Municipal bonds delivered mixed performance in the first half of 2020, with the investment grade portion of the market gaining 2.08% and high yield munis down 2.64%.1 The municipal market was waylaid by pandemic-fueled dislocation in the first quarter, resulting in a monthly record $44 billion in municipal fund net outflows in March alone, before federal financial support improved investor confidence and reversed fund flows.2
Unprecedented federal support has improved investor sentiment
The COVID-19 pandemic upended the U.S. economy in the first half of the year, depressing tax collections and straining budgets. With state and local governments implementing sizable austerity measures, federal support has been instrumental in propping up the municipal market. Congress provided emergency relief in the form of the CARES Act, which included $150 billion of grants to state and local governments for COVID-19-related expenditures, as well as billions of dollars in direct aid to municipal issuers – including not-for-profit healthcare facilities, transit agencies, and airports.
Supplementing federal relief measures, the Federal Reserve has provided critical monetary support in several forms, including the Municipal Liquidity Facility (MLF), which was announced in April in order to provide direct loans of up to $500 billion to states and municipalities. The initial eligibility thresholds of the MLF were later modified to include less-populated counties and cities and two revenue-bond issuers per state. However, even after cutting the spread on tax-exempt notes by 50 basis points in August, the MLF remains expensive relative to the public markets, which could limit its utility. In June, Illinois tapped the facility by borrowing $1.2 billion in one-year general obligation notes, and in August, New York’s Metropolitan Transportation Authority became the second issuer to utilize the MLF by borrowing $450.7 million.
While emergency relief and Fed lending programs have helped anchor short-term borrowing rates and have buoyed investor sentiment, federal support is not a panacea for all municipal issuers. Given the severity of the pandemic’s economic shock and the scale of austerity measures, we believe more aid to state and local governments is needed.
Spreads on high quality issues have narrowed, flows have reversed
Record fund outflows, combined with razor-thin broker-dealer balance sheets and concerns about municipal credit risk, led to widening credit spreads in the first quarter of 2020. These trends largely reversed course in the second quarter, which saw improved investor confidence, net inflows, and narrowing spreads for high quality issues. In fact, yields for AAA rated municipals with maturities of less than 20 years have fallen to all-time lows but are still at attractive levels relative to ultra-low Treasury rates.
The story is slightly different farther down the credit spectrum, where high yield and BBB rated issues have not fully recovered and spreads remain wide from a historical perspective. Liquidity, too, remains challenged, with broker-dealer inventory at all-time lows, which presents both a risk and an opportunity for muni investors.
Supply has ramped up, could hit record levels
Municipal supply rebounded in the second and third quarters, spurred in part by low borrowing costs. June alone saw $45.3 billion in municipal new issuance – the highest level since November of 2019 – although taxable issuance accounted for one-third of this total and tax-exempt issuance was muted.3 This is due in part to issuers of tax-exempt debt awaiting details of a long-discussed but still elusive Phase 4 stimulus plan. As issuers learn their fate from Congress, we expect tax-exempt cash flow borrowing to increase heading into the fall. This may pressure short-term yields modestly higher.
We expect taxable supply to remain elevated through the second half of 2020 and into 2021. Because of changes resulting from the 2017 Tax Cut and Jobs Act (TCJA), municipal issuers are refinancing tax-exempt bonds with taxable munis at a record pace. Absent a policy change, this activity is likely to continue and turn 2020 into the largest year of taxable municipal issuance since the Build America Bonds program expired in 2010.
Policy issues loom large
Budget pressures and shifting political winds could mean higher taxes at both the state and local level, which would generally support tax-exempt municipals. Although no one knows for sure how the November elections will turn out, the potential for Democratic control of both the White House and Congress materially increases the chances for higher personal and corporate income tax rates. Higher marginal tax rates could, in turn, spur demand from banks and insurance companies, which have been net sellers of munis since the TCJA was enacted. The potential for meaningful legislation at the state level also bears watching; lawmakers in California are already contemplating higher income taxes and perhaps even a wealth tax to close the state’s rising budget deficit.
Three other policy issues – advance refunding, infrastructure, and changes in state and local tax (SALT) deductions – are on our radar but remain contingent on November’s election results and are not likely to see momentum before 2021.
The 2017 tax bill eliminated the tax-exempt status of advance refunding, which allows issuers to reduce borrowing costs by retiring existing callable bonds at lower rates. Restoring tax-exempt advance refunding bonds is an important priority for state and local officials who were able to save on interest costs under the pre-TCJA tax code. In July, the House advanced a $1.5 billion infrastructure bill that would do that, but the bill has since stalled.
In addition, SALT deductions are currently capped at $10,000 annually under the TCJA. The current caps have fueled demand for tax-efficient sources of income in high-tax states where SALT deductions have the greatest impact but are now curtailed. A restoration of the unlimited SALT deduction would reverse this process and could potentially benefit low- and no-tax state bonds on the margins.
Austerity, slow growth remain headwinds to state and local governments
While few states, local governments, and agency obligors have been spared from the economic repercussions of the pandemic, those that entered 2020 with sizable rainy-day funds and manageable debt levels should be better positioned than issuers without this kind of financial cushion. Regardless, fiscal austerity measures are likely to sap spending and gross investment by state and local governments, which account for more than 10% of U.S. GDP.
We anticipate a long and gradual economic recovery in the coming years, with pre-COVID-19 growth levels not returning until 2022 at the earliest. Correspondingly, we believe the Fed will keep interest rates at current levels into 2023, which should support municipal demand.
Students, parents, and teachers are also grappling with the issue of returning to traditional classroom settings. While these decisions are likely to be localized, a long-term shift toward remote learning is already underway and will likely pressure less-selective higher-ed institutions with modest endowments.
Defaults may rise, but credit quality is key
Against this market backdrop, bonds issued by essential-service and high-demand service providers are likely to attract investor attention. Examples include large not-for-profit healthcare systems, waste, water, and utilities, well-funded public universities, toll authorities, and large hub airports. Conversely, continuing-care retirement communities, retail-focused developments, and student housing may face an uphill climb.
Although we do not expect to see a large wave of municipal defaults, we would not be surprised to see municipal default rates edge up to the 0.50%-1.00% range over the coming year. Here some context is order. From a long-term perspective, municipal defaults are relatively rare – in part due to the flexibility that state and local governments have in raising revenues. From 1970-2018, the average annual municipal default rate was 0.015%. This increased to 0.27% following the recession of 2009-2010 but still represents a low figure relative to other asset classes.4
By and large, we expect most defaults to be contained to lower-rated issues and severely affected sectors. For most munis, including state and local governments, the next several years will be a story of austerity and modest downgrade pressure, rather than defaults.
Potential investment opportunities
Given these expectations, we see several areas of opportunity for investors:
- Longer-duration bonds: The Fed’s lending programs have largely focused on maturities of fewer than 36 months. However, the municipal bond market has an average maturity of approximately 12 years, and many issuers prefer to issue 30-year fixed-rate bonds. Recent Fed activity has led to a steepening of the yield curve and could present return opportunities in longer-dated bonds.
- Select BBB/BBs: While credit spreads for the highest-quality munis have tightened considerably since March, spreads on lower-rated issues have lagged the recovery in other credit markets and are at multi-year wides. As such, we see value in select bonds rated BB and BBB that can withstand stress tests for a slower economic recovery.
- Taxable munis: Taxable issuance has spiked as tax-exempt issuers remain on the sidelines in hopes of a Phase 4 stimulus bill. Due to elevated issuance, investors may want to keep an eye on taxable municipals, which are priced attractively relative to similarly rated corporate bonds.
Although state and local governments face budget pressures, many of these same issuers have policy levers that position them to weather economic stresses, which should bode well for the municipal markets over the long haul. And while default rates may rise and liquidity challenges remain, rising state and federal taxes and low interest rates should support municipal demand, as investors search for high quality, tax-efficient income in a low-rate world.
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