2018 Fixed Income Market Outlook

Craig Elder
Senior Fixed Income Analyst

What Has Changed

• Repeals the tax exemption of municipal advance refundings
• Repeals the authority to issue tax credit bonds, including NCREBs, QECBs, QZABs and QSCBs
• Lowers the corporate rate from 35% to 21%
• Introduces seven individual tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%
• Allows individuals to deduct up to $10,000 in income, property and sales tax
• Lowers the cap on the mortgage interest deduction to $750,000 for new home purchases
• Repeals the Affordable Care Act’s individual mandate
• Repeals personal exemptions
• Nearly doubles standard deductions
• Limits the interest deduction on business debt

What Was Maintained

• Maintains the tax exemption for private activity bonds (PABs) and sports stadium financing
• Doubles the child tax credit to $2,000, rather than repealing it

The tax cut bill announcement and then approval was swift and large. The financial markets were not expecting the introduction nor passage this quickly, which likely explains the volatility we’ve seen since the bill’s introduction on November 2. From a fixed income asset class view, the winners in this are municipal bond investors. Because of the supply limitations, investor demand will still be strong. Big losers are lower-rated, highly leveraged corporations (junk bond issuers).

Whenever something big like this happens to the municipal market, it’s always worth looking at the supply and demand equation. The elimination of the tax exemption for advance refundings is significant – Bloomberg estimates that it could cut supply by as much as one-third. That loss, coupled with the rush to market in November and December, will probably result in a sizable decrease in municipal supply in early 2018.

While supply in 2018 may be held in check, we do not believe demand for municipal bonds will abate, as individuals in the highest tax bracket – those most likely to purchase tax-exempt bonds – are still in a high tax bracket, and their ability to reduce their tax liability has been diminished by the new law. Mutual funds and money managers will still find the tax exemption attractive. If supply goes down and demand remains the same or increases, we think issuers can expect rates to stay on the low side – or at least not rise as significantly as Treasurys.

Lower-rated, highly leveraged corporations will have limitations placed on their interest deductions for their debt. Net interest write-offs will be capped at 30% of adjusted taxable income.

The decrease of the corporate tax rate from 35% to 21% will make munis less attractive among institutional buyers, such as banks and insurance companies. However, it’s hard to say how this will play out. Most corporations weren’t paying the 35% tax rate anyway, so we still believe that institutions, especially middle markets, will continue to find value in the muni market.

However, especially in the first part of the year, pricing in the muni market will probably be challenging and come with an increase in cost. According to The Bond Buyer, the number of bank loans and private placements will probably decrease, and existing municipal bank loans are likely to see higher interest rates if their loan documents have corporate tax gross-up provisions.

Alternatively, taxable municipal issuance will likely increase as an alternative to advance refundings, which brings alternative buyers such as foreign investors and crossover buyers.

Part of that was due to the tax reform saga that dominated the headlines, but we feel the Fed was so transparent with what they were going to do that investors were expecting rate hikes. Two weeks ahead of the meeting, the Fed funds futures were putting the probability of a rate hike at 95%. That kind of certainty leads to very few surprises that disrupt markets.

What’s interesting is that where the Fed was talking about four rate hikes in 2018, the FOMC dot plots (forecasts by Fed governors and regional Fed presidents) called for three rate hikes and the Fed funds futures just two.

First off, it’s hard to speculate what the Fed will do as the players on the field are still undetermined. The Fed chair, vice chair and some governor spots all are open at this date. Jerome Powell will be nominated to replace Janet Yellen as Fed chair, and most expect he will continue Chair Yellen’s somewhat dovish monetary policies, trying to spur economic activity through low interest rates. Somewhat counterbalancing Powell’s nomination as Fed chair, the president also nominated Marvin Goodfriend, who has something of a hawkish reputation, to the Federal Reserve Board of Governors. Also, the New York Fed president, Bill Dudley, is resigning in mid-2018 – he is considered somewhat of a dove.

When all is said and done, the thinking at this time is the Fed as a whole will be a little more hawkish than it has been, taking a more aggressive stance on interest rate policy. That said, if Jerome Powell, who has said he wants the unwinding of the Fed’s balance sheet to be “like watching paint dry,” takes the same attitude toward interest rate hikes, then four rate hikes in 2018 may be unlikely.

Another reason we have a tough time seeing four rate hikes next year is the lack of inflation. The PCE Core Index, the Fed’s favorite measure of inflation, was only 1.5% in November, which is well below the Fed’s target of 2%.

Why is this important? Short-term interest rates are driven by the Federal Reserve and where they set the Fed funds targets, while long-term yields are driven by future inflation expectations. As the Fed continues to increase the funds’ target rates, yields on the short end of the curve will increase. However, yields on the long end have yet to budge due to inflation remaining below the Fed’s target. With the short end moving up and the long end remaining flat, you end up with the flattest yield curve in about a decade, which discourages investors from investing in longer-term bonds. Currently, the slope of the yield curve (as measured by the two-year versus the 10-year Treasury) is 52 basis points – a normal slope of the yield curve is between 100 and 110 basis points.

I’ll give you Janet Yellen's answer during her last testimony before Congress: “That's something we haven't figured out yet.” We don't think anybody knows for sure. Normally, an unemployment rate of 4.1% signals that we are at full employment, which should result in some wage-driven inflation. But that’s something we have not experienced yet. As we mentioned above, core PCE inflation is the number to watch. Right now it is at 1.5%, which is still below the 2.0% Fed target rate, but it has been trending higher over the past three months.

You basically say stay fairly short – if we were doing a muni ladder, we'd focus two to 10 years out. This shows that we still fear duration risk more than we fear credit risk. In other words, we are more worried about interest rates going higher than we are about credit quality deterioration.

We think infrastructure could get done. Before running for office, President Trump was a developer – that's his industry. Plus there’s so much work that needs to be done. You can't wait 25 years to repair bridges. But here's the thing: Everybody wants new roads, everybody wants new bridges and if you're in a port city, everybody wants port improvements. But who pays for it? Are you going to get assistance from the federal government, something along the lines of the Build America Bonds program during the Obama administration? Can you make them tax-free? Is Congress going to agree to spend money on infrastructure? Those questions have yet to be resolved.

North Korea is the hot spot that causes the headline risk. However, businesses’ attention is primarily focused on trade. There are risks to having canceled the TPP, which was designed to combat China’s growing economic dominance. The NAFTA negotiations are very important as well, as are the Brexit talks in Europe.


In short, 2018 is looking like a year where you’ll want to spend time with your financial advisor and your CPA, as it is shaping up to be a year of change.