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Seeing opportunity in taxable muni issuance

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      By Brian C. Barney, CFAMunicipal Portfolio Manager, Eaton Vance Management

      New York - The municipal bond market is witnessing the biggest surge in federally taxable muni issuance since the Build America Bonds program expired in 2010.1 Over the last five years, taxable supply has accounted for roughly $30 billion annually. This year's total could double that pace, with over $60 billion expected by the end of 2019. And most of this debt has just been issued during the past few months.

      Federally taxable municipal issuance climbing in 2019taxablemunischart1update

      Source: Bloomberg as of December 3, 2019. Eaton Vance estimate of $10 billion issuance for the rest of 2019 based on conversations with leading underwriters.

      Issuers choose to borrow on a taxable basis and pay a higher interest cost relative to tax-exempt issuance for a variety of reasons, but primarily because it allows for more flexibility in the use of loan proceeds. For example, taxable municipal debt could be used for working capital, to finance for-profit infrastructure or development — that is, private business use — or to bolster unfunded pension plans.

      Cost savings on existing debt

      We can attribute the recent spike in taxable issuance to cost savings on existing debt. As part of the Tax Cut and Jobs Act (TCJA) of 2017, municipalities lost the ability to advance refund — or refinance — outstanding tax-exempt debt with new tax-exempt bonds at lower cost. However, the law still allows for refinancing to occur with new issuance of taxable debt instead.

      Given the dynamics of low interest rates in both taxable and tax-exempt markets, along with a flat U.S. Treasury yield curve, issuers are finding great savings by refinancing outstanding tax-exempt debt with taxable debt.

      For example, on November 11, the State of Texas sold $705 million of taxable refunding bonds on behalf of its Texas Transportation Commission. The proceeds of this sale were used to purchase U.S. Treasury securities, which were deposited into an escrow account that will pay interest and principal for debt issued in 2012 until the first call date on that older loan. In this advanced refunding process, the interest costs on the new taxable debt are lower than the outstanding interest costs on the existing tax-exempt debt. By bringing down its overall borrowing costs, Texas has been able to realize large savings.

      Cheaper valuations for taxable munis

      As a result of the increased supply, taxable muni yields and spreads have increased relative to U.S. Treasuries and U.S. corporate bonds. According to Bloomberg data, 10-year AA-rated taxable munis (yielding 2.56%) have a spread to U.S. Treasuries that's 19 basis points (bps) wider than similarly rated U.S. corporates (yielding 2.37%). We feel this could present an opportunity for investors to add incremental yield and diversify credit exposure.

      Spreads of 10-year AA taxable munis over 10-year US Treasuries have widenedtaxablemunischart2update

      Source: Bloomberg as of December 3, 2019. 

      Bottom line: Taxable munis are becoming a larger part of the issuance in the municipal bond market. This phenomenon is presenting opportunities for both institutional and individual buyers who value high credit quality, diversification and attractive income as compared to other taxable fixed income sectors.