Municipal Bond Views 2Q 2021
Themes and portfolio implications for 2Q 2021
- Municipal bond market fundamentals are stabilizing faster than expected, boosted by three significant fiscal stimulus programs.
- Technicals are starting to become more balanced moving into spring, but tax season may be less pronounced than usual because the deadline was extended.
- Municipal valuations have been stretched and volatile; we expect continuing ratio volatility, given the potential for tax rate increases, changes in state and local tax (SALT) deduction caps, advance refundings and with a federal infrastructure bill in the early stages.
- Credit spreads have been tightening; a credit cushion will help offset some of the rise in rates.
- Investors may want to maintain municipal allocations amid strong fundamentals and potentially higher tax rates, and should consider adding duration as rates rise.
FUNDAMENTALS ARE STABILIZING; VALUATIONS MAY BE VOLATILE
MARGARET BYRNE: Rick, the American Rescue Plan Act of 2021 (ARP) provides significant support to municipal issuers. How will the stimulus affect state and local municipal credit?
RICHARD TAORMINA: The ARP is a significant positive for state and local credit. We expect the ARP to mend balance sheets and keep state and local governments from being a drag on economic recovery. Credit stability is coming faster than the market expected. We are no longer anticipating mass downgrades, especially since the ARP supports municipalities directly and indirectly.
If we take a step back, though, municipal issuers have once again been unbelievably resilient and done a very good job managing—during the years leading up to the pandemic and through it. During lockdowns, they went to work balancing budgets, often relying on record-size rainy day funds. Municipalities belt-tightened right away, using a range of levers to mitigate revenue declines: hiring and pay freezes, furloughs and spending cuts.
These actions could become a drag on the economy. But municipalities can be thankful for the speed with which the federal government and the Federal Reserve stepped in over the last year with three significant, unprecedented and much-needed aid packages. The $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act alone let nearly $350 billion flow directly to municipal credits. Along with stimulus checks and increased unemployment payments, this resulted in better than expected revenue performance.
The March 2020 CARES Act was followed by December’s $900 million coronavirus aid package. Then, in mid-March 2021, the massive ARP passed, providing $195 billion to state governments and $130 billion to municipalities. In addition, schools, which faced reduced state aid and rising reopening costs, will receive over $125 billion. Another $40 billion is earmarked for higher education, $30 billion for mass transit and $8 billion for airports. This package was not restricted to COVID-19-related expenses (as the CARES Act was), allowing issuers to replace lost revenue and offset a range of negative economic impacts from the pandemic.
Keep in mind that belt-tightening and the use of record reserves helped whittle down aggregate state budget deficits. But the pandemic played out differently across the economy and society: High wage earners stayed employed, paid income taxes and spent money, which for many states—particularly those with a personal income tax—meant tax collections higher than anticipated, in some cases at pre-pandemic levels. But states and localities reliant on the lower paying service sector, and on tourism-based industries, were hurt.
Looking forward, the stimulus will generally help issuers avoid further cutbacks and layoffs, and may even position state and local governments to provide more of an economic boost than markets are currently anticipating.
MB: Over the past few months, a severe supply/demand imbalance took municipal yields to historically rich levels vs. Treasuries. Do you think that this imbalance will persist over 2021?
RT: The relationship between municipal bonds and Treasuries depends on many factors, including technicals, seasonality, interest rates and, more recently, the potential for additional federal stimulus.
Typically, in the municipal market, technicals primarily determine valuation. On the supply side, we saw reduced issuance from November through February, while demand remained strong. Issuers pulled forward supply in October to get ahead of the election uncertainty. And remember, issuance is typically lower in January and February as issuers plan their year’s financings—particularly this year, when issuers waited to see if additional stimulus would impact their financing needs.
With seasonality, the muni market is typically under more pressure during tax time as individual investors pull money to pay taxes. With the deadline now extended a month, we may see that cheapening start a little later and even get muted by the typically strong summer technicals (when demand from reinvestment of principal and interest payments supports the market).
Demand has remained strong for three reasons. One, expectations that tax rates will rise. Two, support from the reinvestment in January and February of over $60 billion in interest and principal payments. And three, the large amount of cash still on the sidelines. Interest rates, however, are a wild card. If rates suddenly jump, potentially spurring an outflow cycle, that could cheapen the market.
In our view, volatility in valuations will likely persist this year. Supply, demand, interest rates and federal programs and changes being discussed could create periods of volatility that we will look to exploit.
MB: Credit spreads widened significantly last year. Has that trend entirely reversed, and how do you view the relative attractiveness of higher vs. lower quality credits?
RT: High quality credit did extremely well in 2020 (EXHIBIT 1). Municipalities benefited from both direct and indirect stimulus aid. At the onset of the pandemic in March 2020, we did an extensive analysis of the industries, sectors and issuers most likely to be affected by the pandemic and created a Covid Resiliency Score that helped us identify strong issuers being improperly penalized.
Credit spreads are fast approaching pre-pandemic levels
EXHIBIT 1: CREDIT SPREADS (BPS) OVER MMD* 30-YEAR MUNICIPAL AAA GO
Spreads on high quality paper tightened first. With no support from flows, lower rated credits lagged until inflows into high yield funds picked up in the last quarter of 2020 and into this year. We generally added credit across the platform. Spreads are now almost back to pre-pandemic levels on lower rated credits and should continue to tighten, given expected economic strength and stronger municipal fundamentals.
MB: Can we talk about some potential changes—advance refunding, infrastructure, the SALT cap and tax rates? How might they affect supply, demand and valuations?
RT: A number of proposals by the Biden administration could markedly affect the municipal market. Stepping back for a moment, the Tax Cuts and Jobs Act of 2017 that overhauled the tax code prohibited municipal issuers from using tax-exempt debt to advance-refund existing tax-exempt debt. As interest rates fell in mid-2019, issuers realized that they could advance-refund using taxable municipals. If this prohibition is reversed—depending on the level of interest rates later this year—tax-exempt issuance could rise.
A federal infrastructure program could substantially increase municipal supply. If it’s designed like the Build America Bonds program, we could see an uptick in taxable municipal supply. It depends on the size of the subsidy and the relative value of municipals vs. Treasuries at the time. And with improving credits, issuers may be more willing to issue debt for much-needed infrastructure.
We saw demand jump after the SALT deduction was capped at $10,000, as taxpayers flocked to the municipal market to take advantage of one of the few tax shelters still available. Raising or eliminating the cap has been a high priority for higher tax states.
As for taxes, there’s been talk of increasing taxes on individuals earning over $400,000. Corporate tax rates may increase from 21% to 28%. Overall, with tax increases likely, tax-exempt supply possibly becoming constrained and fundamentals receiving a shot in the arm—it’s all pretty good news for the municipal market.
We believe that it’s still crucial to have the market experience to identify value, combined with in-depth credit analysis, to ensure that the credits in portfolios are resilient.