2020 was a strong year for municipal bonds, with the municipal market showing resilience after a difficult first quarter. While the economic backdrop remains challenging, we believe the U.S. economy is likely to rebound strongly in 2021, driven by vaccine rollouts and continued fiscal and monetary support. Even with a strong recovery, interest rates are likely to remain low, while inflation should stay below the Fed’s long-term symmetric target of 2%.
Much of this optimism is already priced into equity and credit valuations, although pockets of value still exist within the muni market. With Democrats now in control of both the White House and Congress, the coming year could bring material changes to the municipal market.
State and local government finances not as dire as feared
Despite economic stagnation and periodic lockdowns throughout much of the past year, state and local credit has held up relatively well throughout the pandemic – bolstered by monetary and fiscal support, as well as solid market fundamentals (see our blog “Making Sense of the Move in Munis”):
- Through September 2020, combined sales and income tax collections were down just 1% on a year-over-year basis in the U.S. – far less than original estimates.1
- Since the first quarter of 2020, personal income tax is down 1.6% compared with the same months in the previous year, but sales and use tax revenues are up.2
- Local government revenues are also holding up well and have been buoyed by a surprisingly resilient housing market, which bodes well for property tax collections. In the latter half of 2020, property values saw monthly increases of 9% over the prior year.3
How has state and local credit fared so well?
Part of the explanation lies in the composition of unemployment. While lower-income earners have borne the brunt of the pandemic, higher earners with the flexibility to work from home have done relatively well. That has led to stable revenue – particularly in states with progressive income taxes. For example, California, the largest state issuer of municipal bonds, is expected to have a cash cushion of around $30 billion to $40 billion for much of the coming fiscal year, and does not expect to borrow externally for its cash flow needs.
Additionally, fiscal support has included expanded unemployment benefits, which has helped to support tax revenues, while the significant post-spring rally in the equity market bolstered revenue from capital gains taxes.
Default rates should stay low, but downgrades are possible
As a result of January’s Georgia U.S. Senate runoffs, Democrats enjoy unified control of the legislative agenda, which means fiscal policy should remain supportive of municipal credit. Joe Biden’s presidency and a narrowly leaning Democratic Senate make additional state and local government aid more likely in 2021, while select revenue bond sectors could also stand to benefit. In fact, President Biden’s latest relief proposal allocates $350 billion in aid to state and local governments. Although this amount could eventually get whittled down, we expect material aid to eventually be delivered.
However, government support will not be enough to stave off downgrades for certain high quality portions of the municipal market more acutely affected by the COVID-19 pandemic. In particular, tourism-dependent regions and cities suffering from outmigration – even if only temporarily – will be faced with the difficult choice of cutting services, raising revenues, or relying on additional borrowing.
In our view, even economic recovery will not prevent significant deterioration in sectors that were already facing secular headwinds, including senior living facilities and sales-tax-backed municipals with a strong reliance on brick-and-mortar retail activity. For investors, making the distinction between different credits in these sectors will be critical. As always, there is no substitute for bottom-up credit research in a market with 50,000 issuers from which to choose.
Supply dynamics could change materially
In 2021, the composition of municipal supply could be a key swing factor for high quality muni performance. Last year, taxable muni supply hit an all-time record of $181 billion, due in no small part to the elimination of tax-exempt advance refundings in the 2017 Tax Cuts and Jobs Act (TCJA). The shrinking supply of tax exempts has provided a tailwind to muni market performance, particularly for high quality tax-exempt munis, which have enjoyed a full recovery to pre-pandemic levels.
Although the timing is uncertain, we believe the return of tax-exempt advance refundings is likely in 2021. Notably, Pete Buttigieg, the former mayor of South Bend, Indiana, and now President Biden’s transportation secretary, touted the benefits of advance refunding in his Senate nomination proceedings. Projected to save just $17 billion over a 10-year period in the TCJA, bringing back tax-exempt advance refundings would not be especially costly but would provide additional savings for state and local governments attempting to manage stressed budgets.
The more consequential effect would be on supply dynamics. A return of tax-exempt advance refundings – possibly as part of a comprehensive infrastructure or tax bill – would increase tax-exempt supply and could materially decrease taxable muni supply. Depending on its makeup, a large-scale infrastructure bill could also expand the municipal market as a whole. Increased municipal supply would be welcomed by yield-hungry investors but may require a significant concession from all-time low yields. We see the biggest negative impact from such a policy change on long-duration, AAA and AA rated securities with little yield or spread to cushion the shock.
Select lower-rated credits are well-positioned, but risks remain
While credit spreads for the highest-quality munis have tightened considerably since April 2020, spreads on lower-rated issues have lagged the recovery in other markets and remain at multiyear wides, which is creating opportunities in lower-rated municipal credits. In particular, BBB and high yield credits are attractively valued relative to corporates, with spreads to investment grade munis still well above pre-pandemic levels.
While our baseline forecast for munis is constructive – particularly for lower-rated municipals – there are a number of risks to our view, and high quality (AAA and AA) munis are no longer cheap relative to U.S. Treasuries or U.S. investment grade corporate debt. Fiscal fatigue, prolonged economic scarring, or a rapid rise in rates coinciding with a surge in tax-exempt supply could all threaten to overwhelm already thin broker-dealer inventories that intermediate risk transfers.
For this reason, it’s critical that investors stay ahead of the liquidity cycle, ensuring dry powder is available to take advantage of any potential temporary dislocation.
Higher income taxes may not move the needle
Under the Biden administration, both personal and corporate income tax rates could rise. While this would appear to be a net positive for the municipal market, the effect on municipal demand will likely be modest.
Historically, changes in top marginal tax rates have predicted municipal performance in the following year just 50% of the time. Consider, too, that the break-even tax rate for municipals is anywhere from 25%-30%. That means tax-exempt municipals are already highly efficient for investors in the highest tax brackets – the same high earners President Biden’s tax plan would target.
On the corporate side, banks and insurance companies have been net sellers of munis since passage of the TCJA in November 2017. Under the Biden administration, corporate tax rates could rise to the mid-20% range. That would likely bring banks and insurance companies back into the fold but not in sufficient numbers to replace corporate demand lost after the TCJA. This leaves the high quality muni market structurally more susceptible to price shocks during modest outflow cycles.
While state and local governments will still need to navigate difficult economic conditions in the months to come, municipal credit remains resilient and we believe the municipal market will benefit from vaccine rollouts, economic recovery, and federal policy support. Although we still see value in select lower-rated credits, there are downside risks in the form of rising tax-exempt supply. We believe bottom-up research, careful credit selection, and liquidity management will be keys to investor success in 2021.
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