HOUSE_OVERSIGHT_014601.jpg

Exhibit 81: Municipal Bond Mutual Fund Flows The pace of outflows at the end of 2016 was surpassed in recent history only by the 2013 taper tantrum. 4-Week Rolling Average, $ bn 3 | +l ll ey . | 4 2007 =2008 §=2009 2010 2011 2012 2013 2014 §=692015 = 2016 Data through December 31, 2016. Source: Investment Strategy Group, ICI. Exhibit 82: Annual Municipal Bond Returns Since 1994 Intermediate municipal bonds experienced a rare loss in 2016. Ranked Annual Returns (%)} lta. LO a fez) S a o i a fez) 2002 2000 2011 2009 998 2001 2007 2014 996 2003 2008 2006 2012 2010 2004 2015 2005 1999 2016 2013 1994 Data as of December 31, 2016. Source: Investment Strategy Group, Barclays. only add to existing concerns about pension funding levels. While there is clearly no shortage of risks, the silver lining to last year’s rout is that we begin 2017 with a much larger valuation buffer to help absorb them. As seen in Exhibit 83, the ratio of municipal yields to Treasury yields is above average for both 5- and 10-year maturities. In turn, investors can currently earn an extra 70 basis points of after-tax yield by owning five- year municipal bonds instead of same-maturity Treasuries—a yield pickup more than double the post-crisis median of 31 basis points. Moreover, this incremental after-tax yield would still be around 50 basis points if the top individual tax on investment income were reduced by 10 percentage points—from 43.4% with the Affordable Care Act (ACA) tax to 33% under new policy recommendations. In short, municipal spreads currently offer a potential offset to rising rates and potential tax changes. Also keep in mind that municipal fundamentals remain stable. Major state and local tax revenues have continued to increase at a moderate 3% pace, which should be supported by the above-trend US economic growth and rising home prices we forecast. Meanwhile, governments have exercised restraint on capital spending. Consider that net issuance expectations of $30 billion for 2017 stand well below the pre-crisis 10-year annual average of $110 billion.'!5 This restraint has not only kept net supply low—as new issuance has been largely offset by maturing debt—but has also helped municipal finances. Ratings trends have improved as a result of both stable revenue and spending discipline, with upgrades in the Moody’s universe seeing a notable uptick in last year’s third quarter (see Exhibit 84). Of course, underfunded long-term pension liabilities remain a source of concern. But with aggregate funding levels holding steady at around 74%, we do not think this will be a primary focus in 2017, particularly given last year’s increase in stock prices. While rising equity values will do little to remedy municipals’ inadequate funding contributions, they will help increase the value of pension assets. Moreover, these medium-term concerns are not the primary driver of recent municipal bond weakness. After all, today’s funding levels are no worse than they were in October of last year, a time when municipal bonds were enjoying some of their best returns ever. All told, we expect intermediate municipal strategies to gain about 1% in 2017. With this return close to that of cash but with more downside potential, we still think it makes sense for clients to fund various tactical tilts from their high-quality municipal bond allocation. This recommendation is motivated primarily by rate risk and not credit concerns, since we expect municipal defaults to be rare events. Outside tilt funding, we recommend clients target their 68 | Goldman Sachs | JANUARY 2017 HOUSE_OVERSIGHT_014601