Strong Fiscal Backdrop Boosted Muni Performance, Demand
Through July 2021, the U.S. municipal bond (muni) market delivered strong performance, underscoring the resiliency we anticipated at the beginning of the year. According to Bloomberg, municipal bonds (taxable, tax-exempt and high-yield) significantly outperformed U.S. Treasuries and the broad investment-grade U.S. bond market.
Additionally, year-to-date flows into the asset class totaled approximately $80 billion as of July 31. These results represent one of the fastest periods of inflows for the asset class, according to Lipper.
Furthermore, investment-grade municipal bond spreads have recovered from recent volatility, compressing to pre-pandemic levels, according to Bloomberg. Much of the municipal spread recovery is due to fiscal and monetary aid, which helped boost the market’s fundamental backdrop. Concerns about potential higher capital gains and personal income tax rates have also helped, sparking record demand for tax-exempt municipals in the face of relatively flat supply.
Ratios of municipals to Treasuries, another measure of relative value, have moved higher. Investment-grade ratios became historically rich in June, meaning muni valuations were relatively unattractive versus Treasuries. However, that relative value has improved recently.
Record Revenues Promote Positive Credit Conditions
Record fiscal-year state revenues primarily account for our generally positive view toward municipal credit. The federal government’s $5.2 trillion in various federal coronavirus relief packages largely generated the better-than-expected revenues and record reserves. Because of this, we have stable to positive outlooks for all muni sectors expect private higher education, where we’ve been cautious for a while.
Additionally, the annual municipal bond default rate remains historically low, despite all the employment and economic challenges of 2020. According to credit rating agency Moody’s, only two Moody’s-rated municipalities defaulted in 2020, and neither default was associated with the COVID-19 crisis. Moody’s also reports that year-to-date municipal credit ratings upgrades are outpacing downgrades in a reversal of 2020’s trends.
Against the broad backdrop of low yields and rich valuations, a robust research effort helps identify opportunities. We are finding value among select investment-grade, high-yield and non-rated securities with attractive risk/reward characteristics.
Virus, Fed Policy Are Creating Uncertainties
When gauging the municipal market climate for the rest of 2021, the delta variant of COVID-19 remains a key influence. The trajectory of the virus and the success of vaccinations and treatment protocols will have implications for the economy and financial markets.
Federal Reserve (Fed) policy, particularly the central bank’s imminent tapering of asset purchases, is also a primary market driver. The Fed’s been signaling it will start scaling back its bond buying soon. The market’s reaction and how the Fed’s decision fits with policymakers’ assessments of employment and inflation remain factors we’re monitoring.
Federal Spending Specifics Still Unknown but Likely to Aid Municipalities
Congress continues to debate President Joe Biden’s two-pronged $4.5 trillion infrastructure and budget package. The first component is the $1 trillion American Jobs Plan that recently passed the U.S. Senate with bipartisan support. The bill includes $550 billion of incremental spending on traditional infrastructure projects, such as roads, bridges and public transit.
Given its attention to traditional infrastructure, the bill could have several positive implications for the municipal market. Specifically, we view the bill as a positive factor for municipal credit and the overall economy. The spending is slated to span five years, meaning $110 billion of federal money will flow into the economy each year.
State and local governments will be able to fund vital infrastructure projects without having to tap their own reserves or increase their debt levels. The range of infrastructure projects likely will benefit specific sectors of the municipal market. At the same time, each project’s purpose should enhance overall productivity, thereby boosting economic growth.