March. And the Treasury secretary, Steven Mnuchin, recently told the Senate Finance Committee that the Trump administration supported preserving the municipal bond tax exemption.

The result of all of these developments is that muni bond mutual and exchange-traded funds have enjoyed a surprisingly good run this year.

For instance, the SPDR Nuveen Bloomberg Barclays Municipal Bond ETF, whose biggest holdings include revenue bonds issued by the California State University System as well as the University of California, has generated total returns of 3.6 percent this year and 2.2 percent in the recently ended quarter.

Even before investors factor in the tax break (muni income is exempt from federal taxes and, in some cases, state taxes as well), that performance compares favorably with the 2.3 percent returns for the Vanguard Total Bond Market ETF this year and the 1.6 percent gains in the last quarter.

Going forward, though, navigating the muni bond landscape will get a whole lot trickier, money managers say.

Even if Trump cannot produce annual growth of greater than 3 percent, which has eluded the economy lately -- or the 4 percent rate that the White House promised earlier this year -- the administration is still planning to move forward on its efforts to cut taxes.

Ultimately, how much income tax rates eventually come down, if at all, will help determine the direction of muni bond prices. But the tax cut debate itself is likely to create short-term volatility for these investments.

What's more, muni investors are largely following a conservative strategy.

"You can see where investors are hiding out," says Mark Freeman, co-manager of the Westwood Income Opportunity Fund. "Everybody is bunched up at the short end of the curve," he said, referring to muni debt with a maturity of no more than five years.

Gregg Fisher, founder of the investment management firm Gerstein Fisher, says investors should remember a big reason for buying muni and other core bonds in the first place: "For the certainty that they present," he said.

That's why he suggests investors play it relatively safe for the foundation of a muni portfolio, by sticking with bonds that are from high-quality issuers with investment-grade ratings (reducing the risk of a default) and that mature in less than five years.

Business on 07/15/2017

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