The desk views the municipal bond market as positioned for continued resilience amid evolving federal policies, with attractive yield spreads over Treasuries. Per the full note from UBS, while inflationary pressures and uncertainties around tariffs create short-term volatility risks, the expected tax-equivalent yields, especially in high-tax states, remain compelling. We highlight the yield advantage where in-state bonds exceed 7.5% after tax considerations, contributing to our barbell preference strategy outlined in the report.
What the desk is arguing
The desk argues that while policy uncertainties are prominent, they support the resilience of the municipal market, particularly in light of attractive yield spreads over Treasuries. Per the full note from UBS, year-to-date performance has shown munis rallying, allowing investors to capture yields of 150 to 200 basis points above Treasuries on a tax-equivalent basis, with specific opportunities in high-income states.
With recent inflation data providing limited impetus for the Fed to cut rates in the immediate term, the call for a barbell strategy on maturities between 2 and 30 years appears well grounded. This positioning allows for capitalizing on both short and long-term market segments, mitigating the potential impacts of volatility while maintaining attractive returns.
Where it sits in our coverage
Our consensus target for the municipal bond market sits at 1.075, with a range from 1.04 to 1.12. Specific firm targets include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
Given our positioning aligns closely with the upper bound of the spread, we remain cautiously optimistic about municipal yields while recognizing the short-term volatility risks highlighted in the current market commentary.
How other firms see it
Firms like jpmorgan and other aligned institutions view the municipal bond market as positively positioned, anticipating continued strength in yields backed by solid fundamentals. Conversely, bofa presents a more cautious viewpoint, indicating potential risks that could dampen municipal performance.
Investors should keep an eye on tax-equivalent yield dynamics, particularly within high-income brackets, as these trends reflect broader economic signals. Additionally, the trajectory of U.S. Treasury yields will likely be a pivotal factor in shaping municipal bond valuations in the near term.
01Municipal bond yields remain attractive, especially in high-income states.
02Short-term volatility risks exist due to macroeconomic policy uncertainties.
03A barbell strategy is favored to mitigate risks across different maturities.
04Expect limited Fed action in the face of recent inflation data.
Market implications
Focus on the municipal bond yields, particularly where in-state bonds exceed 7.5% in tax-equivalent terms. Watch for upcoming inflation data as it may influence the Fed and consequently the municipal market's trajectory.
Risks to this view
The main risk to the call resides in unexpected Federal Reserve policy changes that could lead to a rapid increase in rates, significantly impacting municipal bond valuations and yield spreads.
ubs
Hi everyone, Siobhan Chapman here, and welcome to Top of the Morning on the UBS Market Moves podcast channel. Today's conversation will primarily focus on the Municipal Market Guide, Policy Matters. Joining us for the conversation today, I'm glad to welcome back Sudeep Makhraji, Fixed Income Strategist, Ted Galgano, Municipal Strategist, and David Perlman, ETF Strategist.
With that introduction, I'll pass it over to you, Sudeep. Thank you, Siobhan. Yes.
And there's a lot of talk about the mini market. We're talking about the Municipal Market Guide, just published recently. And there's a lot of talk that's right into it, so I'll hit the high points first, and then get Ted and David into the conversation.
So policy uncertainties is on everyone's mind, especially tariffs, and that has increased upside inflation risks and downside risks to growth. That said, we still believe that the economy will stay resilient, and treasury rates will be lower by year-end. That's our view.
But the risk of rate volatility is elevated in the short-term. Munis had a nice rally since mid-Jan, so years are lower, but it's still attractive, getting just shy of 150 to 200 basis points over treasuries at the longer end on a tax-equivalent basis. And when accounting for the fact that muni interest is federally tax-exempt.
But in-state bonds in high-income states like California and New York, after factoring the state tax exemption, tax-equivalent yields exceed 7.5%. So yields are attractive, but there is risk of rate volatility in the short-run. Lastly, recent inflation data gives the Fed little reason to cut rates in the short-term, and they've said so in their reports.
So that sets the broad macro investment context for munis. So using that, let me now lay out what our preferences are. That is, how we think investors should be positioned.
So we retain our barbell preference for the 2 to 5-year on the AAA curve and the 7 to 30-year on the curve, and now with an even split in allocation. In our last report in Jan, we had an overweight on that long end. We continue to like higher-quality credits in general, especially for the longer-duration part of the portfolio, but we do recommend some BBBs in high yield for the shorter end.
Lower-rated credit spreads generally remain compressed. The risk-reward for BBBs in high yield looks kind of unappealing, except for those short maturities. That said, investors should use these types of spreads to rotate out of lower-rated not-for-profit hospital bonds.
Those are facing the headwinds, and rotate into, let's say, higher-rated transportation bonds and state geos, so lower-rated hospitals to higher-rated transportation is our preference. Coming back to policy, there's a lot of noise about federal policy. There's a bunch of policy proposals out there, health care, departmental education, sanctuary city funding, and so on and so forth.
We just remind our investors that there is naturally some concern as to the impact on muni markets, but these will require congressional approval, where slim Republican majorities are likely to moderate legislative outcomes. Some more to come on this topic, but I think we want to kind of moderate investor concerns on these topics in terms of its impact on the muni market. However, these could add to market volatility in the short term, and this is part of our thesis that this short-term risk is elevated.
If federal funding to some sectors is disrupted, it may boost issuance even further to fill the gap, adding to already high supply pressures. Now, fund flows have been good, and they're balanced out these high supply numbers, but in the short term, overall, the interrelated factors of supply, treasury rates, and federal policy will be the driving factors in the muni market. So that's kind of a synopsis of our take on the market and our preferences.
Let's now turn our attention to the most important policy issue for the muni market that is on everyone's mind, the fate of the muni tax exemption. So let me get my colleague Ted Galgano into the conversation to discuss that. So, Ted, the muni market continues to be laser-focused on the fate of the tax exemption.
This is not a new issue, it has surfaced in previous election cycles, but the risk appears to be elevated this time around. So could you provide some brief comments as to why is the risk higher this time, the proposals on the table right now, and our expectation regarding the outcome? Sure, Sudeep, and good afternoon, everybody.
So with most of President Trump's signature legislation, which was the 2017 Tax Cuts and Job Act, which is set to expire at the end of this year, Congress has been busy examining possible ways to offset the estimated $4 trillion cost that's going to be associated with extending the tax cuts. So consequently, the elimination of the tax exemption has emerged as a potential means to help fund those tax cuts, hence, you know, some of the alarming headlines that we've been reading and certainly fielding questions on. With Republicans holding only a slim majority in Congress, this will be a challenging balancing act requiring extensive negotiations.
However, recent discussions in the Republican caucus seem to be centering more around a floor of $1.5 trillion, you know, so the question is, will this be enough to obtain conservative votes? You know, we will see. In this context, the Ways and Means Committee issued a 51-page report outlining a list of items to guide Congress.
Some of those items listed increased revenues, while others decreased revenues. This is meant to help guide policy decisions as Congress explores ways to offset some of those costs associated with extending or, in some cases, increasing tax cuts. You know, remember some of the pledges from the campaign trail to stop taxing tips or lowering the corporate tax rate from 20 to 15 percent for some entities.
Some items listed are considered non-starters, like the elimination of the home mortgage interest deduction. That's a third rail issue. However, other items, like the municipal tax exemption, are certainly in play at this point.
I hope that context, anyway, helps provide some background and explain the headlines about the potential elimination of the tax exemption. The tax exemption, by the way, costs U.S. taxpayers about $51 billion in 2023 alone. In CIO's view, while there is some threat to the full elimination of the tax exemption, we still feel or we still view the full elimination as a lower probability event, though it certainly cannot be entirely discounted.
That said, where do we see issues? We see private activity bonds as the most at-risk segment of the municipal market, especially since they were considered for cuts in 2017, but ultimately spared. That subsector of bonds includes issuers like not-for-profit hospitals, public and private higher education, and airports, among others.
So to give you an idea of some of the muni-related items listed in the Ways and Means Committee report that I mentioned earlier, on one end of the spectrum, we have the full repeal of the state and local tax deduction, which is better known as SALT. The deduction is currently capped at $10,000 for households. If repealed, meaning no more deduction at all for taxpayers, it would save the federal government about $1 trillion.
On the other end of that spectrum is the increase in the SALT deduction from the current $10,000 cap to a $30,000 cap, which would cost the federal government about $500 billion. So it seems the SALT cap will most likely be increased, not decreased, even though this costs the government money, in part given the thin majority in Congress and pressure from Republicans in high-tax states, notably in New York and Cal, to lift the elimination of the cap. However, with the thin majority in Congress we've been talking about, every vote carries considerable weight.
We highly doubt it will be fully eliminated, as we just stated, but we do expect it will be raised to at least, you know, the number seems to be around $20,000 or more for married couples. Since the cap is a major revenue generator, which offset tax cuts in 2017, we highly doubt the cap will be fully eliminated or be eliminated much higher than the number I just mentioned. Other like eliminations, things at risk are hospitals' ability to issue tax-exempt debt, which would save the federal government $260 billion, while eliminating state and local governments' tax-exemption status saves another $250 million, just to give you some ideas.
Under the original Tax Cut and Job Act, the municipal market tax exemption was on the menu as it is today. Although it prevailed, it was curtailed. For instance, the issuer's ability to advance refund debt was fully eliminated.
For an issuer, that's like you and I, our ability to refinance a mortgage and save money. So it costs issuers more money, but it saved the federal government money by eliminating that ability. So why is this such an issue today?
Why do we think the risk has increased? U.S. deficits have soared since 2017, partly due to COVID-19, which is increasing U.S. government debt load. With interest rates much higher today, servicing that debt load has become much more expensive.
So while there's been talk of one beautiful comprehensive bill passing through Congress that will address issues like border security and tax reform, it seems more likely that this will be split into two bills, with the more contentious tax reform issue being taken up in the second half of the year. If Congress cannot come to a consensus and takes no action, which we view as unlikely, tax rates will revert to their higher 2017 levels. One final note for bonds enthusiasts.
If we are wrong about this and the tax exemption is fully eliminated, we believe existing bonds will be grandfathered, so they'll keep their tax exemption, and will likely increase in value due to investor demand and diminishing supplies. Thank you, everyone. Back over to you, Sudeep.
Thank you, Ted. That was really a comprehensive coverage of what we know so far about the tax exemption and our views. That's really helpful.
Let's now talk about our spotlight session of the Municipal Market Guide, wherein we discuss key trends in three different vehicles for investing in the mini market, mutual funds, ETFs, and separately managed accounts, or SMAs, as they call them. And for that, let me get my colleague, David Borman, into the conversation. So David, can you briefly talk about these three types of vehicles and the key trends you're watching there?
All right. Thanks, Sudeep. And hello, everyone.
So I'm going to start with and primarily focus on the municipal ETF market, given that I'm an ETF strategist. So firstly, with the municipal ETF market, we've seen continued growth since its inception in September 2007. We're now at 36 issuers of municipal bond ETFs, and they combine for 112 ETFs and $141 billion in assets.
So just to put that in perspective, if you look back 15 years ago, municipal ETF assets accounted for only 1% of the assets held in municipal bond ETFs and mutual funds. That number has grown to 15% at the end of 2024. So despite the growth that we've seen with municipal ETFs, the market is still concentrated.
BlackRock has 41% of the muni ETF assets, and Vanguard has 27%. And in general, where ETFs are often associated with passive investing, actively managed municipal ETFs have been a driver of growth. If you look at the municipal ETF market with 112 ETFs, 70 of them are actively managed, and their share of municipal ETF assets is 17%.
From if you look at flows in 2024, inflows into municipal ETFs totaled $18 billion, 67% of those flows went to broad-based municipal ETFs. These are strategies just investing in nationally in passive-debt municipal bonds. We did see, if you look at it just from the maturity perspective, we saw greater demand for short- and intermediate-term strategies compared to longer-term ones, which wasn't surprising given the move higher in treasury yield that we saw last year.
Municipal single-state ETFs also saw continued adoption. And then for the actively managed municipal ETF market, it continues to really punch above its weight in terms of its share of flows. So 42% of the inflows for muni ETFs went into actively managed strategies compared to their 17% market share.
So that's a space that continues to grow. For municipal mutual funds, the past few years we had seen outflows, but that reversed this year where the flows into municipal bond mutual funds totaled $29 billion. Another notable aspect of the flows for municipal mutual funds was that 45% of the flows went into high-yield municipal bond funds.
Their market share is 16%. So they're really taking a disproportionate amount of the flows compared to their market share. So if you look at the returns in the underlying markets, high-yield munis returned about 5% in 2024, whereas the investor-grade market returned just over 1%.
So we suspect that sharp outperformance from the high-yield muni market drove the increased demand for high-yield municipal mutual funds. Interesting, we didn't see that carry over to the ETFs. High-yield municipal ETF flows were about 5% of the flows, and that's in line with their share of assets in the muni ETF market.
So finally, just a quick comment on the municipal bond separately managed accounts space. It's seen significant growth since 2018. Total assets in municipal bond SMAs are now more than $1.6 billion.
While SMAs generally require higher investment minimums than mutual funds or ETFs, they do offer greater levels of customization. Additionally, technological advancements have made it easier to manage and invest in SMAs. So we do expect to see continued growth from municipal SMAs.
Asad, back to you, Siddhi. Thank you, David. A really interesting take on all that is going on in the ETF, mutual fund, and the SMA space.
So let me wrap up by saying that in terms of the muni market, supply rates and policy will continue to drive markets and uncertainty in municipalities. So our barbell preference tries to capture essentially attractive users at the long end, while the short-end exposure keeps some powder dry for taking advantage of rate volatility should it occur. Higher quality further out the curve with some triple B and high-yield exposure at the front of the curve.
We hope that you enjoyed our talks on the market. We are at the end of our podcast. And with that, I hand it back to Shiva.
Thank you so much for joining us. Again, today we have been joined by Siddhit Mechraji, fixed income strategist, Ted Galgano, municipal strategist, and David Pearlman, ETF strategist. And as a reminder to our listeners, Top of the Morning is a part of the UBS Market Moves podcast channel, which is available where podcasts are found, including on Apple Podcasts and Spotify.
Visit UBS.com forward slash studios to view the entire podcast offering, as well as UBS trending video series. From UBS Studios, I'm Siobhan Chapman, and thank you for joining us. Thank you for tuning in.
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