Munis break their streak
Foresight is 20/20
Our vision for municipals this year BlackRock's municipal bond experts share their market outlook and actions you can take to raise your portfolio's potential in 2020.
Peter Hayes, Head of the Municipal Bonds Group Sean Carney, Head of Municipal Strategy
A return to normal is in sight
Just as the term "20/20 vision" refers to normal visual acuity, the year 2020 means a return to normal for municipal bond performance. 2019 was a stellar year for the asset class, with prolonged periods of net negative supply and persistently strong demand propelled by the impact of 2017 tax reform, all against a backdrop of falling interest rates. (Bond prices rise as rates fall.) The S&P Municipal Bond Index barreled past analyst expectations (~4%) to finish the year with a gain of 7.3%.
We expect the market's positive momentum to continue in 2020, but to expect gains similar to 2019 would be unrealistic. We see potential for slightly higher interest rates in the first half of 2020 weighing on muni bond prices and possibly causing issuance to be lower than market consensus (which is lofty, in our opinion). The latter half of the year, however, may bring greater volatility as the U.S. presidential election comes into focus, which could push rates lower and muni bond prices higher.
Our forecast for muni returns this year is between 2 and 3%, comprised largely of coupon income as opposed to price appreciation. Although lower than last year, these more "normal" returns for munis, packaged with the benefits of tax exemptions, consistent income and diversification from equity volatility, are compelling enough to move cash off the sidelines and stay invested.
Investors will need to be more tactical as market conditions become increasingly dynamic in the coming year. We anticipate higher levels of interest rate
volatility, emerging risks affecting the municipal credit environment, and a renewed interest from non-traditional buyers as taxable issuance increases. These factors will require investors to be keenly attentive and take swift action just to keep up with the market's average return. A more practical approach is to invest in flexible municipal strategies that adapt as markets change.
2019 was outside the norm Cumulative flows in/out of municipal mutual funds
100
80
60 40 20
Billion ($)
0 -20 -40
-60 week 13
2008-18 2019
week 26
week 39
week 52
Source: Investment Company Institute, as of 12/31/19. Based on weekly data.
January 2020|Municipal market outlook
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Municipals have provided consistent income over time Composition of annual total return
15
10
Annual return
5
0
-5
-10
2001
2003
Coupon return Price return
2005
2007
2009
2011
2013
Source: BlackRock, above data reflects annual returns on the Bloomberg Barclays Municipal Bond Index, as of 12/31/19.
2015
2017
2019
Solid demand: investors haven't blinked
Net flows into municipal mutual funds hit a new record in 2019, exceeding $90 billion. Moving into 2020, demand should remain strong, especially among retail investors, as a growing number of retirees are seeking high quality fixed income assets that provide consistent levels of income over time. While price return is sensitive to macro trends (such as interest rate movements), coupon return has historically provided a stable portion of total returns in the municipal market.
Another benefit of muni bonds that is particularly germane at this time is their negative correlation to equity prices. After a decade-long bull market, stocks delivered yet another year of surprisingly strong returns in 2019, which means many investors are now exposed to a high level of equity risk. Adding municipal bonds to a portfolio is an effective way to diversify equity and equity-like risks.
Municipal bonds can be a ballast for equity risk Average total returns during S&P 500 selloffs
0.74
0.75
-1.32
-0.59
-4.79 S&P 500
U.S. high Multisector Municipal High yield yield fixed income bonds muni bonds
Set your sights on stabilization in supply
A major driver behind 2019's knock-out performance was the powerful tailwind of net negative supply, i.e., when the total amount of tax-exempt debt that is called, refunded or reaches maturity exceeds the amount of new issuance. While this dynamic is typical and expected during certain times of each year, the seasonal periods of net negative supply were particularly extensive and robust in 2019.
We do not expect this trend to continue in 2020 as gross supply (new issuance) is likely to keep pace at a level that roughly replaces the debt that will be removed from the market via calls, maturities and redemptions. This more balanced environment allows for a healthy market, but it does not create the potential for spectacular returns like we saw last year.
Our strategy focus
We enter 2020 with a long duration stance (i.e., taking a higher amount of interest rate risk) given our expectation that the momentum from late 2019 is likely to prop up returns in early 2020. During the year, we will tactically pull back on duration as we see supply and demand balancing out, especially if rates are drifting modestly higher. Our preference for credit and unique structures (e.g., AMT bonds, lower coupons, etc.) coupled with our active participation in the primary market will fill the void of duration when seasonal trends turn less favorable. We believe additional taxable supply will attract more nontraditional buyers to the municipal market, while taxexempt issuance will continue to be absorbed by retail demand, which remains strong and focused on the many favorable characteristics of the asset class.
Source: Morningstar, as of 12/31/19. Data represents average returns for 13 months since 2010 in which the S&P 500 Index declined more than 2%. The S&P 500 Index is a widely accepted measure of large-cap U.S. stock performance. Performance of U.S. high yield represented by the Morningstar High-Yield Bond fund category average; multisector fixed income, Morningstar Multisector Bond fund category; municipal bonds, Barclays Municipal Bond Index; high yield muni bonds, Barclays High Yield Municipal Bond Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
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Keep an eye on the news
State and local governments could come under pressure this year if the U.S. economy slows enough to constrain revenues from sales and income tax receipts. Pension underfunding for a handful of high-profile issuers remains a significant concern, and this risk will become more evident should equity markets decline. At the local level, property tax receipts tend to perform relatively well during a slowdown; however, local governments often bear the brunt of state spending cuts. We prefer revenue bonds over general obligation bonds as the latter can be vulnerable to risks stemming from state and local budget negotiations.
The high yield municipal market remains an important driver of returns. In 2019, the S&P High Yield Municipal Bond Index returned 10.8%, compared to 7.3% for the broader S&P Municipal Bond Index. Outside a major slowdown in the U.S. economy, we anticipate high yield will outperform again, albeit to a much lesser extent. Lower rates and limited supply provide a tailwind for real estate related sectors, and municipal tobacco bonds should benefit from dwindling supply if issuers are able to refinance existing bonds and attain investment grade ratings on their new bonds. In the non-rated space, however, we are concerned about the lack of bondholder protection and subpar credit underwriting standards for highly leveraged projects. We remain constructive on high
yield overall. Despite currently tight credit spreads, the sector provides significant diversification benefits, high levels of income and the potential to be rewarded for superior security selection.
Cyber security risks are an increasing concern for investors. Nearly 1,000 state and local governments, healthcare providers, universities, colleges and school districts were victims of cyber-attacks in 2019, according to security firm EMSISOFT. The outcomes of these attacks vary, but almost always require heavy investments in technology and security software. Rating agencies incorporate cyber risks into their analyses including such factors as vulnerability, preparedness, policies and procedures, technology investments and infrastructure, and insurance coverage.
Impact investing is growing in popularity. This refers to investments made into companies, organizations, and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return. We believe the municipal market is likely to attract impact investors given that a large portion of muni bonds are issued to finance projects that benefit the public at large and are aligned with the United Nation's sustainable development goals.
New Year's resolutions for municipal investors: actions you can take in 2020
1. Be invested. If you have cash sitting on the sidelines, you've been missing out on the consistent stream of income provided by municipal bonds. A buy-and-hold approach provides better potential for total returns, which we expect will be composed largely of coupon return this year.
2. Be flexible. The municipal market will be more challenging this year. Investors will need to be agile and move quickly around interest rate, market structure, credit and tax regime changes.
3. Be diversified. Consider using municipal bonds as a ballast for equity risk in your portfolio. Exposure to high tax states, revenue bonds and high yield prove beneficial for income generation within a well-rounded municipal allocation.
4. Be cautious. Don't be blind-sided by emerging risks such as the proliferation of cyber-attacks on public entities. Keep abreast of current events that pose a threat to your portfolio.
5. Be opportunistic. Look for investments that could benefit from growing trends. Municipal bonds issued to fund projects that provide social or environmental benefits could get a boost from the rising popularity of impact investing.
You can pursue all of these goals with one investment in a flexible municipal strategy. Learn more at .
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Why BlackRock municipal funds?
Platform depth and scale
As the world's largest muni bond manager, we have direct access to rating agencies, sell-side research
and municipal issuers.
Credit research
Our analysts challenge the credit rating agencies to ensure that BlackRock's mutual funds are
holding the most suitable credits.
Risk management
BlackRock's risk management technology, Aladdin?, helps
anticipate risks in different market scenarios, so we can be better prepared for the unexpected.
Want to know more?
Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income from tax-exempt bonds may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 13, 2020, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader.
?2020 BlackRock, Inc. All Rights Reserved. BLACKROCK and ALADDIN are registered trademarks of BlackRock, Inc. All other trademarks are those of their respective owners.
Prepared by BlackRock Investments, LLC, member FINRA.
Not FDIC Insured ? May Lose Value ? No Bank Guarantee
Lit No. MUNI-OUTLOOK-0120
OE41916T-0120
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