Municipal bonds (munis) are tax-advantaged securities that state and local governments issue to fund public projects, such as roads and bridges. For active managers, the muni market is vast, diverse and brimming with opportunity. Portfolio Manager Joe Gotelli explains how delving deeper into the muni market—much more so than passive portfolios do—identifies attractive securities across sectors and the quality spectrum.
We view the muni asset class as a heterogenous market of individual bonds, rather than a group of homogenous securities. Therefore, we believe an active strategy, driven by fundamental credit research, is an ideal way to invest in this market. Our efforts are designed to expand and enhance the investments available to muni investors. Unlike passive investing, research-focused management allows us to leverage investment opportunities across sectors and quality buckets.
We combine a top-down overview with bottom-up analysis, as Figure 1 illustrates. Our top-down effort examines broad market influences, including economic growth, interest rates and the relative value of munis versus taxable fixed-income securities. This analysis helps us determine how much we allocate toward high-yield securities and higher-yielding sectors—weightings that coincide with our assessment of economic growth.
The bottom-up portion of the strategy includes sector, industry and security selection. Fundamental credit research guides this process, which then triggers relative value analysis and risk considerations. This research effort helps highlight market inefficiencies, or places where price and value are out of sync. We believe this analysis broadens investment opportunities versus passive alternatives.
Fundamental research expands our investment universe to include securities with higher yields, credits that are lower rated and market segments that may be less liquid relative to the highest quality munis. Investing in these riskier segments of the market requires a dedicated level of research to uncover promising opportunities and monitor their progress.
Although high-yield and lower-rated munis often exhibit greater volatility than investment-grade securities, they also may help mitigate other risks, such as interest rate sensitivity. We believe the higher rate of income from high-yield munis compounded over time can generate attractive total return potential for long-term investors.
Our management style enables us to respond quickly and opportunistically to changing and challenging market climates. This ability proved beneficial in 2020, as COVID-19-related economic shutdowns led to unprecedented volatility and a steep sell-off of credit-sensitive assets. Several sectors of the muni market, including bonds tied to mass transit, hotel tax revenues, student housing and hospitals, suffered severely. But, when market dislocations are sharp and quick, such as this one was, active managers seek to uncover value.
We worked diligently to gauge the credit implications of COVID-19. Based on this analysis, we identified sectors and securities where valuations were attractive. In our view, the fundamental long-term credit risks for many sectors and securities were not as dire as market conditions suggested, highlighting attractive buying opportunities. Ultimately, swift action from the Federal Reserve and the federal government restored market liquidity, and as the economy started reopening, many of these securities rebounded.
The muni market has recovered significantly from the March 2020 sell-off, but we believe portions of the market still offer value. In particular, lower quality munis (BBB rated and high yield) have not experienced the same magnitude of recovery as similar quality securities in the corporate bond market. We expect lower-rated munis to benefit from the reopening trends we expect to unfold as 2021 progresses, particularly as COVID-19 vaccines become more widely available. Overall, as the economy improves, we expect credit-related sectors and securities to outperform versus higher-grade munis.
With a new year and a new presidential administration, taxes have moved to the forefront for many investors. Raising taxes on high-income earners remains a priority for the Biden administration. However, passing a new tax bill given the current economic climate will be a difficult task. We expect other priorities to take precedence in the first year.
Nevertheless, given the history of the top U.S. marginal income tax rates, it’s likely taxes eventually will rise. As Figure 2 illustrates, there's plenty of room for federal marginal tax rates to increase. And for many investors, higher marginal rates only increase the value of tax-exempt income. Such a scenario likely would support the muni asset class.
Fortunately, the projections we saw in the early days of the pandemic for state tax revenues to plunge haven’t occurred. Through the first nine months of 2020, state tax revenues declined 4.4% in aggregate versus the same period in 2019, according to U.S. Census Bureau data. Local revenues were up nearly $30 billion for the period, largely due to stability in property and sales taxes. Combined state and local tax revenues declined only 0.7% for the nine-month period, compared with 2019.
Of course, states that rely more on tourism-based revenue are struggling more than others with diversified sources of revenue. Nevertheless, we don't expect a significant number of defaults among high-profile investment-grade issuers. For smaller entities, the impact of COVID-19 may be more lasting, and we expect some distress among select issuers through 2022.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Credit letter ratings indicate the credit worthiness of the underlying bonds in the portfolio and generally range from AAA (highest) to D (lowest).
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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