Cumberland Advisors Market Commentary – Muni Bonds Turn Toward the Election

Author: John R. Mousseau, CFA, Post Date: October 6, 2020
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With the presidential election a month away, we start to mull over what the bond market might look like post-election day.

Market Commentary - Cumberland Advisors - (Mousseau)

While most polls have Vice-President Biden ahead by 6–7% points, we know the race has the potential to be much closer, since the 50 individual states decide the election by virtue of voting by state through the Electoral College.

Here’s a quick view of the markets at the start of the quarter and the end of the quarter.



Source: Bloomberg

 

As you can see, there was very little movement during the quarter. The 10-year and 30-year Treasuries were up 3 basis points during the quarter, and 10-year and 30-year AAA tax-free munis were down 7 and 8 basis points respectively, so we saw a decline in the muni-to-Treasury yield ratios during the quarter.  This trend is also a function of the overall market’s feeling better about muni credit the further we move away from the pandemic days of last spring.

Bond volatility in general has crept lower. As we can see below (courtesy of Bianco Research), bond market volatility has dropped precipitously since the upheaval of March 2nd.

 

One thing 2016 taught us is that an unexpected result can change the status quo very fast. Below is a chart of the Bond Buyer Index after the 2016 election. The sharp rise in longer muni rates was caused by expectations of cut taxes, infrastructure spending, and inflationary pressures. All of these concerns helped spur bond fund redemptions and higher yields, presenting, as we know from past experience, a buying opportunity.

 

There are a few assumptions we are making if there is a Biden win after November 3rd.

Higher taxes. The former vice president has not been shy about saying that he will raise taxes on the wealthy. And given the current deficit, which has grown since the onset of COVID-19, there is a good case to be made that marginal federal tax rates may rise at some point even if President Trump is reelected. Here is a yield chart of AAA munis from last week.

Source: Bloomberg

 

We take the existing AAA yield curve and calculate the taxable equivalent yield of the current top federal marginal tax rate of 37%, and then we boost that rate to the old (pre-2017) tax rate of 39.6% and then 41% and 43%. For longer municipal bonds the bump up in taxable equivalent yields is the greatest at the highest coupon levels. And even now, many bonds trade at rates much higher than the AAA curve. For example, many muni bonds are yielding 2–2.25%. A 2% tax-free yield has the taxable equivalents of 3.17, 3.31, 3.39, and 3.51 at the above tax rates. These taxable equivalent yields are SIGNIFICANTLY higher than taxable alternatives are. A higher marginal rate should also flatten the muni yield curve over time as the demand for longer-dated paper increases because of the benefits it provides on a taxable equivalent yield.

The offset to that calculation is that clarity of knowing who the next president is may provide a platform for some higher interest rates at the margin. The chart below shows the difference between 10-year Treasury bond CORE inflation, as measured by the Consumer Price Index less food and energy.

 

We have been at negative REAL yields for a while. But, as in 2016 when Brexit forced the bond market to negative real yields, the resolution of the politics could change expectations to higher levels of spending and potential inflation. We feel this will be potentially true if the US Senate goes Republican and the Democrats have the White House, House of Representatives, and the Senate all in the same camp. More fiscal stimulus, more deficits, and an immediate infrastructure program are all strong possibilities if we get the Blue Wave that sweeps the White House, House, and Senate all into the Democratic column.  We think markets will take notice and start to price in this potential— possibly before election day. Of course, there are lots of issues between now and then– the health of the president and Mrs. Trump, the uncertainty of future debates, and the uncertainty surrounding many swing states in the election.

How do we prepare for this?

We start to take some profits on bonds bought during the sell-off in March; we start to let matured bonds lie fallow in some short-term paper for a month or so; and we do the same with called bonds. In other words, we try to dampen down the duration or price risk of the portfolios at the margin.

On the credit side of things, we remain vigilant. Though municipal governments could use another stimulus package, the economy’s opening up – even as we start to reach a COVID vaccine – is crucial.  There is no question that the opening of the economy on the state and local level is just as important as any stimulus. The pace of increased economic activity is key here. We have seen some downgrades to municipal issuers; and this, of course, is to be expected. But the changes have been anything but a free fall in ratings, and that is because most municipal governments were in fairly good shape entering the pandemic.

An election with a clear winner, if that is what unfolds, will be a harbinger of higher rates down the road and will start to get interest rates back into the positive REAL category, where they have spent most of their time historically.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
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