Municipal Bond Views
Themes and implications for 3Q 2021
- Strong technicals, rapidly stabilizing fundamentals and potentially higher tax rates will keep municipals in a steady state despite historically rich ratios and tighter spreads.
- Summer technicals are especially positive this year; issuers are factoring stimulus payments into their budgets and pondering the uncertainties of an infrastructure program and the potential for tax-exempt advance refunding.
- Credit, back to at least pre-pandemic spreads, will likely continue to perform well, given solid fundamentals, a strong economy and massive government support programs.
- Fiscal stimulus has provided a windfall to municipalities that more than offsets lost revenues over the past year.
- Maintain municipal allocations and consider adding duration when rates rise, but for now, watch your coupons.
Municipals look poised for continued strong performance
Municipal market performance has been strong and should continue to benefit from positive technicals and fundamentals. We are monitoring the effects on supply and demand from potential tax hikes, tax-exempt advance refundings and the infrastructure program.
MARGARET BYRNE: Rick, municipals have had an exceptional year, outperforming Treasuries across the curve, reflected in the richness of the municipal-to-Treasury ratio. Municipals also outperformed compared to the broad taxable market, returning an astonishing 275 basis points over the Agg [Bloomberg Barclays U.S. Aggregate Bond Index]. Can you discuss what’s driving this outperformance?
RICHARD TAORMINA: The market has really benefited from a number of important factors, including policy, strong technicals and improving fundamentals.
From a policy perspective, we have two tailwinds, both tax related, impacting flows into the market. This year alone, we’ve seen one of the strongest year-to-date periods on record, with over $60 billion flowing into municipal mutual funds (Exhibit 1).
Flows into municipal mutual funds have been steady and positive
Exhibit 1: Municipal mutual fund flows
The Tax Cuts and Jobs Act of 2017, which eliminated the state and local tax [SALT] deduction, spurred a municipal bond buying spree. Starting in 2019, when over $93 billion flowed into municipal mutual funds, investors turned to the muni market as one of the last remaining tax shelters. Additionally, this year there is the expectation that, to help pay for some of the Biden administration’s upcoming stimulus programs, the top personal income tax rate will increase from 37% to 39.6%.
Technicals are really strong, especially now. From June through August, we anticipate about $125 billion of issuance. At the same time, we estimate that as much as $165 billion of maturing principal and interest payments to investors will likely be reinvested into the market. In other words, we are starting with net negative supply of $40 billion to $50 billion against a strong wave of inflows.
State and local governments are finalizing their budgets this year and have a lot to consider. The American Rescue Plan [ARP] Act of 2021 provides for $350 billion in stimulus money to states, local governments and tribal governments. States alone will receive $195 billion and are evaluating how best to use these unprecedented federal stimulus dollars. They are prohibited from using the money for tax cuts or to fund pensions. What we’ve seen so far is that some states are restoring government services, sending checks to residents and/or shoring up unemployment trust funds, all of which should be positive for local economies.
Municipalities are also weighing the possibility that tax-exempt advance refundings, which result in greater savings, will be permitted in future legislation.
An infrastructure program could have a pretty significant effect on issuance in both the taxable and tax-exempt markets. We believe a Build America Bonds [BABs]1-type program is likely—issued in the taxable market with a federal subsidy for qualified infrastructure projects.
MB: This all sounds good for municipal credit.
RT: Almost every sector has benefited from direct and indirect stimulus, and as a result, municipal credit has stabilized. Revenues were bouncing back even prior to the additional direct aid from the American Rescue Plan. The Wayfair decision—the 2018 U.S. Supreme Court decision expanding the ability to tax internet sales—and massive indirect federal aid played a key role.2
The ARP is providing stimulus to states that, on average, equates to almost 20% of their pre-pandemic operating revenue. That is substantial, especially when we consider that a well-funded rainy-day fund is in the range of 5%-10%.
In April, we moved our outlook for almost every sector to stable or positive. We even raised the outlook from negative to stable for states like Illinois and New Jersey, which were struggling prior to the pandemic.
MB: Everything sounds almost too good to be true. Is there anything you are particularly concerned about, either in credit or structure?
RT: Over the past few years, as interest rates have declined and remained low, there has been a significant increase in lower coupon issuance—I’m talking about 2% and 3% coupon bonds. These bonds have alluring yields vs. higher coupon bonds. However, if and when rates rise, these bonds could underperform dramatically. Not only is their duration longer than premium bonds, but they would also risk “falling out of de minimis,” and if they did, the discount would be taxed at the personal income tax rate, not the capital gains rate.3
Overall, we expect strong summer technicals and potentially higher tax rates, along with stable and improving credit fundamentals, to continue to support the municipal market.
1 Build America Bonds (BABs) were taxable municipal bonds issued with a federal subsidy as part of a program under the American Recovery and Reinvestment Act of 2009. The Build America Bonds program, which expired in 2010, was designed to help ensure that local municipalities and counties could raise much-needed capital following the 2008–09 financial crisis.
2 South Dakota v. Wayfair, Inc., No. 17-494 (U.S. June 21, 2018).
3 According to the Internal Revenue Service’s de minimis tax rule, when a discount bond is purchased at a price such that its discount is less than 0.25% of face value for each full year from the date of purchase to maturity, the accretion is taxed as capital gains. When it is purchased at a price at which its discount exceeds the de minimis threshold, the accretion is taxed as ordinary income.