Why the explosive growth of taxable munis could be sustainable
The issuance of taxable municipal securities leapt to record levels in 2019 against a post-advance refunding backdrop of historically low rates and heightened interest from an expanding pool of international investors.
The exponential surge of such issuance in the past three months could signal an even larger boom for this asset class on the horizon, leading some market participants to question the future shape of the municipal securities market and the impact of ballooning taxable issuance on tax-exempt financing.
Through the end of October, $46.2 billion of taxable munis have been sold, representing 14% of total issuance. This is both the highest par amount of taxable debt issued and the largest market share of taxable muni issuance since Build America Bonds inflated both in 2009 and 2010. If BABs are eliminated from the taxable total and market share in those years, the 2019 figures are the highest on record.
But much of the 2019 spike has come in the second half of the year. After $13.6 billion of taxable muni issuance in the first half of 2019, $16.6 billion of taxable debt was brought to market in the third quarter, followed by $14.5 billion in October alone, according to Refinitiv data. Through the end of October, more taxable muni debt has been issued in the past four months than in the entirety of four of the past five years.
While taxable muni issuance this year has already broken records, the magnitude of the second half surge has some market participants believing that we’re only scratching the surface of how big a piece of the pie taxables can ultimately take. In fact, Bank of America Merrill Lynch is forecasting the taxable muni market to not only exceed $60 billion of issuance this year, but balloon to $105 billion in 2020. While this is an aggressive estimate, should it come to fruition, taxable munis would represent about a quarter of the total municipal market.
Taxables have maintained a steady presence in the overall municipal market since the sunset of the BABs program, eclipsing $30 billion of issuance in all but one year. And since 2002, at least $24 billion of taxable munis have come to market each year.
“Taxable sales create a balance in the marketplace, in a sense, by letting municipal issuers explore different channels of distribution,” said Hector Negroni, founder of Fundamental Credit Opportunities. “It demonstrates that our marketplace can be expanded beyond the narrow profile of tax-exemption and broadening demand ultimately improves efficiency.”
But what’s driving a spike of this magnitude?
According to market participants, it’s a confluence of factors, including the elimination of the popular advance refunding tool in the 2017 tax cuts, the historically low rate environment that shows no signs of abating, and, perhaps most significantly, growing interest from a wide variety of international investors in taxable U.S. municipals.
“The demand base globally is very strong,” said James Pruskowski, head of institutional and wealth management for municipals at BlackRock, who has traveled the world educating investors about this asset class.
“The international regulatory environment, particularly Basel III, Solvency II and the Sustainability Development Goals adopted by most U.N. member countries, are of the some key reasons behind global investors’ interest,” Pruskowski said.
Banks and life insurance companies throughout Asia, the U.K., and Germany are new adopters of the asset class in recent years. Interest is also growing in the Nordic region, he said.
“The combination of the growth in supply of negative yielding assets globally and the strong dollar makes the U.S. one of the best opportunities for bond investors,” Pruskowski said. “The steady growth in taxable muni supply in recent months provides a window of opportunity for investors to enhance strategies at corporate equivalent yields.”
William McEvoy, chief financial officer at Boston-based national broker/dealer and registered investment advisory firm Cantella & Co., noted “increased demand for taxable municipal debt in the past few months as investors around the globe clamor for any incremental yield.”
McEvoy said he expects this demand to continue, “if not increase.”
“If the economy shows any further signs of slowing, or even slips into a recession,” he said, “corporate balance sheets will come under enhanced scrutiny, leaving the possibility of rotation from investment grade corporate debt into the taxable municipal space.”
Patrick Brett, managing director and head of municipal debt capital markets at Citi, has been following the taxable trend and international investment since he started Citi's London municipal desk in the mid-2000s, a desk that is still staffed to the present day.
"Taxable issuance is here to stay,” Brett said. “Obviously it will ebb and flow with the Treasury market, and it may not be as high as it has been the past few months, but international investors had already been getting more active over the past two years and of course even more so back in the heyday of BABs."
The taxable municipal securities market was essentially created by the 1986 tax reform through the establishment of the private activity bond cap. It was, however, a minor component of the overall market through the turn of the century, failing to account for even 10% of muni issuance until 2003, when a $10 billion Illinois pension obligation deal helped push taxable issuance to $41.1 billion, which stood as the non-BAB taxable record until last month.
International interest in taxable municipals saw a significant uptick with the Obama-era Build America Bond program a decade ago, which provided issuers the opportunity to offer taxable municipal debt with a federal subsidy of as much as one-third. Over the two years of the program’s existence, $182 billion of BABs were issued.
To market these assets, major shops held international roadshows touting these securities and, in the process, familiarizing international buyers with U.S. munis.
Today, they continue to do so with fully taxable muni bonds.
"This market is too big to ignore,” Brett said. “If you are ignoring it you're getting short that part of your benchmark. It kind of forces investment grade investors to pay attention. They are becoming much more important in terms of order books."
Despite this, a sentiment exists among a minority of market participants that a successful taxable muni market could threaten the long-term future of the tax-exempt market, perhaps signaling to Congress that the muni exemption could be a target. However, most agree that the benefits seen from the taxable marketplace — such as the vastly expanded pool of investors and an enhanced ability to take advantage of low rates and attractive muni-Treasury ratios in a post-advance refunding world — outweigh those risks which, to date, have no basis in reality.
Some issuers find the taxable approach so viable that they have gone all-in with it as a strategy. The Cities of Dallas and Fort Worth, Texas, opted to ignore the alternative minimum tax bond market entirely when looking to refinance $1.2 billion of DFW airport debt earlier this year, instead issuing the entire deal as taxable debt directly marketed to international investors. The sale netted international orders equal to 40% of the par offering, and the issuer plans to use taxable debt over AMT issuance for its entire $10 billion capital program.
Though there’s risk that the appeal of taxable munis could fade with rising rates, many market participants expect rates to remain low in the near-term. And George Friedlander, managing partner at Court Street Group Research, believes that rates would have to move up “quite a bit” to quell the surge of taxable muni issuance.
“Issuers who fear further increases in rates will use taxable advance refundings when taxable yields are below older long muni yields,” Friedlander said.