January 3, 2017

Treasury yields are likely to drift higher in the first quarter as economic growth continues and may receive a boost in the near-term from the recently passed tax reform legislation.   We believe increases in yields will be modest because inflation remains low and U.S. interest rates continue to be attractive relative to other developed market sovereign yields which spurs demand from foreign investors.  While corporate bond yields have compressed, we believe they could narrow further as provisions of the tax reform discourage debt issuance and repatriation of cash stranded overseas could reduce the need for new issuance.  We continue to maintain a duration in our Clients’ bond portfolios that is shorter than the bond indices and to favor high quality intermediate corporate bonds.

Tax reform has also had an impact on the municipal bond market.  A lower corporate tax rate is likely to reduce demand from crossover buyers such as insurance companies, while the limitations on state and local tax deductibility (SALT) increase the attractiveness of municipals for high income individuals.  In addition, the threat of eliminating the tax exempt status of private activity bonds and advance refundings prompted heavy issuance in the fourth quarter.  This issuance was met with strong demand, resulting in the ratio of a Aaa-rated 10-year General Obligation municipal bond yield to a 10-year Treasury yield declining in the fourth quarter to 84%.  While the final version of the bill preserved private activity bonds, advance refundings have been eliminated and thus issuance in the first quarter is likely to be slower, supporting the low muni-to-Treasury yield ratio.