Municipal Bond Outlook:

Still Upbeat as Infrastructure Legislation Progresses

Joe Gotelli and David Moore | October 2021

Key Takeaways

  • Municipals outpaced other U.S. bonds year to date through July 2021 amid a still-solid fundamental backdrop.
  • Demand for tax-advantaged municipal bonds remains robust, as investors expect massive federal spending plans to lead to higher taxes.
  • Infrastructure and budget bills working their way through Congress should bode well for the broad economy and the municipal bond market.
  • COVID-19’s trajectory and central bank policy remain key risk factors we’re monitoring.
  • California’s economy faces state-specific challenges from wildfires and drought. But like other states, a strong fiscal backdrop continues to support a positive outlook for the Golden State’s municipal bonds. 

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.

Infrastructure and Budget Price Tag Should Bolster Demand for Tax-Exempt Munis

Biden’s companion piece, a $3.5 trillion budget package, includes funding for the traditional infrastructure bill along with a variety of social and climate programs. This bill recently passed the House of Representatives on a partisan vote.

What we don’t yet know is how the country will pay for nearly $5 trillion in new spending. Depending on the funding mechanisms—including potentially higher taxes for corporations, individuals and investors—this bill likely will drive demand for tax-advantaged municipals.

More Muni Market Perks May Be in the Works

We had expected the infrastructure bill to include provisions for alternative municipal financing programs. These include direct pay bonds (similar to the Build America Bonds program where the federal government subsidized interest rates) and tax-exempt advance refunding bonds (a way for municipalities to refinance existing debt).

We also hoped the bill would eliminate the $10,000 cap on state and local tax (SALT) deductions. (See Infrastructure and Tax Proposals Lift Muni Market’s Profile.) But the Senate version of the bill did not include these items.

This doesn't necessarily mean the market is at a disadvantage. We've seen strong growth in the taxable municipal bond market, which issuers are using to advance refund tax-exempt debt. We’re also seeing expanded use of private activity bonds, which allow for private capital to fund select public projects, such as airports.

We remain optimistic that legislators will consider direct pay bonds, tax-exempt advance refundings and SALT deduction revisions over the next couple of months. These programs ultimately may find their way into the Senate’s budget reconciliation process.

California Is Still a Muni Bond Standout

Performance patterns, spread movements and investor interest in California’s municipal bond market have generally tracked national trends. The state’s fiscal backdrop is also strong, which has helped fuel market gains.

Benefiting from Revenue Windfall

California has enjoyed better-than-expected revenues. For example, general fund revenues for fiscal 2021 were approximately 50% higher than anticipated. Additionally, the state’s rainy-day fund remains well funded.

The state’s fiscal 2022 budget continues to inspire confidence from a credit perspective. Officials are set to use 85% of the state’s revenue windfall on one-time items. And the recurring spending will phase in over several years.

Furthermore, most of the state’s $27 billion share of the federal American Rescue Plan remains unspent. This factor bolsters our view that California is well positioned for near- and long-term challenges.

Overcoming Natural Disasters

With the recall election now decided, the state can focus on other issues pressuring its economy—wildfires and drought. Here’s our take on how these challenges may affect California’s municipal bonds:

  • Wildfires. There’s never been a municipal bond default in California or any other state from a wildfire or other natural disaster. Most municipal credits have good liquidity positions, which allow issuers to get through the initial disaster phase while awaiting federal assistance and insurance payments. Additionally, among the muni sectors affected by wildfires, our portfolio teams carefully evaluate each security’s risk/reward tradeoff.
  • Droughts. California has a long history of managing droughts. The state has already set aside funds to enhance its water supply. Our research suggests large water providers currently have capacity to meet demand levels for two to five years.
  • Recall election. Gavin Newsom (D) recently overcame his recall challenge and will remain governor for at least another year. In the wake of the recall, it’s important to note the budget surplus remains intact, and many of the state’s financial practices remain institutionalized. Legislative gridlock may be on the horizon, though, given the next general election is only a year away in November 2022.

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